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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 This implementation would effectively reinstitute the Glass-Steagall Act which was rescinded in 1999.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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