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The Volcker Rule & AIG: It’s Not About Prop Trading
Watching the President announcing his proposals to forbid commercial banks from engaging in proprietary trading, I am reminded of the reaction by Washington a decade ago to the Enron and WorldCom accounting scandals, namely the Sarbanes-Oxley law. The final solution had nothing to do with the problem and everything to do with the strange politics of the capital city and the national Congress.
The basic problems of the Enron/WorldCom scandals was financial fraud and the use of off-balance sheet vehicles to commit same. By responding with more stringent corporate governance requirements, the Congress was seen to be responding -- but without harming Wall Street’s basic business model. In that regard, note that today former SEC chairman Bill Donaldson was standing next to President Obama on the dais, along with Paul Volcker and Treasury Secretary Tim Geithner.
A decade on, we have the same basic problem, namely the use of OBS vehicles and OTC structured securities and derivatives to commit financial fraud via deceptive instruments and poor or no disclosure. Author Martin Mayer teaches us that another name for OTC markets is “bucket shop,” thus the focus on prop trading today in the President’s comments was entirely off target. The Volcker Rule, at least as articulated today, does not solve the problem. And what is the problem?
The poster child victim for this latest round of rape and pillage by the large dealer banks is, of course, American International Group (AIG) along with many, many other public and private Buy Side investors. The FDIC and the Deposit Insurance Fund is another large, perhaps the largest victim of the structured finance shell game. Prop trading was not the problem with AIG nor the cause of the financial crisis, but instead the rancid production from the securities underwriting side of the business.
Not a single major securities firm or bank failed due to prop trading during the past several years. Instead, it was the customer side of the business, usually the mortgage conduit, that was the problem, the securities underwriting side of the business that the Volcker Rule conveniently ignores. And this is the one area that you will most certainly not hear President Obama or Bill Donaldson or Chairman Volcker or HFS Committee Chairman Barney Frank mention. You can torment prop traders, but leave the syndicate desk alone.
The dealers, starting with Goldman Sachs (GS) and Deutsche Bank (DB) were seemingly sucking AIG’s blood for years, one reason why the latest response by Washington has nothing to do with either OTC derivatives, structured assets or OBS financial vehicles. And this is why, IMHO, the continuing inquiry into the AIG mess presents a terrible risk to GS, DB and the other dealers, especially when you recall that the AIG insurance underwriting units were lending collateral to support some of the derivatives trades. Deliberately causing a loss to a regulated insurance underwriter is a felony in New York and most other states in the US. Thus the necessity of the bailout.
If you accept situations such as AIG and other cases where Buy Side investors (and, indirectly, the US taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype “problems” that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles.
Neither prop trading nor market share are the causes of the financial crisis. Instead, opaque OTC markets, deliberately deceptive structured financial instruments and a general lack of disclosure are the problems. Bring the closed, bilateral world of OTC markets into the sunlight of multilateral, public price discovery and require SEC registration for all securitizations, and you start down the path to a practical solution. But don’t hold your breath waiting.
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Wall St.'s game is avoiding regulation and exploiting conflicts of interest. This proposal isn't a cure all. There are loopholes that will have to be plugged. It is a start. Split prop and agency business. Big is bad due to the interconnection of the parts. Wall St. has always been crooked and it always will be. This can't be changed. Crime cannot be eliminated. Rules must be established, continuously amended and vigorously enforced to limit criminal activity. Future phases must increase transparency of derivatives and asset backed securities.
Banks are too big, duh.
How about limiting the size of gov't.
But truely,AIG shareholders were the victim and were defrauded by not only the dealers but also the gov't in that they did not allow the rule of law to govern. AIG would not have honored its policies on the basis of fraudulent underwriting by originators and the rule of law would have exposed the true culprits.
Once again the administration just doesn't get it. Let's just make a new law that will not be enforced if we get a little squeamish.
Instead, opaque OTC markets, deliberately deceptive structured financial instruments and a general lack of disclosure are the problems. Bring the closed, bilateral world of OTC markets into the sunlight of multilateral, public price discovery and require SEC registration for all securitizations, and you start down the path to a practical solution. But don’t hold your breath waiting.
