The Volcker Failure


We all want sound banks.  We all want banks that are small enough to fail.  We all want the assurance that our deposits are safe, without having to bankrupt the FDIC in the event of a bank default.  The Volcker Rule accomplishes none of that.  While doing nothing to protect our money, the Rule will raise our cost of banking, and damage the liquidity and functioning of our capital markets.  At the same time, the Rule creates a false sense of security by purporting to take the steps necessary to protect us.

First, some disclosure:  I am a banker, or should I say, I am an employee of a European bank.  I manage money, and am not directly affected by the Volcker Rule.  But I'm in a good position to understand what's going on, because I have spent most of the past 23 years on bank trading desks.  The years that I was not on those desks were spent structuring investments similar in form to the ones that blew up and damaged us so badly.  (I can honestly say that the ones I contributed to were fine, were not mortgage-related, and matured prior to the crisis.)

To understand why the Volcker Rule fails so miserably, you have to understand a little bit about modern banking and capital markets, and the businesses that are affected by the Rule.  (Volcker himself has confessed to not understanding capital markets, and we can all take him at his word on that.)

There are three groups of bankers affected by the Volcker Rule: prop traders, market makers, and CDO structurers.

For almost all banks, their proprietary (prop) trading businesses are very small.  Prop trading has been out of favor for all intents and purposes since the large hedge fund LTCM blew up and required a bailout 15 years ago.  As a question of style, some banks do continue to maintain small teams of prop traders, while many have gotten out of the business altogether.  Prop traders tend to sit off by themselves and take positions in generally liquid investments like stocks, bonds, currencies, and futures.  They almost never take positions in illiquid assets, or things they can't easily and quickly sell.

Market makers...make markets.  When a customer calls to buy or sell something, market makers are prepared to satisfy that customer need, whether or not they have the security, or whether or not they want to buy it.  By definition, these traders take risk, because when they buy something from a customer, the value of what they bought will fluctuate.  There is no way to make a market without being exposed to price movements, though generally market makers do not take large exposure for long periods.  They often hedge their positions, or liquidate what they bought as soon as they can.  Market makers strive to capture the "bid-ask spread" by buying from one customer and selling to another at a slightly higher price.

Far from the trading desks--and I mean far away, like on a different floor or in another building altogether--are the CDO structurers.  "CDO" stands for "collateralized debt obligations," and their production requires sophisticated structuring, intensive legal work, and a nimble, dedicated sales force in order to create and distribute them.  Structurers make special purpose vehicles that buy bonds, loans, or mortgages (CBO, CLO, CMO), then slice them up (senior and subordinated, etc) and sell them off.   

The stuff of the financial crisis came right off of the CDO desks.  The packagers created securities that the rating agencies blessed with a triple-A label, even though they were nothing of the sort.  The structurers, rating agencies, and investors all believed the high-tech models that measured risk, based on an apple pie assumption that real estate never goes down and homebuyers never default, whether or not they have jobs, proper ID, or a pulse.  And if they do default, the property will always be worth more than the mortgage anyway.

It is not true that banks stuffed these CDO products onto the unsuspecting, certainly not for the most part.  In fact the banks that created the products were believers, and big buyers for themselves, Goldman Sachs notwithstanding.  After all, it was AAA, right?  Billions and billions of dollars of structured deals stayed on the banks' books.  These securities were never purchased by prop desks or market makers.  Instead, they were held among the banks' loan portfolios, in quantities so large that it was the top layer of management that made the ultimate decision to buy. 

To make matters worse, distributing structured deals is not easy.  The issuing banks have to find buyers for all classes of securities, all at once.  They might find buyers for 80% of the deal, but without that last 20%, the deal can't happen.  No distribution fees, no sales bonuses, no register ringing, no praise from the boss' boss.  So what did the banks do?  They bought that last piece themselves.  Often that piece was the riskiest--after all, they couldn't find buyers for it.

You may find this hard to believe, but the Volcker Rule does nothing to inhibit or prevent the creation, distribution, or investment in CDOs, CLOs, CMOs, or C anything else.  Zip.  Nada.  I pored over the document, and wrote it all up right here.

There is nothing "proprietary" about CDOs or CLOs, any more than there is about loans or mortgages.  In fact CLOs are just "collateralized loan obligations," and Volcker couldn't very well come down on those.  After all, that's what banks do.  But that's where the risk is. Banks go belly up from credit exposure of one form or another, whether it's death by subprime mortgages, bad loan portfolios, or CMOs.

But how do you take credit risk away from banks?  You can't, any more than you can take the risk of an auto accident away from the driver of a car.  What you can do is manage the risk.  You can make sure the banks are not too big to fail, because sometimes banks fail.  Or, if you want to allow for a certain number of big banks for economies of scale and cross-market efficiencies, you can charge them an insurance premium based on how large they are.  The larger the bank, the more it pays.  If banks don't want to pay the premium, they can split in two.  Or four, or eight.  This is the solution favored by our Secretary of the Treasury, Tim Geithner.

It's hard not to conclude that Mr. Volcker and his band of lawmakers mistook proprietary trading and market-making with unavoidable bank credit risk.  This is a huge mistake, and it will cost you money at the same time that it hurts our markets and our economy.

The damage won't come from firing all the prop traders, though they did no harm and made banks money, some even during the financial crisis.  To maintain well-functioning capital markets it's nice to have these guys around, because when you want to sell your Australian dollars or Apple shares, someone has to be there to buy from you, even if it's on an exchange.  But the banks never did have a lot of prop traders around anyway.  That's the Volcker Rule, engaging a team of surgeons and anesthesiologists to remove a hangnail.

The real problem is, what will become of market making.  The traders will be regulated to death, having to keep track of literally 17 different regulatory parameters controlling everything from hedging each and every transaction at the time of execution right down to traders' compensation.  Market making will require a team of compliance officers and chief executives willing to assume personal liability for what traders do, 24-7, three hundred and sixty-five days a year.

It'll be amazing if banks stay in the market making game at all, but if they do, it'll raise their costs dramatically, and there's only one place the extra cost will come from:  you.  Market making itself will be a more costly exercise, with wider bid-ask spreads to make up for the added infrastructure.  This means a genuine dearth of liquidity, the hallmark of a well-functioning capital market.  You won't feel it so much, but your mutual funds, IRAs, and pension plans will all pay more to transact, and they'll pass that cost on to you.

Volcker downplays the importance of liquidity, saying in his recent letter to rebut some of the criticism that we should not assume "market making brings a public benefit."  But don't follow what he says, watch what he does:  What single class of investments is exempted from the Volcker Rule?  US treasury bonds, of course.  What in the world would happen to our government bond markets without sufficient liquidity to support them?  And that's to say nothing about the risk of speculating in long-term bonds of any persuasion.

The Volcker Rule is an utter failure.  It in no way protects us in the manner that it sets out to do.  In fact, it confounds and burdens our banking system during a time that should be spent rebuilding and safeguarding against another crisis.  The Volcker Rule is a red herring that misdiagnoses the problem and applies the entirely wrong medicine to a benign, healthy part of the body.

Paul Volcker is an American hero.  At a time of runaway inflation thirty years ago, he had the backbone to raise interest rates to the breaking point.  The economy stalled badly, but as a result inflation was broken for generations.  Volcker laid the foundation for a healthy economy and one of the longest-running bull markets in modern history.  He should have quit while he was ahead.