Whither Prop Trading? Thoughts From Whitney And Bernstein
Meredith Whitney is much less sanguine than all the naysayers who believes that the Obama plan is just more hot air.To wit, the maven proposes a very dire scenario should the plan be consummated.
This morning the Obama administration announced a proposal which could potentially change the entire face of the financial industry by limiting leverage, banning proprietary trading within banks, and breaking up concentrated market shares. We note, this proposal comes just over a week after a big bank tax was proposed which would penalize leverage within the industry. While details are slight with respect to the White House's proposal for potentially game changing regulatory overhaul, it is clear to us that the market is not overreacting to what directionally could be a decidedly lower move for capital market profits for the banks. Not only are banks expensive on the prospect of "normalized" earnings, but waiting for normalized earnings is like Waiting for Godot in our opinion, particularly in light of increased regulatory momentum. In addition, we believe the medium term impact of the proposal will be a reduction of liquidity in not only the corporate market but also in the consumer market. For the record, we believe the possibility of this proposal going the distance is high. This proposal is currently just a basic outline, but sentiment amongst the American voting block is against the large banks and therefore we believe political actions will respond in sympathy.
First, "Limit the scope" of proprietary trading actiivites. We are not sure what qualifies as proprietary trading and if this may include any long or short bias to a position, however it is clear that this will dramatically reduce trading profits as well as market liquidity. Pure execution trading models simply make less money. This is why JPM, GS, and others make more in their trading operations than others. Potentially, this could move more flow volume to exchanges and away from market makers. This clearly would be a positive for the likes of CME and others.
"Limit the scope" of private equity. What we interpret this to mean at a minimum is not only obvious private equity portfolios but also individual corporate stakes in companies like ICBC, CCB, Bank Itau, etc.
"Limit the size" or market share concentration of the banks. This is more self explanatory to us. 2/3 of mortgage and credit products are controlled by the top four banks. The reality of breaking this up will be an operational challenge as many of the smaller regional banks not only sold their mortgage and credit card businesses to the larger banks years ago but with them also their respective technology and systems. Given the operational challenges, we are reminded of the original opposition to this proposal a year ago which was the length of time this would take and the corresponding removal of liquidity from the system to executive the transaction. Given the fact that the securitization market remains closed, funding these businesses will be deposit dependant and therefore difficult to scale. In sum, we expect even more consumer credit to come out of the market over the medium term if this proposal goes the distance.
Meredith's question about prop trading are very relevant as up until a month ago, nobody had any idea just how big of an impact prop trading had in the total Goldman P&L (for example). The first thing that has to be done, is for the SEC (hahahaha) to demand that banks break out not only the contribution from prop trading on various regulatory filings, but for the financial institutions to indicate just what the "risk-mitigating" basis of these trades is (i.e., did they come about to hedge positions or merely to front-run clients).
And as the question of what prop trading truly is, Brad Hintz from Bernstein shares the following insight:
Proprietary Trading: Taken literally, the first proposal would limit proprietary trading that is unrelated to client activity, or any trading desk that does not interface with clients. For Goldman Sachs, according to management commentary, this form of activity represents 10% "give or take a percentage point or two" of annual firm revenues. Unfortunately, the proposed trading limitation fails to cure the problem of "too large to fail" capital market banks. If Lehman had been a bank under these rules, it might have avoided its real estate losses; however, it still would have held large mortgage positions on its balance sheet as well as un-securitized whole loans prior to "MBS creation". These positions were frozen when market conditions shifted unfavorably for the firm, and Lehman found itself with an illiquid risk position that it could not fund. Drexel still would have failed had it been a bank under these rules as its high-yield book resided on a market making, client-oriented desk when the junk bond market collapsed. Morgan Stanley would likely have taken its losses in Q4 '07 as its infamous long-short MBS pair trade was part of the overall mortgage business. Only UBS and Merrill Lynch might have been precluded from holding an AAA-rated tranche after the original mortgages were securitized by the bank or the CDO had been created.
We point out that technically all fixed income trading activities are a form of proprietary trading – a bank needs fixed income inventory positions to make a market in OTC securities. But if a bank has a securities inventory position, the institution is taking market risk. If the bank actively increases or decreases the inventory to profit from a move in client demand from market making, then the bank is flow trading. If it places a position on a desk that is not responsible for market making, then in the definition of Goldman, it is proprietary trading. This narrow definition of proprietary trading in FICC is like claiming that you are "a little pregnant" - there is no such thing - either you are or you are not. As such, either a bank is a fixed income trading house and it is taking trading risk or the bank is not a material participant in the fixed income market.
And this part is particularly relevant for the Fed's ongoing mechanisms to absorb massive excess supply of bond issuance:
Bernstein would guess that the wording of "operations unrelated to serving customers" in the Administration's release may be related to primary dealers in government bonds that must take on market risk to remain profitable when dealing with clients in the Treasury market. With virtually no bid-offer spread, proprietary trading exemption would be necessary for the government desks. But we find it hard to believe that the new proposals are meant to allow unlimited risk taking in high yield, derivatives and emerging markets desks as these desks make a market for its clients. Unfortunately, at this point, nobody knows exactly what the limitation, or even the definition, will be.
Bernstein's conclusions regarding the biggest loser:
All other matters being fixed this new regulatory proposal would appear to be a significant threat to Goldman Sachs and its large trading business. But everything is not fixed and if in the unlikely event that the proposal was to become law we would expect a new GS to emerge. Indeed, in a worse case a new securities industry would emerge as the capital markets businesses of the other large universal banks would be spun off (much like Morgan Bank spun off its bond department in the Great Depression to form Morgan Stanley) with GS as the clear industry leader.
One thing is certain- the administration and the Treasury need to provide much more insight into just how they plan to effectuate the prop ban and just what it is that they refer to when they discuss "proprietary trading."