The opacity, deception and lack of disclosure go hand-in-hand, of course. My own view is a little more conspiratorial: the fiat dollar-based system needed ever-increasing leverage to continue to function, and "financial innovation" was the solution chosen. It all had to be kept out of the light in order for (gullible) people to believe it. Bringing these OTC products into the sunlight would be the equivalent of auditing the Fed: USD armageddon. That is why I'm not holding my breath waiting. It is what needs to be done, though, as the system right now is completely based on lies and artificial support, which is unsustainable.
Lots of pain now, for a few years, then renewed opportunities, or decades of pain, subservience, and high taxes. Choose.
I agree with the post, and am totally dismayed that the people driving the train don't/can't/are unwilling to see what's ahead.
I do however feel that you need to take one step back from the conclusion that derivatives are the problem. The problem started way before CDO cubed etc, when 20 years worth of excess liquidity forced banks/lenders/ any FI to chase margin and lend down the credit spectrum.
08/09 we saw the liquidity crunch, and the publicising of private debt. Free liquidity continues for the moment. I haven't a clue whether we have another crunch (govs are challenged over liquidity - deflation) or we head straight to a hyperinflationary environment.
Until we see the excess liquidity drained, the longer we will live this lie.
Prop trading is the golden goose that pays the rent so the rest of the racketeering enterprise can seek out newfangled innovative methods of opaque financial thievery.
Bravo!
If only the whole nation weren't so suckered by it all...the Kingfish's machine was diddly squat compared to our government-banking cartel.
What Paul Volcker is trying to do is simple. Separate the money of the ordinary people in banks that will be conservatively managed and in case of failure the money of these people is guaranteed by the government. The rest like the hedge fund called Golden Sachs may do whatever they want with their own money and if they fail they may go to hell and continue doing "God's work" there.
@ Budd Fox
on Thu, 01/21/2010 - 21:36
#201702
On the insurance issue...why aren't CDS limited by the same rules we have found necessary for life insurance. You can't take out on someone you have no relation to. There are too many perverse incentives to murder some random person if you can take out insurance on them, and how crazy would it be if 10000 people could take out insurance on a beat cop and then one day he goes down to sniper. But this is essentially what Wall Street was doing with companies, taking out life insurance on the and then killing them. Plus, the insurance company could not pay the claims to 10000 people after just one death and stay solvent, but Wall Street knew govt would pay.
That this was ever was allowed is just plain stupid. We knew from centuries of experience with insurance and regulation how this would end, and yet Wall Street was allowed to do something no other industry or persons would ever be allowed to do.
Complete corruption of our financial cops is the only reason this can happen, even now.
Excellent post.
All we need is smart cops, like street detectives with lots of CSI tools to get our financial murderers, but all we have are Barney Frife.
I'm firmly convinced GS et al new AIG would NEVER be able to make good on their "insurance" because the "premiums" they were charging so much lower in cost than amount of typical capital reserves would have been needed per to standard leverage limits.
Just like PIMCO knew govt would back Fannie and Freddie, GS knew they would get full payment from their insurance stooge via US taxpayer.
Financial institutions backed by US taxpayer will always constantly looking for ways to subvert risk regulations and this post mentions an important way by taking risks not with trading, but lending etc..
We simply need smart professionals with tools...good luck with that
Any chance there is a list of all the then (and maybe still now) heads of FICC in each TBTF during the zenith of this rapacious assault?
Seems to me these asset-backed asswipes in particular, these masters of the odious should be pilloried publicly.
Agreed on shutting down the SIV's etc. We really don't need Romulan cloaking devices for our TBTF's do we? With all the yammering about transparency, bring it on.
I'm getting my outrageous AIG stories a little mixed up.
Last week we learned that AIG had hidden vaults where the kept bearer bonds in what amounted to an off balance sheet slush fund.
Today ..."The dealers, starting with Goldman Sachs (GS) and Deutsche Bank (DB) were seemingly sucking AIG’s blood for years, one reason why the latest response by Washington has nothing to do with either OTC derivatives, structured assets or OBS financial vehicles."...
So does AIG own the slush fund in their hidden vaults or does it belong to the banksters.
I swear this starting to read like a cheap detective novel.
