Wednesday, January 19, 2011

Warren Buffett, Michael Lewis and the Volcker Rule

A Wall Street Journal article on the most recent steps taken by regulators in implementing the Volcker Rule observed:
... [the Volcker Rule] seeks to prevent banks from putting capital at risk by prohibiting proprietary trading and banning certain relationships with hedge funds and private-equity funds.
As expected, the study didn't recommend a precise review of each trade to see if it complies with the law. But it did recommend firms flag each trade in a variety of ways, including whether a customer or the trader initiated the position.
The council acknowledged it is difficult to distinguish between prohibited proprietary trading and a permitted activity, such as market-making, hedging or some other trade done on behalf of a bank's client.
Sorting out this "grey area" will be the key focus for the individual agencies, said Mary Miller, Treasury assistant secretary for financial markets, during the open meeting.
The study recommends requiring banks to close proprietary trading desks, since their activity is unambiguously in violation of the Volcker rule. This is already happening. Major Wall Street firms, including Goldman Sachs Group Inc. and Morgan Stanley, have seen high-profile traders depart or plan to start new firms in anticipation of the new restrictions.
The study also recommends banks be required to set up internal controls and compliance regimes.
One new wrinkle getting notice on Wall Street: The study recommends company chief executives attest to their company's compliance, signaling how important the council considers the Volcker provision.
That all sounds wonderful, however, the reality is that the whole focus on sorting out the grey area is fundamentally flawed.

Recently, Michael Lewis wrote a column in which he discussed how hard it is to distinguish between proprietary trading and acting as an agent for the customer.
The banks have no intention of ceasing their prop trading. They are merely disguising the activity, by giving it some other name.
... The fullest explanation came from a former Lehman Brothers corporate bond salesman named Robert Wosnitzer, who is now at New York University, writing a dissertation on the history of proprietary trading. He’s been interviewing Wall Street bond traders, he said, and they have been surprisingly open about their intentions to exploit one obvious loophole in the new law.
... “One trader I interviewed,” Wosnitzer says, “said that from here on out, if he wants to take a proprietary position in a credit, he will argue that he bought the position because a customer wanted to sell the position, and he was providing liquidity; and in order to keep the trade on, he would merely offer the bonds 10 basis points higher than the offered side, so that he will in effect never get lifted out of the position, while being able to say that he is offering the bonds for sale to clients, but no one wants ‘em. When the trade finally gets to where he wants it -- i.e., either realizing full profit, or slaughtered by losses -- he will then sell it on the bid side, and move on.
Of course, there is all sorts of flawed logic here, but the point is that...there are a hundred different ways to claim to be acting as an agent or for a customer.”
This ambiguity is no doubt one reason the financial reform bill passed in the first place. Even its clearest prohibitions are couched in language inviting Wall Street to evade them.
These hundreds of different ways to "hide" from the Volcker Rule provide plausible deniability to CEOs and allow them to sign on that their firm is in compliance with the Volcker Rule when in fact the "proprietary trading" activity has not stopped.

Mr. Lewis discussed why proprietary trading is so important to the large financial institutions.
But the new game of cat and mouse raises a simple, even naive question: Why do these giant Wall Street firms want so badly to make huge bets with their shareholders’ capital?
Save Us
After all, the point of the ban on proprietary trading is as much to save the banks from themselves as to save us from them. We have just come through a period where putatively shrewd individual bond traders lost not millions but billions of dollars for their firms, by making really stupid bets.
Even before the crisis there was never any reason to think that traders at big Wall Street firms had any special ability to gamble in the financial markets. Anyone with a talent for investing is unlikely to waste it on Morgan Stanley or Bank of America; he’ll use it for himself, or for some hedge fund, which allows him to keep more of his returns.
And if this were true before the financial crisis it is even more true after it, when trading inside a big Wall Street bank will be less pleasant and more fraught with politics.
Yet Wall Street’s biggest firms apparently still badly want their traders to be allowed to roll the bones. Why?
What They Do
One answer -- which Wosnitzer points to -- is that this is what Wall Street firms now mainly do. Beginning in the mid- 1980s, the Wall Street investment bank, seeing less and less profit in the mere servicing of customers, ceased to organize itself around its customers’ needs, and began to build itself around its own big and often abstruse gambles.
The outsized gains (and losses), the huge individual paychecks, the growing ability of traders to bounce from firm to firm from one year to the next, the tolerance for complexity that doubles as opacity: all of the signature traits of modern Wall Street follows from the willingness of the big firms to allow small groups of traders to make giant bets with shareholders’ capital, which the shareholders themselves don’t and can’t understand.
It is not only the shareholders that don't and can't understand.  It is also the regulators that don't and can't understand the giant bets being taken.

Given all the obstacles the regulators face in drafting regulations that actually achieve the outcome intended by the Volcker Rule, the regulators came up with a novel solution.
Regulators seemed willing to allow Wall Street firms to draft the initial compliance programs.
The study's approach "empowers the industry to write a bottoms-up program that reflects how things are done," says William Sweet, a partner at Skadden, Arps, Slate, Meagher & Flom LLP. The big question now is how regulators will greet each firm's plan to comply with the Volcker Rule.
Both Wall Street and the regulators should be thrilled with each firm's plan to comply with the Volcker Rule.  Wall Street because it can write a plan that will not prevent it from continuing with proprietary trading under another name.  The regulators because they can claim that Wall Street is in compliance.

If the regulators ever actually wanted to perform their regulatory function, there is a simple regulation they could put in place that would guarantee compliance with the Volcker Rule and eliminate proprietary trading under any name by the large Wall Street firms.

The regulators should require that the Wall Street firms disclose to all market participants at the end of each business day each and every position in their trading and investment portfolios.

As Warren Buffett would be happy to point out, this simple regulation would dramatically squash the potential profitability of proprietary trading under any name.

A number of years ago, he negotiated with the SEC and received permission to delay disclosure for his investment positions.

Why would he have wanted to delay disclosure?

If he was buying, he wanted to delay disclosure to minimize the price he paid for his entire position.  By not filing, he does not have to compete with investors who piggyback on his reputation and ideas. These investors would have increased the cost of his position by driving up the price of stock with their buying.

If he was selling, he wanted to delay disclosure to maximize the price he received for his entire position.  By not filing, he does not have to compete with investors who piggyback on his reputation.  These investors would have decreased his sale proceeds by driving the price of the stock down with their selling.

Clearly, there are advantages to having opacity when it comes to buying and selling securities.

Eliminating opacity in the trading and investment portfolios also has another advantage for regulators.  Regulators can now turn to other market participants, like portfolio managers and competitors, for help in analyzing what are the risk of an individual firm's trading and investment portfolio.

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