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Proprietary Trading Did Bring Down Wall Street

Posted by Larry Doyle on February 3, 2010 12:37 PM |

The Wall Street lobby in all its glory is fighting tooth and nail to defend its turf from the volley launched by former Fed Chair Paul Volcker. Recall that the newly designated Volcker Rule, if implemented, would disallow proprietary activities from those institutions taking consumer deposits. This implementation would effectively reinstitute the Glass-Steagall Act which was rescinded in 1999.

The proprietary activities most often highlighted by those in the banking community are investment and trading activity within private equity, hedge fund and prop trading desks. The banks are screaming that these activities should not and need not be separated from their overall operations because these activities did not cause our economic crisis. They would be correct on one hand, but how convenient that their definition of proprietary is not truly comprehensive. How so?

I raised the question as to what constitutes proprietary trading when I wrote, “Mr. President, Are SIVs Considered Prop Trading?” What is a SIV? A structured investment vehicle. How did they work?

A separate entity would be set up off balance sheet, typically funded through the commercial paper market, with a spread made between the differential in funding cost and return on assets purchased. These SIVs were often viewed as very low risk because they invested in AAA if not AAA+ assets. How can an asset be rated AAA+? Easily . . . rating agencies provided that rating to certain bonds in selected deals which had a better risk profile than that of the AAA bond. These AAA+ bonds were also called super-senior bonds.

The brain surgeons running the banks viewed these SIVs as cash cows. Given the liquidity in the commercial paper market and the AAA+ rating on the bonds, the banks would typically accrue 20-25 basis points (.20-.25%) on the SIV and go back to managing the real risks in their other business units.

So let’s get this straight. The SIV borrowed money through the commercial paper market and purchased assets from other banks or from its own broker-dealer operation. In the process, the SIV generated what appeared to be low returns, but also with low risk.

Would you call this a proprietary business? I would. Well, what happened to these supposed low risk vehicles?

Funding dried up given the highly suspect quality of the assets purchased into the SIVs. The value of the assets themselves dropped like a rock. The banks owned hundreds of billions of assets in these SIVs. The losses brought Wall Street and our country to its knees.

Let’s stop with the nonsense that proprietary activities did not bring down Wall Street. A SIV is and was very much proprietary.

When will the crowd in Washington and Wall Street be honest with themselves and America and acknowledge this?


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  • Patriot

    Do you think Congress would understand how a SIV works? When they hear SIV, they’re thinking sieve as in the money that flows through their PAC into their pocket.

  • fiscalliberal

    Thank you for pointing this out. I watched the hearing with Volker yesterday and Congress and a lot of blogs seem to be so willing to question the proprietary trading and I do not think a one of them has come up with the example you give which makes a lot of sense. Volker seems to want it there because financial people are very inovative and he wants to arm the regulaters to stop the unsafe manipulations

    • LD

      Volcker gets it, but he clearly wants the definition to be comprehensive rather than merely having the banks say,” OK, we’ll give you the SIVs but we’re keeping everything else.”

      The fact is, this time it was the SIVs, the next time it could very easily be some group of traders within a prop trading group who decide they’re swinging for the fences under the “heads we win, tails you lose” approach.

      Rigorous risk parameters with severe capital ratios need to be implemented. All the stuff that did not happen and – to a large extent – still has not happened.

      Volcker is stating “do NOT put the taxpayer at risk with these kinds of activities.”

      Thanks for the plug.

  • divvytrader

    i think you 100% wrong LD . These SIV’s were created and filled up with blessing from senior management . Can’t find enough folks to make good loans to ? Just set up a SIV and create cashflow magically from ‘off balance sheet ‘ , The creation of SIV’s by banks was no different than the degredation of lending standards at all levels . Subprime , Alt-A , Option One ? Covenent Lite levereaged loans ? Its all a complete breakdown of basic Lending 101 . No mention of this by Volcker .

    Can you name me a single instance of some equity arb trader or UST/FNM arb trader who blew up a bank ? a commodity trader that blew up a bank ?

    And where did those SIV’s buy alot of their crapola ? why from their securitization desks , of course . Not a word out of Volcker on where securitization fits in his vision for banks .

    Reading Volcker’s statement , he says banks should be running payment systems , clearing trades for custs , extending credit to consumer and business , and asset management .

    How could he not get into specifics ? you really think if JPM whacks the GNMA arb trader and the equity arb trader that all is well ?

    If you look at what Volcker deemed as ‘ good bank business’ , its clear he’s talking about reinstituting Glass Stegall ….. OK , fine ….. BUT SAY SO! …..

    Next , picture BAC and JPM moving forward with this .

    JPM takes its broker dealer , securitization folks , investment bankers , research and some back office folks and spins it off into a new public entity ……

    Do you quickly see how once that business is all gone that JPM will be left with many thousands of folks they can’t possibly use going forward ? the layoffs would be staggering !

    And then there is the small problem about all those EU banks , Canadian banks , Japanese banks , etc still set up as super money cenbter banks able to fund their broker dealers with ultra cheap cash and undercut lending rates by the new JPM/C/BAC pure bankss ……

    No way we’ll compete unless all these guys agree to go same route and i see Geithner , Dodd , Shelby all making same point .

    Obama is using Volcker like toilet paper ….. The need to make changes at banks to stop ‘ too big to fail ‘ is badly needed and on surface , thats what Volcker claims his rule will do but as you look at what he says , its useless .

    Andy Kessler in WSJ has right idea today . Just set a new leverage limit on all FDIC insured banks to be at by some date in future . Let banks figure out what business they want to be in and what ones they want to get out of but if you set leverage to like 8×1 or so and make sure EVERYTHING on balance sheet , the banks can figure out what they stay in and what they get out of and they all shrink big time .

    • LD

      Divvy…I am having a hard time figuring out where you and I disagree. That is, specifically about the proprietary nature of the SIV. I promoted SIVs as proprietary vehicles and you seem to further promote that principle. In fact, I think you effectively reenforced it, while stating that you disagreed with my premise.

      I think we are in agreement.

  • divvytrader

    Larry : Let me be clear . SIVs are NOT prop trading ! They are an extension of the breakdown in lending rules / ethics in USA . Former CEO at Citibank blessing this no different than expansion of Alt-A lending , subprime lending , Option ARM , covenant lite biz loans , Commercial RE loans at absurd rent growth assumptions .

    How do we protect the public from next bail out if the fundamental reason banks exist ( assumed ability to lend money wisely ) is shown to be flawed !

    My point is that Volcker assumes all will be fine if we just force banks to give up prop trading ( by the way , most banks i know made a TON of money through this cris ) and make them focus on basic lending ( ie home loans , buziness loans , car loans , credit card debt , etc ) which in fact is where these banks all blew up !

    Reality is the Fed and Treasury and Congress stood by as banks eliminated all common sense in lending standards and they don’t want public acknowledging this so they are created a strawman ( prop traders ) to blame all the losses on ……. killing the strawman simply protects the status quo .

    Volcker already getting locked back up in the ‘crazy aunt in the attic’ room at WH . Obama has finished using him and its on to next charade . Dodd , Frank , Schumer , Shelby all bipartisanly trashing ‘ Volcker Rule ‘ and no chance it sees light of day .

    • LD

      We are mostly in agreement but to be frank I view SIVs as the intersection of the lending business, securitization business, and prop trading business.

      I think it is a matter of semantics, but have you even heard SIVs brought into the debate? No, because the Wall Street lobby is fighting hard to frame the debate.

      I do agree with you that capital constraints and leverage ratios are ultimately the key points in the debate.

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