Truth is stranger than fiction because it's real.
Prop trading was a component that is certainly to be taken into consideration...thinking that some was even involuntary.
When the CMBSs and CDOs CLOs MBSs RMBSs and assorted acronyms markets started to sour, notably, when the ABX triple A index blimped down from 99/100 for the first time in seven years, was early /mid 2007. From then on, you couldn't see it , but all that crap that was packaged by the TBTF could barely be sold ...therefore they warehoused it. They warehoused it wherever they could, in and OFF balance sheet in a myriad of SPV that are almost never reported and that somehow fall off even the SarbOX border. And that was the first and foremost cause of the Minsky moment...after Lehman was let go, what really blew the whole thing were CDS...Credit Default Swaps.
Just think of the nature of the thing, is basically an insurance...was born and left to himself many years as represented just an insurance form on the default of some entity you may be holding debt in your portfolio...AND THIS IS THE KEY.
YOU CANNOT TAKE UP A FIRE INSURANCE FOR SOMEONE ELSE'S HOME, YOU CANNOT INSURE YOURSELF, IN THE INSURANCE BUSINESS FOR A RISK YOU ARE NOT CARRYING...and for a very real reason that even a child can understand....Say Joe Bloke is a very careless man and stores flammables in his home and smokes heavily, if you allow all the town to take out an insurance policy on Joe Bloke's home, and it burns...THE INSURANCE COMPANY DOES NOT HAVE ENOUGH MONEY TO PAY!!
But the bunch of mentally deranged deficient idiots that appears on TV siding Obama and he himself, cannot understand that without forbidding this practice immediately, with immediate effect and declaring all the existing contracts null and void, the counterparty risk in the system is STILL EXPANDING TO TOTALLY INSANE LEVELS.
How many people are taking CDS against a Greece default...without holding Greece debt? How many are buying GS CDSs...without holding or even shorting GS shares?
So, it's ok to say that if you prop trade mostly for a living you are an hedge fund and not a bank...but there are other more urgent things to regulate...and first, the payment of ALL bonuses must be forbidden by law and all proceeds to be directed into special balance sheets funds to shore up the TBTF capital, and this valid for EVERY YEAR till the Mark to Fantasy is allowed to exists, all the off balance sheet SPVs MUST be reemerged inside the balance sheet....and be prepared to discover the real extent of the mess, as I am pretty sure that half the US GDP growth of 2005/6/7 was fake...bogus crap packaged and resold to Ponzi victims ( not innocent...but victims)
Correct me if I'm wrong but "prop trading" should by definition encompass all bets made with the house money, for the house's gain or loss irrespective of asset class or whether it's derivatives or cash securities, exchange traded or OTC. If firms like GS were rapidly shorting the same securitized waste they were issuing, seems inherently conflicted ergo ripe for separation. This wasn't "agency" business it was pure principal trading and unlikely riskless from what I can discern.
The deck was effectively stacked and loaded as they understood the underlying credit complexities (maybe not, see next paragraph) and likely had fair idea who was long.
In a Wharton School interview John Thain was discussing the ML CDO quagmire and in words to this effect said something like "we took one of the fastest supercomputers in the country to run a valuation model on just one of these tranches and it took 3 hours! I guess you can say nobody really understood the value of these things."
OK...so prop trading or not, how the fuck does someone who's a CEO post Sarb-Ox admit neither he (MIT degrees and all) nor anyone else could truthfully sign off on their financials? If you can't work out what the fuck something is worth, even with your "mark to model", how are you not violating SarbOx or some other disclosure rule.
This is not over and when the FHA melts down, later this year or next and another couple hundred billion is required to plug that leak...watch out.
What galls me is the bright bulbs who structured this rubbish are now out there "re-structuring" the same crap they helped package.
Agreed...transparency, a blinding blast of sunlight on the pricing and structures of all this arcane shit is just what the doctor (van helsing) orders for all vampires, even the cephalopod sub-species.
IMHO, something is only worth what someone else is willing to pay for it. You know, good old fashioned price discovery. Who cares what some supercomputer says it's worth? But marking to market is another topic.
Please set me straight...
