These Banks Are Scarier Than Halloween

I've said it before and I'll say it again, nothing has changed in banking. And that's downright scary.

While the failure of Lehman Brothers was certainly frightful at the time, it apparently didn't shake things up enough. Sure, it brought about a lot of jawboning about banks being "too big to fail" and the danger of their opaque trading segments. But did anything really come of it?

Fast-forward to today and what we find are huge financial institutions -- some, like JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC), even larger thanks to government-led acquisitions -- making most of their money in the dark corners of their business. A glance at earnings reports from Goldman Sachs (NYSE:GS) and JPMorgan show booming business in heavily cloaked trading. Even more traditional banks like Wells Fargo (NYSE:WFC) are finding ways to pull in money through avenues like hedges on mortgage servicing rights.

If you enjoyed the gut-wrenching revelations that seemed to come daily during the financial crisis, then you can go about your merry way. But if you'd rather avoid a second showing of that horror flick, then all of the above should be very worrisome.

But all is not lost, because there are plenty of ways that Uncle Sam can step in to help turn down the fright-o-meter.

Hair-raisingly huge
Huge banks are not our friend, because, as the hackneyed saying goes, "the bigger they are, the harder they fall." Here's a look at some of the largest U.S. financials by assets:

Source: Capital IQ, a Standard & Poor's company. Fannie Mae assets as of 6/30/09.

It's OK for Coca-Cola (NYSE:KO) to have far-reaching global operations and to command a significant percentage of the fizzy-beverage market, because a small misstep by Coke won't result in a meltdown that could imperil the U.S. or global financial system. The latter, however, is a real risk when it comes to huge global banks, so capping how large a financial company can get would be a prudent move.

Leery about leverage
Another way we can look at the fright factor of the financial industry is by checking out the leverage that these companies employ. As a company stacks more assets on top of its shareholder equity cushion, it starts to look more and more like the final stages of a Jenga game -- ready to be toppled by even one poorly timed movement.

Source: Capital IQ, a Standard & Poor's company. MetLife and AIG leverage ratios as of 6/30/09.

These leverage levels are a far cry from what we saw at the height of the bubble (Merrill Lynch was at 28-to-1 in September 2007), but I'd bet my lucky Chewbacca action figure that without strict regulations these levels will start to creep right back up as soon as the companies see opportunity to cash in with more leverage. Case in point, after dropping considerably, Morgan Stanley's leverage ratio has risen each of the past two quarters.

Fear of the dark
During the third quarter, Goldman Sachs generated more than $12 billion in revenue and more than $3 billion in net income. Anyone want to tell me how it did that? If you have an answer, you're either guessing or you work there and are divulging company secrets.

Don't get me wrong, I understand the argument for proprietary trading secrets. I'd also say that I'd be fine with my son doing science experiments in his room with the door closed. However, as soon as he sets his bed on fire by experimenting with lighter fluid, an open-door policy would be the new law of the land.

I think it's high time for an open-door policy in the financial industry. It's better for shareholders, it's better for customers, and it's better for the financial system as a whole.

Harboring the haunted
The bottom line for investors in banks is to stay quick on your feet. Whether or not the changes I've suggested above come to pass, it's very likely that Uncle Sam is going to take some sort of action that could very well chop some of the value off of some of the largest banks.

At the same time, until we get better transparency from the major financial institutions, it's hard to tell what exactly some of them are doing to earn their huge bottom-line profits. While the "well, they're making money so they must be doing something right" philosophy might work for a while, unless you know which earnings streams are sustainable and which ones aren't, you may be setting yourself up for a bone-chilling fright if some of those trading strategies start looking like profit-devouring zombies.

Think you have better ideas to address problems in the financial system? Scroll down to the comment section and share your thoughts.