Volcker Rule aims at wrong targets
Rules proposed by the former Fed chief seek to limit proprietary trading and private equity investments at banks, but these activities didn't cause the financial crisis.
had more to do with breaking the back of inflation in this country than former Fed Chairman Paul Volcker. Thirty
years ago, he stopped it in its tracks with higher interest rates. He was on
top of his game in a way that many people argue ultimately produced the great bull
market that ended in 2000.
However, just as there are instances in which other finance seers (as opposed to financiers) subsequently lost their way, especially Bob Rubin, a once revered Treasury secretary, now known as presiding over a bank one-third owned by the federal government because of actions he approved, the question to ask is whether Volcker, an icon 30 years ago, still has a keen understanding of what went wrong in this banking crisis.
I cannot recall a single instance where proprietary trading, internal hedge funds, or private equity played a role in creating the banking mess that President Obama has decided to focus on with his much-ballyhooed "Volcker Rule."
Almost 100% of the problems that caused TARP and the U.S. guarantees are directly related to poor lending decisions and a lax regulatory environment directly traceable to the state and federal governments. A Volcker Rule wouldn't have stopped any of it.
Take them case by
case. First, there were two major financial institutions that literally saw
runs on the bank, causing the FDIC to seek bank help and offer risky government
guarantees to acquirers. The two that needed multi-billion dollar guarantees to
be purchased were Washington Mutual and Wachovia (WB),
both because of horrendous and injudicious lending directly by Washington
Mutual and indirectly via Golden West, a terrible acquisition by Wachovia. Of
those two, only Washington Mutual needed real government help as Wells Fargo
swept in and voided a government-guaranteed plan for Citigroup (C) to
buy Wachovia. Washington Mutual and Wachovia were mortgage lenders, not prop
traders or private equity investors. Neither had hedge funds.
Citigroup's need for federal intervention came from gigantic off-balance-sheet instruments made up chiefly of first and second mortgage loans, not prop trading, of which it did little, although it did have some private equity exposure. The latter's losses were totally manageable and did not even rise up to the level of material losses. Citigroup did not have an internal hedge fund.
Bear Stearns and Lehman Brothers shared one problem: reckless mortgage lending and the subsequent packaging of soured residential mortgage loans that were jammed into hedge-fund clients. In each case, these banks did facilitate, as part of their normal course of business, huge amounts of credit, 30-40 to 1 at times, loans to hedge funds to buy their products, including, in Bear's case, two internal hedge funds. When the mortgages these two firms had packaged starting going bad, both firms demanded more collateral. Given that the funds that bought this paper had been consistent returners, the shock of actual losses on their methods of profit rocked their clients and made it impossible for most to obtain more capital to meet margin calls. So, all three had to take back their mortgage bonds and fell in desperate need of capital.
Bear's hedge fund was not material to its demise, although it did dent profits. The flowback was material and the government had to guarantee some of the losses in order to facilitate the sale of Bear to JPMorgan Chase (JPM). You could argue that Bear should not have been allowed to offer such extensive leverage to clients to buy the mortgage bonds, but that leverage was checked off by the New York Fed. A reasonable rule limiting too-big-to-fail protection to those firms that used FDIC protection to lever up makes sense, but Bear did not have that kind of protection, not being a true depository institution. As part of the Fed's oversight, however, the Fed did have the ability to limit that leverage and simply chose not to. The Fed could have changed that overnight and subsequently has. The Volcker Rule would have done nothing to avert this bailout.
Lehman's tougher. In order to become the biggest fixed-income house -- something on which the reckless Dick Fuld insisted to crown his glory -- it had to provide the same liquidity to hedge-fund clients that Bear did, and it endured the same flowback problem that toppled Bear. Lehman did have a very extensive private equity real-estate business, some of which was under water. You could argue that the internal private equity investments played a role in Lehman's demise, but the idea of its centrality to the failure is chimerical. So, the Volcker Rule would not have prevented the death of either Lehman or Bear, and it is inconceivable to me that Volcker did not know that. Could he be that unknowledgeable? I hope not. I know that the Treasury Secretary, Tim Geithner, has an excellent grasp of these two obituaries and must be totally baffled how the Volcker Rule is germane at all to the situation.
Now, the accelerant in the toppling of both Lehman and Bear was hedge-fund raiding of the stock, which then caused ratings downgrades that eliminated short-term funding abilities. Here, we know -- although the government has not investigated this proximate cause -- that hedge funds placed giant credit derivative swaps, betting on the failure of both firms, and then pressed their bets in various non-nefarious ways, including endless shorting, to knock down stocks. The CDS market allowed both the insurance of inventory and bond issuance by investment banks and also insurance on unowned banks to profit from their collapse. This is what I endlessly called the arson campaigns against these firms, taking out insurance and then wreaking havoc/arson against them to be paid off.