My understanding is that prop desks that are part of the bank holding companies essentially have access to the discount window and hence vast sums of very low interest capital to throw into the market. Wouldn't removing the prop desk strategies at these banks be a step in returning some integrity to the markets? It only seems right that in order to bet, you actually take on risk.
I've been through many compliance reviews over my trading and I have always been a customer (flow) trader. However, as most people know, spreads are so tight in most markets that you make your money prop trading. So, you tell compliance that all your trades are "pre hedges" for future customer flow. It's complete crap but everyone's happy.
With these new restictions, the above scenario will happen more and more. It's almost impossible to seperate "flow" from "prop." These new rules are a sham and will just force banks to invent new ways to obsuscate the truth. Great, even more smoke and mirrors...
It was both Derivatives and prop trading that contrbuted to the crisis. Or the prop trading of derivatives. GS loaded up on AIG CDS as a "hedge" relative to their hefty counterparty risk. This action is under the guise of risk management not prop trading but there's a fine line is it not? If you have to buy credit protection on one of your largest counterparties wouldn't a more moral and prudent course of action be to say, "Hey fella, your a tad overwieghted in this stuff - you good?"
It was no secret in 07 that buyers of Bear CDs we also short the stock and/or long puts, remember when the 10$ strike was requested when the stock was trading in the 50s? That's not client driven thats a member of the exchange making that request....Lehman and Wamu were taken down similarly. Was is prop or risk management? If you trade prop at GS it was clearly the latter.
Good points - a lot of trading can be justified under the excuse of "risk management".
"Our phone system is provided by Verizon, and if they go down our phone system will go out and we will be hurt, we need to short Verizon."
"We buy all our coffee from Starbucks, if they go under we won't be able to get that great coffee for our traders, so we need to buy CDS against them".
Etc.
No worries. With a transparent market and regulation and leverage equivalent to State Insurance, short away. Covering the bet and not hiding the market in the voice broker swamp to properly protect the integrity equal to a mark-to-market environment is as simple or difficult as it gets.
Like the large multinational investment banks had nothing to do with the CDS and CDO market much less heavily leverage in the OTC market...as they are today.
A good summary. Obviously the prop trading of commercial banks was a neglibile part of the crisis. It was the investment banks who helped nurture and feed the system and those big ones are gone or in GS's case, now commercial banks. In fact this is essentially an attack on GS which is great politics and that is what has me worried.
Todays press, well maybe always but especially todays, are like a bunch of 6 year olds playing soccer. They all chase the kicked ball. I don't doubt that this one proposal will suck all coverage of the issues into just this one. We have to assume that is the intent. To make it look like something is being done when it isn't. I can forsee 8 months of this being kicked about in congress and the press after which something with lots of holes will be passed and GS quitely sheds its commercial bank structure.
Thanks, this is a great post.
However, AIGs main exposures were not complex. All the subprime exposures, despite the "structured" nature of the securities were NOT complex.
The main problem in the crisis was v v simple -- too much leverage to the housing bubble. The main problem at AIG was adding unchecked leverage to credit spreads. Both are very simple.
Moving CDS to exchanges with better MTM collateral will help this a bit. But some part of it is just a natural human-nature, capitalist nature thing. Capitalism is prone to bubbles and bursts. When that bubble is real-estate it has the widest impact.
Finally, ironically... we dont need any regulation in the aftermath. We actually need to encourage risk-taking in the aftermath. We need smart, counter-cyclical regulation 10 or 20-yrs from now... when everything looks fantastic and everyone is rolling in $$$.
That's the problem.
