What Fines Mean for Wells Fargo and Citigroup

By Maxwell Fisher - May 7, 2012 | Tickers: C, NES.DL, UBS, WFC | 0 Comments

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When, oh when, will they ever learn? Banks of over $50 billion in assets are being watched. Banks of over $500 billion in assets, and there are only four of those in this country, are being watched like hawks. This week, two of the “big four” U.S banks, along with one huge international European based bank and another large domestic bank, were fined for selling inappropriate securities to their customers. The banks involved in having their wrists slapped to the tune of a $9.1 million total in fines and restitution were Morgan Stanley (NYSE: MS), Citigroup (NYSE: C), Wells Fargo (NYSE: WFC) and UBS (NYSE: UBS). The fines were levied by the Financial Industry Regulatory Authority (FINRA) and not by any sort of outside group or the legal system.

Exchange Traded Funds are common place in this day and age, and are the current equivalent of old school index funds. They are plain, simple to understand, and typically involve lower risk to an investor than choosing individual equities. But these ETF's have “evil variants” if you will, that turn them on their heads into exceptionally risky investments. Specifically, the banks at issue were selling inverse and leveraged ETF's to their retail customers. The leveraged ETF's of course, simply worked to exacerbate the performance of the underlying ETF. The inverse funds utilize a maze of derivatives and short sales to obtain the reverse result, or even a leveraged reverse result of the underlying ETF. FINRA cites additional risk to the longer term investor, because these nontraditional ETF's prices reset daily. Looking at the time period from December 1, 2008 to April 30, 2009, during which the Dow Jones Oil and Gas Index advanced 2%, a twice leveraged ETF fell 6%, and a twice inversed ETF fell 26% in the same period.

This all goes back to the repeal of the Banking Act of 1933, 48 Stat. 162 (1933), better if less accurately known as the Glass Steagall act. The old legislation's stated purpose was to eliminate speculation in banking and came out of the stock market crash of 1929.  It specifically disallowed connections between commercial banks and securities dealers. Its death knell came in 1998, when the Federal Reserve's warped reading of the Banking Act allowed for Citigroup to buy what was then known as Salomon Smith Barney. Congress codified the Federal Reserve's actions into law in 1999 when the official repeal of Glass Steagall was signed by President Clinton. Its repeal made the very psychology of banking change to accept more risk, and I believe that was a substantial underlying cause of the banking and credit crisis last decade.

The banks at issue neither admitted nor denied the allegations, though they obviously accepted the results of the investigation. The report also stated that investigations on this matter were ongoing and that additional fines at other banks are possible.

Wells Fargo's involvement in this mess goes back to its acquisition of Wachovia. Over the long run, I expect this will prove to be the best large bank merger of the late 2000's, but it has not been without its headaches. Wachovia was fined over $4 million in 2009 for failing to maintain adequate supervisory or compliance oversight. Much of this type of lack of supervision was obviously not immediately corrected, and for that, FINRA levied a $2.1 million fine, and ordered another $641,000 in restitution. This overall cost to Wells Fargo of some $2.74 million represents almost 2/10 of one percent of its 2011 profits.

So far this year, Citigroup has been fined $725,000 in January for failing to disclose a potential conflict of interest, $158 million in February for fraudulent mortgage applications, $600,000 in fines, plus another $648,000 in restitution in March for excessive securities mark ups. Of course, the malfeasance that leads to these fines was not usually not committed in 2012, but the by month progression of fines is simply absurd, and emblematic of the culture of reduced regulation that the repeal of Glass Steagall engendered. FINRA found Citigroup had not trained its staff properly, and sold nontraditional ETF's in inappropriate situations. FINRA fined Citigroup $2.0 million, and assessed another $146,000 in restitution.

UBS is Europe's third largest bank, and was named recently by the international Financial Stability Board as among the 29 global banks too big to fail. Its main retail presence in this country arrived via its purchase of the former Paine Webber brokerage. Maybe following trading rules may not seem so important to a bank whose lack of internal controls allowed for a $2 billion rogue trading loss in 2011. UBS was fined by FINRA for essentially not fixing its pattern of lackadaisical oversight and inadequate training of its brokers that led to a nearly $11 million fine in April, 2011. Specifically in this matter, FINRA used examples of conservative retiree type investors who were sold these nontraditional ETF's and suffered sizable losses, in one case 43% of the principal. UBS was fined $1.5 million, plus ordered to pay $431 thousand in restitution

Morgan Stanley is a trust bank, and as such I believed it should really be above this sort of abuse at the retail level. I believed wrong. Though one might think that retail compliance and supervision issues are traceable back to Morgan Stanley's 2009 shotgun wedding merger with Citigroup and Smith Barney, that too is incorrect. Morgan Stanley's list of compliance and supervisory fines is not a long one, and is highlighted by a $5 million fine and restitution package in March, 2009, stemming from the firm's failure to properly train, monitor, or supervise brokers selling inappropriate securities to retirees. FINRA found Morgan Stanley failed to monitor nontraditional ETF's any differently than regular ETF's and brokers sold such nontraditional securities to individuals of limited worth, and well beyond retirement age. Both these buyers lost over $10,000 each. Morgan Stanley was fined $1.75 million, and ordered to pay an additional $605,000 in restitution.

In a perfect world, I believe we would separate banking from securities and insurance. Yet, at the very least, a thorough regulatory environment, with meaningful penalties for failures, must be enforced.  While these fines, ranging in the millions, are a "wrist slap," I do anticipate that these types of fines could be a cost of doing business for these banks.  Accrued over a longer period of time, the impact on earnings, although slight, could still be material.  For now, I am highlighting an issue about wihch investors in financials should be aware and to monitor.  No need to sound the alarms just yet but I do think the higher uncertainty could ultimately lower the earnings multiples that investors are willing to assign to these specific stocks.

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