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The Ethical Investor: Wall Street Ripoff #9 - Convincing You That Their Bank Is Stable and Safe

10/26/2012 08:40 am ET | Updated Dec 26, 2012

One of the advantages that small investors cite as to why they continue to deal with Wall Street's large banks after how they were treated in the crisis is that they like dealing with large, reputable well-capitalized institutions that they are certain will be around in ten or twenty years.

Nothing could be further from the truth. These banks, even the largest ones are anything but stable, conservatively financed institutions. Almost all of the largest US banks are trading at substantial discounts to their book value. Why? Investors are convinced that the banks still have not come completely clean about all their bad loan losses. If these losses were recognized, the banks' book value would decline and come in line closer to the market determined value.

Also, many are starting to wonder if the long term operating strategy of banks makes any sense. Banks want to remain leveraged at 20 to 30 to one, debt and deposits to equity, once you count all their assets and not just what they call "at risk" assets. But, this makes little sense in a world fraught with risk. With such large leverage, if just one out of every thirty loans goes bad, the bank ends up burning through its entire equity base and faces insolvency. I have never met a commercial banker who could make ten good loans in a row without a clunker, much less twenty or thirty in a row. And banks continue to borrow very short term in the commercial paper and overnight repo markets so when things start to go bad they will escalate very quickly.

Of course, the bankers want this high leverage because it juices their returns on the upside and they figure they will always have the taxpayer to bail them out when things go wrong. Bankers get paid big bonuses to put loans on the books and they have long retired to Southampton by the time the loans get in trouble in any future economic downturn.

The fact of the matter is that without leverage, bankers cannot justify their existence. Who would invest in a bank to realize a 1% to 2% return on their investment given the risks if there were no leverage driving their returns up to 10% to 15% per year. The answer is no one. Banking is not a viable long term industry. It depends for its existence on government subsidies and taxpayer bailouts. FDIC insurance keeps depositors thinking their deposits are safe so they ask for a less than market required rate of return, debt investors look for the next bailout and the Fed, completely in the pocket of the bankers, keeps rates at whatever level that maximizes returns to bankers regardless of how much it harms savings levels in the country and retired folks living on their investment income.

The biggest US banks are huge institutions with over $2 trillion or $2,000 billion in assets each. But, their market equity is very small, often less than 5% of that amount. They are always one new crisis from insolvency. While they still haven't recognized all their bad mortgage loans from the housing crisis which is now six years old, they have to look forward to losses from investments and loans to other banks that are in trouble as well as loans to over-leveraged sovereign governments around the world, especially in Europe.

And I haven't even mentioned derivatives yet. The largest US banks report derivative exposures of under $100 billion, but this is nonsense. They are allowed by captured regulators and the Fed to report their derivative exposures on a net basis which assumes that there is no counterparty risk and that everything will get netted out quite nicely in the next downturn. In actuality, the big US banks have tens of trillions of derivatives on their books and even they don't know how to measure their risk. The fact that they handle Credit Default Swaps (CDSs) the same as Interest Rate Swaps tells you they don't understand the first thing about risk management. When an interest rate swap contract fails, the bank could lose 1% or 2% of the notional amount of the contract, when a CDS contract fails or pays off the bank could lose 100% of the covered amount.

No, there is no reason to assume these big banks will be around in the long run. Therefore, do not take comfort that your money is safe with them. If you have less than $250,000 in an FDIC insured deposit account, then at least you have the US standing behind the claim. But, otherwise, beware. And when one of them goes, as we saw in the last crisis, they all go.

20 Ways Wall Street is Ripping Off Small Investors

  1. Providing nominal returns, not real returns.
  2. Encouraging too much diversification, if that's possible.
  3. Hiding fees and expenses.
  4. Turning you into a passive investor.
  5. Convincing you that money markets are the same as cash.
  6. Telling you that bonds are safer than equities.
  7. Explaining that in the long run equities outperform bonds.
  8. Simply by lying about their products.
  9. Convincing you that their bank is a large, stable, safe operation to deal with.
  10. Recommending products that have enormous sales commissions attached to them.
  11. Cheating you on bid/ask spreads.
  12. Selling you what they don't want.
  13. Measuring your success in dollars.
  14. Lending your securities to others.
  15. Ripping your eyes out if you ever try to close your account.
  16. Grabbing any slight positive real return for themselves.
  17. Sticking toxic waste to small investors.
  18. Pretending they can pick stocks.
  19. Acting like they are your best friend and they have your best interests at heart.
  20. Knowing next to nothing about the value of holding real assets like gold and real estate.

Content concerning financial matters, trading or investments is for informational purposes only and should not be relied upon in making financial, trading or investment decisions.

John R. Talbott is a bestselling author and financial consultant to families whose books predicted the housing crash, the banking crisis and the global economic collapse. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com