My solutions to that problem were threefold: (a) publicly traded CDS market on the CME, ICE and anyone else who wanted in, (b) collateral limits or outright banning of the use of CDS on outfits where you had no stake to protect, as is the case with traditional property casualty insurance (you can't insure what you don't own because the insurance companies correctly fear arson-related bets) and (c) uptick rule restoration to eliminate the endless push down of common stock, usually triggered by rumors that cause press reports to turn negative, prime brokerage outflows and ratings downgrades. None of this involves the Volcker Rule, but again, I question whether Volcker has the current-day sophistication to go with his obvious bearing on these matters. These solutions are addressed in a sophisticated way by the proposals of Barney Frank in the House, but this Volcker Rule totally upsets that well-constructed applecart.
A Volcker Rule that addressed the biggest weakness in the system, the ratings game that protected no one, would have been valuable, but that requires a level of sophistication that might elude a former Fed chairman who was not in office when the agencies had such power.
The weekly bank seizures that have gone on endlessly during this period, as well as the problems of the banks that have not repaid TARP, are 100% mortgage related with no prop/hedge funds/private equity at all. FDIC Chairwoman Sheila Bair knows this but has said nothing on the issue.
GMAC (GJM), which is a potentially huge loss for the feds, was strictly 100% mortgage lending, as it was chiefly no-doc lending, something that was allowed and sanctioned by the states that regulate mortgage lending. The Volcker Rule would have done nothing to salvage this horrible loss either.
Which leaves the three biggest issues, two of which are totally glossed over, because they are the fault of the feds themselves -- Fannie Mae (FNM)and Freddie Mac (FRE) -- and the other because of the well-known case of chicanery in the London office, American International Group (AIG).
Fannie and Freddie will, by far, produce the biggest losses for the government, easily surpassing a trillion dollars when things are through. Much of that has to do with a congressional imperative to have housing be affordable, regardless of the consequences, which caused Fannie and Freddie to underwrite hundreds of billions of dollars worth of mortgages that would have never met the charter of the institutions for years and years. No matter, they were both under tremendous pressure to guarantee those loans, which were, again, often made with little to no serious documentation.
Arguably, both institutions could have kept their combined losses well under a trillion dollars had both institutions chosen not to retain their mortgage bonds on their own balance sheets, using leverage to create short-term profits that led directly to outsized pay packages of the likes of which make the current bonus issues seem like nonissues -- especially given the fact that the latter were, at least, earned from prudence, not greed. The Volcker Rule would have done absolutely nothing to forestall the trillion-dollar losses that should have been expected to happen because of reckless lending. It's irrelevant to the largest loss we taxpayers will take in this era.
AIG's the trickiest. One could argue that AIG is at the true heart of all populist revolt, not Goldman Sachs (GS), because AIG is a $200 billion bailout, where there is ample evidence that only a fraction will come back to the government, even as everyone from the ever-present Hank (Hack) Greenberg to present CEO Robert Benmosche insists that payback will not be a problem. AIG's the trickiest, because there were two AIGs: the AIG that offered traditional insurance and the AIG that owned and insured financial products. It was the latter that caused the company's downfall, and most of that insurance was issued in London. The liabilities were not disclosed and were thought to be minimal anyway, because AIG was insuring, again, mortgage bonds. There was no hedge fund, no prop trading and no private equity exposure. Arguably, the issue here is quite simple: disclosure. We did not know what AIG was up to in London and the loans were denied or hidden, which is a matter for federal prosecution.
The disingenuous discussion of AIG’s problems by Congress has led to an ill-informed populism and backlash, based on a decision by the government not to seize the firm, but let it operate as a basically government-owned institution that paid bonuses to retain people from the non-London offices, just to keep the losses more manageable. The inability of anyone to explain this satisfactorily has led to the public outcry. And the fact that one of the insured institutions that got a make-good was Goldman Sachs is the crux of the current problem.
Which leaves us with, alas, Goldman Sachs, which did have prop trading, did have hedge funds and did have private equity under its roof. The lunacy of the Volcker Rule is well evidenced by Goldman Sachs itself. The reason why Goldman did not fail involves risk management and a lack of concentration on one product: It was diversified to the point that nothing could bring it under. One could argue, cogently and sardonically, that unless firms adopt the Goldman business model, they should be closed, and that if they had, we would not have been in this predicament. This is why the outrage is so great. Goldman was also saved by credit default swaps, which insulated it from client losses on counterparty risk. It also was able to short real estate when others sought the risk of it to boost returns. Another issue of where it would run afoul of the Volcker Rule, another issue that saved it.
Two other instances must be addressed on this topic: JPMorgan and Bank of America (BAC). The former, because it was most similar to the Goldman model, was able to provide the assistance the government needed to prevent further major bank failures. The diversified nature of the business -- because of the anti-Volcker Rule model -- kept that company from failing. Plain and simple. That and, like Goldman, appropriate risk management. Ironic, isn't it, that Volcker's Rule might have made JPMorgan look a lot more like Wachovia or Washington Mutual, the two banks that experienced runs.
Bank of America's problems, u
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