Huffpost Business
The Blog

Featuring fresh takes and real-time analysis from HuffPost's signature lineup of contributors

Lawrence G. McDonald Headshot

A Big Week for US Banks: The Difference Between Good and Evil Proprietary Trading

Posted: Updated:
This week marks a turning point in the recovery from the "Great Recession." The Financial Stability Oversight Counsel will release an 80 page draft of "recommendations" on the Volcker Rule to the Federal Reserve. The main objective? Prevent the next Lehman Brothers. The head of this counsel is none other than Tim Geithner. You know, the man who was in charge of the New York Fed as Lehman tripled the size of it's balance sheet risk 2003-7. According to The Economist, the ten biggest banks all doubled the size of their balance sheets during this period. The main topic at hand will be persistent watering down the Volcker Rule. The Volcker Rule is a proposal by the lovable American economist and former head of the Federal Reserve Paul Volcker. The idea was to restrict large US financial institutions from making certain kinds of speculative investments, "proprietary trading" if they are not on behalf of their customers. Over the last 18 months, this Volcker Rule has gone from an outright ban on proprietary trading and ownership hedge funds at big banks, to be just a shadow of its original vision. I predict this week we will see yet more dilution of the original intent of this rule. The banks will be the big winners and they have Republicans on Capitol Hill to thank. I must say I offer a unique perspective on this topic, after all I was a prop trader at Lehman Brothers during the financial crisis and I'm actually talking. Needless to say, Wall St. is invested in silence. I delivered over 30 keynote speeches last year on this topic, I am not invested in silence. I'm here to tell you how it really works. The Good Proprietary Trading and Evil Regulators must understand there are two vastly different types of proprietary trading. In what I call "good" prop trading a trader is taking directional risk with some of his trading ledger and "facilitating" client orders with the rest. Let me explain, I used to trade all the Airline corporate convertible debt for Lehman, I would have dozens of long and short positions. Long Delta Airlines short Jetblue, long Northwest, short Frontier for example. I would use my long and short positions to make markets for customers. Sure I would take directional bets on long positions we believed in, but the fundamental purpose was to provide markets for customers of the firm, the Fidelitys and T Rowe Prices of the world. This is good clean business and has been around for decades. Things went wrong around 2004, where more and more investment banks started to use their balance sheets to make directional bets in SIZE. Lehman had for that 30% of its net tangible equity in 3 commercial real estate bets. The joke around the firm was that we had become a Real Estate Investment Trust REIT with an investment bank on the side. In my book. A Colossal Failure of Common Sense I point out that some of our biggest risk positions in the firm were not counted in our VAR risk models. At Morgan Stanley, one mortgage backed security trader cost the firm almost $8 billion in one giant CDO position. These "colossal" trades were NOT put on to "facilitate" customer orders. These were pure massive bets with the taxpayer on the other side of the trade if things went wrong. At Lehman we had micro management of risk in some parts of the firm and the wild west in others. This is what the regulators must stop if we're going to prevent the next Lehman Brothers from destroying our global economy again. The New Face of the Volcker Rule According to my friends at DCTripwire.com, the focus of the FSOC Financial Stability Oversight Counsel's draft won't be trading desk specific (as some had feared) but the new face of the Volcker Rule will be a firm wide look at proprietary trading risk. Likewise, banks can get wiggle room if they can justify client trading facilitation. In other words, what is not allowed at one firm may be allowed at another. A JP Morgan research report I read this weekend estimates the new Volcker Rule will slice 14% off Goldman Sachs earnings in 2012. Goldman has looked much more like a hedge fund in recent years than an investment bank, that's about to change. But remember, all we will see this week that's new will be recommendations from the FSOC, the Fed will write the rule over the next nine months. Some people feel that US banks will be disadvantaged to foreign banks where their new regulations may not be as onerous. I say the Canadian and Australian banks with much tighter risk taking controls came out smelling like roses in the financial crisis. How's that for a "disadvantage"? In the end the SEC now estimates it needs 800 additional personnel to meet its expanded duties under Dodd-Frank, but what people are Not focused on is the Republicans now control the funding. Thomas A. Edison once said "an opportunity is missed by most people because it is dressed in overalls and looks like work." And there is a lot of work to be done. This week marks six month anniversary of Dodd Frank passage. Of the 243 new rules mandated, 80 rules proposed, 28 have been approved so far. The Latest in Europe We will know more this week out of the European Union as the European Systemic Risk Board will hold their first meeting. I think what we're seeing in Europe in the financials may be a look into the future for the US. In recent years on our side of the pond credit spreads on US bank debt were very tight to treasuries as the Greenspan and Bernanke puts were priced into the corporate bond markets. Too big to fail banks debt traded with very little risk premium because the market perceived these institutions would be bailed out. Haircuts? What we're seeing in Europe recently paints a starkly different picture. The iTraxx Senior Financial Index (a basket of European bank debt) which was trading with an 80 basis point spread over treasuries in January 2010, is now through the June 2010 wides, trading 200 ish over treasuries (200 basis points = 2%). Translation, haircuts are starting to be priced into European bank debt in a big way. The Rise of Eastern Europe or the fall of the West? On the sovereign debt front, it's interesting to note that last week the SOVx WE (Index of Western European Government Bonds) traded wide of the SOVx CE (Index of Eastern European Government Bonds) or the first time ever. Case in point, Spain was trading wider than Croatia and Romania, ouch. Investors see more risk in Western Europe than Eastern Europe, so much for the Iron Curtain. What a difference a year makes, SOVx WE started 2010 only 81 basis points over treasuries vs. 210 last week. Other Volcker Rule Facts
  • Volcker Rule: modified from its initial form to include multiple exceptions for permitted activities, as well as "de minimus" allowances for investments in hedge funds and private equity. While proprietary trading was also more specifically defined based on what has been commonly referred to as the Merkley-Levin amendment, there is still a fair amount of regulatory discretion provided during the rulemaking phase.
  • "De minimus" investments may be made in hedge funds and private equity funds, so long as the banking entity does not have more than 3 percent of total ownership of the fund and that investment does not represent more than 3 percent of its Tier 1 capital. There is a 2 year phase-in, with Federal Reserve approval for these investments.
  • The Dodd-Frank Act states that rulemaking to implement the new restrictions must occur within 9 months of completion of the study listed above.
  • Affected institutions will have 2 years to conform to the new restrictions, with the ability to appeal to the Federal Reserve for extensions each year, for up to 3 years. There is the potential for a maximum of a 5 year phase-in period, subject to Federal Reserve approval.
  • For illiquid funds, the period can be extended by the Federal Reserve up to 5 years, from having a contractual obligation in effect on May 1, 2010.
  • Firms can be asked to raise additional capital during the phase-in period, starting 15 months after the bill's enactment.
  • The Act calls for banks to hold more money as a cushion against risks, but it doesn't say how much.
  • It also was mum on the amount of cash that firms dealing in derivatives need to set aside in case those bets sour.