I agree with you that leverage was the main problem (in all markets, not just mortgages), but:
Saying that AIG's main exposures were not complex is incorrect. A typical subprime first-level (non-agency subprime MBS/ABS) securitization is backed by thousands of individual mortgages, each of which in theory should be analyzed by whoever buys the bonds (analyzed in terms of LTV, FICO, documentation, location, etc). The cashflow waterfall is also deal-specific, with respect to P&I allocation, allocation of losses (most, but not all, subprime securizations did not allow losses to be allocated to the AAAs), etc. Further, a CDO (in my terminology, second-level securitization) is backed by many, generally subordinate, first-level tranches, each with their own rules, with the CDO itself having its own waterfalls and rules. Most cash CDOs are also not static, meaning the underlying bonds can and do change. The period in which this can happen is known as the revolving period, and many 2003 ABS CDOs, for example, will contain 2007 collateral as the earlier-vintage bonds mature and the cash is reinvested. AIG sold protection on many different indices and bespoke portfolios. Maybe the indices (ABX hurt the most) can be adequately analyzed provided the necessary resources are allocated, but the bespoke portfolios are a nightmare. As I understand it, AIG's basic criteria was that the bonds/portfolios they sold protection on had to be rated at least AA. They were not analyzing the underlying collateral because it was too complex (the rating agencies claimed they could do it, but they were applying corporate CDO technology to mortgage collateral, which was the dumbest thing they did). Many investors avoided CDOs not because they thought the world would blow up, but because the analysis was too difficult.
I'll believe the government when they send me my shares of GM and the other TBTFs.
In exchange traded markets - prop trading is relatively easy to identify.
However, in OTC markets what is prop trading and what is customer flow. For example, big customer comes in and buy US$200mm protection on xyz corporate. Bank changes a spread to the client, but until this position is cleared in the market it is in reality a prop position.
Without prop trading all OTC markets will freeze.
Result - the holes in the legislation will be huge.
I'll believe the government is serious when it files an action to recoup the proceeds of the fraud from GS...the beneficiary,
and puts 10-20 GS and AIG creeps in the Big House for 25 years.
they just might go after GS because it is turning
out to be a real witch hunt. mind you I wouldn't
mind Blankfein bunking with Madoff.
"...the Volcker Rule does not address the problem."
Enough said.
More bullshit from TheBamster's bag of tricks.
I wonder if Volcker's reputation hasn't been whitewashed because he once did some good. He is still a New One World Order guy with single global currency model in his head.
How do you figure? He's proposing a break up of the
concentration of power within these banks. He is a member of the Democratic party One Worlders are Republican.
The furthest thing from anyone's mind is a single
currency because this one world thing and the inter-
connectedness of the global financial system has
proven to be a nightmare for developed nations.
Get a grip. Obama is turning out to be a populist
much to the dismay of the Democratic party. RC Whalen
is dead right in his analysis. Read it again.
Your knowledge of Volcker's history is somewhat shallow.
Google him, then tell me he isn't a consummater insider with far more 'complexity' than you seem to realize.
I know Volcker's history I was there. I don't need to
Google him. What I appreciated about him in spite of being 6'7"he always flew coach no matter the distance while
being at the Fed. Just because you are affliated with
certain org doesn't make you a one worlder. Stop with
the guilt by association he is not a one worlder
trust me. Now go back to your corner of the room.
Volcker started the TBTF concept with Continental Illinois, read Bill Seidman's book, according to him the FDIC wanted to let Continental Illinois fail, but the Fed under Volcker insisted it be bailed out.
Also note that Benanke was absent from the conference today, at least that I saw.
Also note that AIG was not bailed out by the "taxpayer" but by the Fed. As was Bear Stearns/JPM.
The Fed is the root of all financial evil in this country, IMHO. Bernanke should be tried for the crime of high treason against the people.
http://www.fdic.gov/bank/historical/history/235_258.pdf
What PV did was rather admirable. CIB was a POS and looked like W.C. Fields was in the wheelhouse. He wisely averted a stupid Liquidity crisis, but there was no reward, no enabling to return to high-leverage..He just put a torniquet on the situation, the useful role for a Central Bank, but not to create excess reserves to fund beyond the growth of real goods and services with regulated leverage..Greenspan and Bernanke thought enough money would cure anything and accountability was ..well, way too harsh and they had no ability to stand up to the Bulge Bracket pirates. Let PV take the wheel; it's not heavy lifting when you know what to do.
Interesting point, ghost.
And Fastow went from Continental to Enron, because they wanted someone with his scam experience.
And Larry Fink, who first developed Mortgage Backed Securities at First Boston (now Credit Suisse FB), went to Blackstone Group, to form BlackRock......
Ahhh...those connections......
