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
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In that scenario, Lehman had begun to invest in itself. It wasn't betting that favorable outcomes would occur: rather, it was using its own financial power to cause those favorable outcomes to occur. It was no longer the Agent: it was the Producer and the Consumer too. It no longer just owned the Casino; it played.
From a regulatory perspective, trying to exclude the particular methods by which Lehman accomplished this very-profitable (for it...) feat, would be plugging holes in a leaky dike with your fingers. But to say, "you are not allowed to get your company into such-and-such a position, by whatever means you do so," can be spelled out in thirty pages.
For example, the Glass-Steagall Act, which I still consider to be one of the smartest business rules ever made. (You might disagree.) Yes, enough financiers considered it to be "stultifying" for them, but the scenarios that erupted, the moment they ceased to be illegal, have ruined the finance, banking, AND insurance industries in less than twenty-five years' time.
"A brokerage may not own a position in what it brokers, but may profit only from commissions." A one-page law could be made from that sentence, and it would do a world of good.
There are a couple of topics I wish the writer would cover.
First, what effect the tougher regulations elsewhere, say with regard to the Swiss banks, will have on U.S. banks if any. Will tougher capital requirements elsewhere ever tlow through to the Fed's thinking?
How will the U.S. banks with overseas operations be able to skirt the new Resolution authority of the FDIC & Fed?
"The future value of an asset is what a willing buyer would agree to pay a willing seller, at a definite date in the future, for a definite delivery at that time, if both buyer and seller were equally exposed to the risks inherent in such a transaction ... having hedged or insured themselves against said risks in whatever manner they deem to be prudent." Provided that (as Glass-Steagall demanded) "the provider of that insurance may have no material or fiduciary part in the transaction being insured." That's not flim-flam either.
To say, "it's worth what I say it is, because I say it is" ... that's the ultimate definition of flim-flam, and that's precisely what we have. The fact that someone who's spouting lies at you, is wearing a $5,000 Armani suit while he is doing so, does not make that man any less a liar.
Goldman Sach's partners are its highest executives and its biggest stars. An examination of filings by The New York Times reveals the power and wealth of this secretive group. http://www.newslook.com/videos/284625-the-golden-ticket-at-goldman-sachs?autoplay=true