My idea of New York, and by that I mean the controlling interest there, is that they sit back and look upon the rest of the country much as Great Britain looks upon India.
Senator Henrik Shipstead, Minnesota, 1922
In the middle of 2011, Bank of America (NYSE: BAC ) settled an otherwise nondescript lawsuit with the City of San Francisco for the paltry sum of $5 million. The case involved allegations that the bank colluded with competitors to force customers into arbitrating credit card disputes before the National Arbitration Forum, a private mediation company claiming to be a "fair, efficient, and effective system for the resolution of commercial and civil disputes in America and worldwide."
What was the city's beef? Virtually every case heard by the NAF was decided in favor of the bank and its brethren, who, not coincidentally, also financed the mediator's highly profitable operations. While few people would deny that appearing to rig an arbitration forum like this violates deep-seated notions of fair play and substantial justice, what makes this case even worse is that it's merely one in a vast series of systematic business practices employed by the nation's largest lenders over the years to unjustly tilt the financial system in their favor.
A laundry list of systematic deceit
Few practices illustrate the systematic nature of deceit that prevails at the top of the banking industry better than the "credit protection" services thrust upon unwitting customers until federal regulators and private lawsuits led banks to effectively do away with the vacuous services.
The structure of the scheme was simple. Banks used aggressive marketing techniques to persuade customers into paying monthly fees akin to insurance, covering the customer's minimum credit card payments in the event of an illness, death, disability, or job loss. Sounds pretty good, right? The problem is that banks including Capital One Financial (NYSE: COF ) , Citigroup (NYSE: C ) , and Bank of America, among others, are alleged to have involuntarily enrolled customers in the programs while, at the same time, systematically refusing to honor the commitments based on indecipherable legalese in the service contracts.
According to legal filings in a case against Bank of America, one man paid the bank more than $700 for the service even though he never knowingly enrolled in it. When he called to terminate the charges and request his money back, the customer representative wouldn't approve a refund. The estate of a Korean War veteran who passed away from lung cancer was denied coverage because his death wasn't "accidental." And a woman who lost her job as a medical transcriptionist was denied benefits because her unemployment was not caused "exclusively by business bankruptcy, failure or loss of required equipment to conduct business, or damage to the business premises caused by fire, theft, or natural disaster."
Just to reiterate, assuming the allegations made by innumerable bank customers in myriad court filings and cases are to be believed, which isn't unreasonable given the hundreds of millions of dollars paid by the industry to resolve the claims, then these were officially sanctioned programs replete with salespeople and customer service representatives. And if the allegations are to be believed, the practices were intentionally designed to mislead customers into enrolling in the programs, whether they ultimately consented to do so or not, and then to deny benefits when ostensibly qualifying calamities occurred.
Another example of how the nation's biggest banks have systematically exploited their customers over the years involves the way debit-card overdraft fees were assessed until the industry succumbed yet again to pressure from federal regulators and private legal action.
Starting around 2001, the nation's biggest banks implemented automated overdraft programs that allowed customers' charges to go through even if they didn't have sufficient funds in their accounts. The catch was that customers would be assessed a fee ranging from $10 to $38, with a median of $27, each time an overdraft occurred. Fair enough, right? If you're not able to keep track of your account balance, then your bank should have every right to exact a fee in the event that it's required to cover the overage with its own capital.
But here's the thing: The automated systems were programmed to reorder daily transactions from largest to smallest, and not, as fairness and common sense seem to dictate, chronologically. For example, say a customer had an account with a $50 balance and made four transactions of $10 in the morning and one later transaction of $100 in the evening of the same day. In this case, the bank's automated program would debit the $100 transaction first, despite the fact that it actually occurred last, and by doing so subject the customer to five overdraft fees instead of one. The net result of this practice was that overdraft charges were commonly assessed at times when, but for the chronological manipulation, there would have been funds in the account, and thus no overdraft would have occurred.
I could go on and on with examples. In Bank of America's case alone -- and, for the record, while the Charlotte-based bank may be the worst offender in this regard, it's far from an exception -- I recently counted more than 40 legal settlements and judgments stemming from practices like these in the six years spanning from the beginning of 2008 to the end of last year.
To pick out only the most notable, in 2009, Bank of America settled with the SEC over charges that it "misled investors regarding the liquidity risks associated with auction-rate securities," a type of investment that banks allegedly marketed as equivalent to cash in terms of safety until, of course, it wasn't. One year later, it paid restitution for its part in a "nationwide scheme, including bid rigging and other anti-competitive conduct that defrauded state agencies, municipalities, school districts and nonprofits in their purchase of municipal bond derivatives." And in 2012, Bank of America joined four other mortgage servicers to resolve allegations that they routinely submitted fraudulent documents in court-administered foreclosure proceedings in the wake of the financial crisis.
Six blind men describing an elephant
Over the last five years, there's been no shortage of analysts and commentators (including myself) who have derided the nation's biggest banks for any number of misdeeds. What's been missing, however, is a coherent narrative that ties these disparate acts together -- and particularly one that doesn't rely on the facts underlying the financial crisis. In this way, it's like the ancient Indian parable about six blind men charged with describing an elephant to the king. Each feels a different part of the animal only to find out that his description doesn't comport with that of the others.
My point in this column was to avoid the same pitfall. As I hope I have demonstrated, and as students of financial history won't be surprised to hear, the picture that emerges when all the pieces are put together is one of a banking system replete with subtle deceit and trickery; one that's geared toward exploiting the very customers upon which the nation's largest lenders rely. It's an unfortunate narrative to be sure, but it's nevertheless one that can be combated on an individual basis so long as you're aware of its tricks and traps.
For investors, meanwhile, the takeaway is straightforward. It's often said that what can't go on forever, won't. This is why investors should always favor the highest quality financial institutions. Those that have proven themselves through multiple cycles to be the very best, not only at accumulating market share but also at satisfying their customers.
It's for this reason I'd strongly encourage anyone with an inclination toward bank stocks to download our invaluable free report about the one big bank that's built to last. In it, our top analysts detail one financial institution that investors as sophisticated as Warren Buffett are confident will survive and thrive for decades to come. To access this free report instantly, simply click here now.