Big Banks Move to Mask Risk Levels

Quarter-End Loan Figures Sit 42% Below Peak, Then Rise as New Period Progresses; SEC Review

By KATE KELLY, TOM MCGINTY and DAN FITZPATRICK



Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York.



A group of 18 banks—which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc.—understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.



Excessive borrowing by banks was one of the major causes of the financial crisis, leading to catastrophic bank runs in 2008 at firms including Bear Stearns Cos. and Lehman Brothers. Since then, banks have become more sensitive about showing high levels of debt and risk, worried that their stocks and credit ratings could be punished.



That practice, while legal, can give investors a skewed impression of the level of risk that financial firms are taking the vast majority of the time.



"You want your leverage to look better at quarter-end than it actually was during the quarter, to suggest that you're taking less risk," says William Tanona, a former Goldman analyst who now heads U.S. financials research at Collins Stewart, a U.K. investment bank.



Though some banks privately confirm that they temporarily reduce their borrowings at quarter's end, representatives at Goldman, Morgan Stanley, J.P. Morgan and Citigroup declined to comment specifically on the New York Fed data. Some noted that their firm's financial filings include language saying borrowing levels can fluctuate during the quarter.



"The efforts to manage the size of our balance sheet are appropriate and our policies are consistent with all applicable accounting and legal requirements," a Bank of America spokesman said.



An official at the Federal Reserve Board noted that the Fed continuously monitors asset levels at the large bank-holding companies, but the financing activities captured in the New York Fed's data fall under the purview of the Securities and Exchange Commission, which regulates brokerage firms. The New York Fed declined to comment.



The data highlight the banks' levels of short-term financing in the repurchase, or "repo," market. Financial firms use cash from the loans to buy securities, then use the purchased securities as collateral for other loans, and buy more securities. The loans boost the firms' trading power, or "leverage," allowing them to make big trades without putting up big money. This amplifies gains—and losses, which were disastrous in 2008.



According to the data, the banks' outstanding net repo borrowings at the end of each of the past five quarters were on average 42% below their peak in net borrowings in the same quarters. Though the repo market represents just a slice of banks' overall activities, it provides a window into the risks that financial institutions take to trade.



The SEC now is seeking detailed information from nearly two dozen large financial firms about repos, signaling that the agency is looking for accounting techniques that could hide a firm's risk-taking. The SEC's inquiry follows recent disclosures that Lehman used repos to mask some $50 billion in debt before it collapsed in 2008.



The practice of reducing quarter-end repo borrowings has occurred periodically for years, according to the data, which go back to 2001, but never as consistently as in 2009.



The repo market played a role in recent accusations leveled by an examiner in Lehman's bankruptcy case. But rather than reducing quarter-end debt, Lehman took steps to hide it.



Anxious to maintain favorable credit ratings, Lehman engaged in an accounting device known within the firm as "Repo 105" to essentially park about $50 billion of assets away from Lehman's balance sheet, according to the examiner. The move helped Lehman look like it had less debt on its books, the examiner said.



Other Wall Street firms, including Goldman and Morgan Stanley, have denied characterizing their short-term borrowings as sales, the way Lehman did in employing Repo 105. Both of those firms also make standard disclaimers about debt.



For instance, Goldman disclosed in its 2009 annual report that although its balance sheet can "fluctuate," asset levels at the ends of quarters are "typically not materially different" from their levels in the midst of the quarter. Total assets at the end of 2009 were 7% lower than average assets during the year, the report states.



Some banks make big trades that don't show up in quarter-end balance sheets. That is what happened recently at Bank of America involving a trade designed to mature before the end of 2009's first quarter, people familiar with the matter say.



Two Bank of America traders bought $40 billion of mortgage-backed securities from clients for one month, while at the same time agreeing to sell the securities back before quarter's end, according to people familiar with the matter. This "roll" trade provided the clients with cash and the bank with fees.



Robert Qutub, then Bank of America's chief financial officer for global markets, told Michael Nierenberg, a former Bear Stearns trader who oversaw the traders who made the roll trade, to cap the size of the short-term transaction, people familiar with the matter say.



A week later, however, the amount tied to the trade shot up to $60 billion, these people say, before dropping to $25 billion, one of these people said, appearing to some at headquarters that the group had defied the order to cap the trade.



A bank spokeswoman said "the team was aware of and worked within its risk limits."