(This guest post originally appeared at NewDeal2.0)
Senator Chris Dodd is right to wonder, as he said yesterday, why the Obama administration waited so long to support something like the new “Volcker rule” — and then throw it into the mix to complicate the legislation. But that’s not the biggest problem.
What is disturbing is how poorly the Volcker rule has been thought through. When first announced, it sounded like a worthy and needed step in the right direction, and a suggestion the Obama team was waking up to reality. But I also expected more sophisticated details to come.
So far, there are none. The main proposal is to separate “proprietary” trading from lower-risk normal bank activities. I naturally assumed the Obama team was going to expand the definition of proprietary trading beyond its narrow meaning on Wall Street. So far it looks like they didn’t give it much thought before announcing the plan. This is a critical error in judgment.
Volcker apparently thinks that proprietary trading encompasses most of the risk-taking speculation done by the banks. He objects, because they put at risk the money that is guaranteed by the federal government. The banks have access to the Fed window for reserves to bail them out, and trillions of dollars of federally-insured checking and savings savings deposits.
It is hard to imagine he is that out of touch. Disturbingly, Volcker has said publicly that most bankers know the difference between trading for speculation and trading for their customers (making markets). Well, if they do, how do we truly separate the two tasks? It is a lot harder than it looks.
When the banks make markets through their sophisticated trading desks, they often take positions in securities, including in the past collateralized debt obligations and all manner of derivatives, including credit default swaps. They also borrow in the short-term loan markets to do that.
They take so-called directional positions as well. If they think interest rates will fall, they may buy more bonds on the trading desk — and undertake far more complex versions of that same strategy. How much of this goes on? A couple of journalistic pieces quoting bankers claimed not much. Don’t believe a word of that.
It reminds me of how Lewis Ranieri of Salomon started the mortgage-backed securities business in the late 1970s and early 1980s on Wall Street in the first place. He just kept buying mortgage from the dying thrifts — the thrifts especially benefited from a huge tax benefit as per 1981 legislation if they sold their low-yielding mortgages at a loss. Ranieri piled up the bonds in his trading account, to the consternation of his partners at Salomon. When rates fell in 1982, he made a bundle and the mortgage securitization business had a firm foundation.
A half dozen years later, an overconfident Ranieri and Larry Fink, the man who more or less invested the collateralized mortgage obligation and the now infamous tranches, lost a bundle. The losses surely had a part in Ranieri’s losing his job at Salomon then. Fink was no longer a wonder boy at First Boston and left to start BlackRock.
Were these guys just taking positions to facilitate trades? Of course not. Some other examples. In 1987, a trader for Merrill (who used to work at Salomon), Howie Rubin, lost up to $300 million by taking positions in mortgage bonds. In the late 1980s, a trader named Andy Krieger lost a bundle for Bankers Trust in other securities, including derivatives. In 1994, when Greenspan suddenly raised rates, a trader at Kidder named Michael Vranos lost a bundle again on mortgages. These were merely the most flagrant examples. Of course, before that, these men were making a bundle for their companies, and themselves, as well. In fact, Krieger was making most of the money for BTC before that. Ranieri had made most of the money for Salomon before he took his hit. This was proprietary trading anyway you slice it. How do you separate that from pure market making?
From what I’ve read, the Obama people are now trying to deal with this issue. One of assured we are talking to everybody. That sounds like the way they came up with their regulation package also. What they should be doing is gather data on what’s really going on, not just talking to these people. They have to do some research. If they are, tell us about it. I’d for one would love to know the answers.
The Volcker rule could be far-reaching. But it is disturbing that the Obama administration announced it before they had done enough homework to tell us how it would work. And with respect for the one man of influence sticking up for true restraints on the banks, I’d urge Volcker not to minimize the difficulty of the task until he founds out more of what’s really going on.