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The Volcker Rule Has Merit
Volcker is correct in that banks conflicts of interests need to be
stemmed. One would not have to worry about over regulation if one does
not attempt to regulate every single act or attempt to guess what might
go wrong. What needs to be done is to use regulation to disincentivize
banks from engaging in activities that engender systemic risks and/or
harm clients. By putting everybody on the same side of the table, you
don't have to worry about outsmarting the private sector.
From CNBC:
"In
his testimony, Volcker will say there are strong conflicts of interest
inherent in participation by commercial banks in proprietary or
private investment activity."I am
not so naive as to think that all potential conflicts can or should be
expunged from banking or other businesses," Volcker said in his
prepared remarks."But neither am I
so naive as to think that, even with the best efforts of boards and
management, so-called Chinese walls can remain impermeable against the
pressures to seek maximum profit and personal remuneration," he said."
Currently,
banks that own PE funds and hedge funds have a perverse incentive to
maximize AUM over actual returns in a down market. This provides an
implicit call option on the market that is funded by the banks admin
and management fees. These are fees that the banks get anyway, and if
the market goes up the bank also benefits by riding the beta through
incentive fees. The client does not truly have the banks as a partner
as an equity investor even though the bank may put its own capital in
the fund alongside the clients. The incentives are not aligned, to the
detriment of the client.
This also gives the banks the incentive
to take outsized risks at precisely the exact times that they should
be curtailing risks.
A good example is the outrageous losses
Morgan Stanley has been taking through its private real estate
investment funds. It is not as if it was difficult to see that CRE
market was overheated when these funds kicked into high gear purchasing
mode. See Doesn't
Morgan Stanley Read My Blog? where I detailed exactly how insanely
priced the Zell/Blackstone CRE flip was in 2007. Then reference Wall
Street is Back to Paying Big Bonuses. Are You Sharing in this New
Found Prosperity? where I show how much money was lost by the MS
fund when they purchased that insanely priced flip, as well as monies
lost in other overpriced acquisitions at the top of a bubble using max
leverage.
The following is an excerpt from the afore-linked blog
post:
Needless to say, Morgan Stanley, the GP and
effective holder of the "Call Option", actually saw significant cash
flow from carried interest, management and acquisition fees despite its
investor's losses.Upon a close examination of the structure
of funds such as the Morgan Stanley's MSREF, it has been observed that
fund sponsors, acting as the GP (general partner) collect sufficient
cash flows through fees to insulate themselves from negative returns on
their equity contribution in the case of a severe price correction (Please
refer to the hypothetical example below, constructed as an
illustration of a typical real estate fund). The annual management
fees (usually 1.5% of the committed funds) along with acquisition fees
provide the cash flow cushion to absorb any likely erosion in the
capital contribution (usually 10% of the total equity). Further, the
provision of "GP promote" (the GP's right to a disproportionate share
in profits in excess of an agreed upon hurdle rate of return) rewards
the fund sponsor in case of gain, but does not penalize in case of a
loss. Herein lies the "Call Option"! With cash flows increases that are
contingent upon assets under management and the volume of deals done
combined with this implicit "Call Option" on real estate, the incentive
to push forward at full speed at the top of an obvious market bubble
is not only present, but is perversely strong - and in direct conflict
with the interests of the Limited Partners, the majority investors of
the fund!A hypothetical example easily illustrates how the
financial structure of a typical real estate fund is so tilted to the
advantage of the fund sponsor as to be analogous to a cost-free "Call
Option" on the real estate market.The example below
illustrates the impact of change in the value of real estate
investments on the returns of the various stakeholders - lenders,
investors (LPs) and fund sponsor (GP), for a real estate fund with an
initial investment of $9 billion, 60% leverage and a life of 6 years.
The model used to generate this example is freely available for
download to prospective Reggie Middleton, LLC clients and BoomBustBlog
subscribers by clicking here:
Real estate fund
illustration. All are invited to run your own scenario analysis
using your individual circumstances and metrics.
To depict a varying impact on the potential
returns via a change in value of property and operating cash flows in
each year, we have constructed three different scenarios. Under our
base case assumptions, to emulate the performance of real estate fund
floated during the real estate bubble phase, the purchased property
records moderate appreciation in the early years, while the middle
years witness steep declines (similar to the current CRE price
corrections) with little recovery seen in the later years. The
following table summarizes the assumptions under the base case.
Under the base case assumptions, the steep price declines
not only wipes out the positive returns from the operating cash flows
but also shaves off a portion of invested capital resulting in negative
cumulated total returns earned for the real estate fund over
the life of six years. However, owing to 60% leverage, the capital
losses are magnified for the equity investors leading to massive
erosion of equity capital. However, it is noteworthy that the returns
vary substantially for LPs (contributing 90% of equity) and GP
(contributing 10% of equity). It can be observed that the money
collected in the form of management fees and acquisition fees more than
compensates for the lost capital of the GP, eventually emerging with a
net positive cash flow. On the other hand, steep declines in the value
of real estate investments strip the LPs (investors) of their capital.
The huge difference between the returns of GP and LPs and the factors
behind this disconnect reinforces the conflict of interest between the
fund managers and the investors in the fund.
Under the base case assumptions, the
cumulated return of the fund and LPs is -6.75% and -55.86,
respectively while the GP manages a positive return of 17.64%. Under a
relatively optimistic case where some mild recovery is assumed in the
later years (3% annual increase in year 5 and year 6), LP still loses a
over a quarter of its capital invested while GP earns a phenomenal
return. Under a relatively adverse case with 10% annual decline in year
5 and year 6, the LP loses most of its capital while GP still manages
to breakeven by recovering most of the capital losses from the
management and acquisition fees..
Anybody who is wondering who these
investors are who are getting shafted should look no further than
grandma and her pension fund or your local endowment funds...
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Mr. Cofker (spelling?) challenged Mr. Volcker\'s stance by saying that no financial holding company that had a commercial bank failed while performing proprietary trading. It appears as if Mr. Cofker may have received his information from the banking lobby, and did not do his own homework.
Let\'s reference the largest commercial bank/thrift failure of the all:
http://www.allbusiness.com/banking-finance/banking-lending-credit-servic...
It is truly unfortunate that such misinformation and disinformation is allowed to permeate through not only the media, but actual congressional hearings. It is truly a shame. If I am not mistaken, WaMu was the biggest bank/thrift failure, EVER! If anything, this should provide momentum BEHIND the Volcker Rule in lieu of having politicians trying to out-regulate an accomplished regulator on how to regulate banks.
It's ALWAYS the Incentives. ALWAYS.
From the lowest mortgage broker getting a ridiculous fee for steering a less than solvent borrower into a no-doc loan at 10X his annual income, (whereas the broker shoud be paying a penalty instead) right on up to Dick Fuld
taking bazillions in compensation for slicing and dicing those loans into AAA securities, or so say Fitch, and other rating agencies being paid by the firms whose loans they rate.
INCENTIVES! How hard is it?
Hey look, banking regulation that has "merit." I knew if we just waited 233 years we would finally get it right. Thanks Volcker, you're the bestest!