Larry Fink and a many others created the mortgage
the mortgage market. The ones who put it on the map was
Bear Stearns. Now you don't start arguing with me I
did my first mort trade 1985. I remember when Blackrock
started someone on my desk covered them. I also am
an alum of UCLA.
And Fastow went from Continental to Enron, because they wanted someone with his scam experience . [etc.]
Follow the people, Follow the money,
Follow the people, Follow the money.
Eventually it will all wind up in the same place.
Damn, would I like to see that happen...
Thanks very much Chris....
Was LTCM trading with a taxpayer guarantee?
Explicitly, no. Implicitly, well ....
I've often wondered why no one really asked why Glass-Steagall was rescinded in the first place. The banks, of course, wanted it, but I suspect that the real reason had to do with LTCM - knowing that if LTCM truly was accounted for, it would leave smoking holes where most of the banks were (including Goldman Sachs). I suspect that the taking down of Glass-Steagall was to insure that the banks could recapitalize themselves by taking on "non-banking functions" after they made LTCM more or less whole,, and that also marked the start of the "Look the other way" regulatory attitude that continued on with Bush. It would also hint that Greenspan's decision to keep his foot on the accelerator with interest rates after 9/11 had little to do with the economy and everything to do with continuing to recapitalize those banks, after their balance sheets proved to be even worse off than was apparent in the 1990s.
What in the world does GS have to do with LTCM demise?
Greenspan called a meeting of the heads of the various
firms to bid on the various pieces of the portfolio.
Only GS was all in. They wanted the entire portfolio
Greenspan wouldn't let them have it so GS left the
meeting empty handed. They didn't rescind Glass-S
then because there was no reason to. Greenspan kept
his foot on the pedal because he saw no reason not to
he didn't want to deny people the American Dream
of owning their own home. His mistake was thinking
Wall st was moral when greed trumps that anyday. Which
is why all the DC nonsense they are trying to legislate
greed which ultimately will fail. Greenspan's judgement
failed as well in hindsight. When big banks start
thinking like a hedge fund and not a bank that is a
problem.
BOOM, nailed it. This won't reign in the four causes of the financial crisis. It's a political stunt. Linked on my site: http://www.frontieroutlook.com/?p=99
-Alex
I agree that tranparency into the OTC markets are key. The main reason why most derivatives are created with complexity is to pack profit margin and profit opportunity in. But... Isn't it also true that an artificially elevated level of liquidity was available to the more complex real estate securities: MBS>CDO>CDOsquared, cubed, etc. due to the capital available from banks that had access to FDIC guaranteed funds? We also have to eliminate off balance sheet games and force discovery of actual market value of assets. Let the investors decide if the assets support the share price, and not management.
Every big bank that did fail conducted a significant amount of principal trading transactions with, if they weren't themselves, an FDIC insured institution.
Without the ability of plain vanilla banks to offer that expanded market, MBS/CDOs etc. would have been less liquid, rates would may not have been as accomodative, and speculation may have been hindered at the margins by normal market limitations, in lieu of now being supported by the Fed with synthetic bids.
As for the presidents speech, the key takeaway is that no one has to limit their prop desk size, you simply have to conduct business without taxpayer guarantees. I am in total agreement with that for it implicitly limits the size of speculative institutions. None of these firms were big enough to do the damage that they are capable of when they were private partnerships trading with their own capital.
Curious to hear your take.
I'm with you on this, Reggie.
Just because some headlines focused on prop trading doesn't mean that eliminating that particular thing is the main (or only) objective. Volker's been clear on what he thinks needs to happen - that objective is eliminating conficting interests and separating excessive risk/leverage from core financial infrastructure and services (and the gov't backing many believe that deserves).
Would any of these new rules have prevented failures? Maybe not. But they would not be "too big to fail"-ures if they weren't intertwined with essential financial needs of the country/world.
Sure, it is possible that actual law/regulations that come out of this process could miss the target. That would be a shame (or crime- literally) ... but it doesn't mean they don't know what needs to be done at this point.
+11
They really have no idea what they are doing. Don't they see the train coming?
What train do you see coming?
I can only conclude that His Oneness is deliberately doing this in order to force a situation that "requires" further governmental involvement in all things financial. It's a short step to Nationalization once they start determing what entities are allowed to trade what securities and how much.