11 December 2013

Volcker Rule and the Faux Unwinding of Risk

Yesterday, a body of regulatory agencies finalized the tenets of the so-called Volcker Rule, which seeks to limit the ability for banks to engage in investing or trading deemed too risky.

So first of all, there are two kinds of banks – commercial banks and investment banks.  Commercial banks take deposits (our savings or checking accounts) and use the surplus funds to make loans to businesses, consumers and potential homeowners, earning a return in the process.  Investment banks perform a variety of other activities, some of which may be deemed riskier than making a plain-vanilla loan.  Mostly, they trade their own capital for profit, act as financial advisors in transactions and they engage in market-making in securities markets to facilitate liquidity for their corporate and institutional clients.

A commercial bank’s source of capital, as already alluded to, are the deposits that we give them to safeguard for us.  Those are insured by the FDIC, an industry self-funded entity, with an implicit guarantee provided by the Federal government.  In contrast, an investment bank’s source of capital is basically just like every other business’s.  They must have partners buy-in providing equity capital and/or borrow it by issuing debt in the public market.

The “cost of capital” for a commercial bank is the interest rate that they must pay on our savings account or the marketable equivalent through issuing certificates of deposit.  Both offer comparatively low interest rates.  In other words, the cost of bank deposits for the commercial bank is comparatively cheap.  Because the lender is unsophisticated (just every-day people opening a bank account), the funds are insured with a Federal back-stop and there had traditionally been a limit to the amount of risk a bank could take reinvesting those funds.

The cost of capital for an investment bank is much more expensive.  It must pay whatever the market demands.  And the market is sophisticated, the funds are not insured and the investing of the funds will be riskier.

So for example, in a normal investment environment (unlike now), commercial banks might have to offer savings deposit or CD rates somewhere around ~2.5-4%.  An investment bank would have to source capital through either issuing notes which would carry an interest rate more like ~6-8% or issuing equity, which would “cost” ~10-12% (by issuing equity, you give up a share in the earnings and profits of your business; basically if the stock tends to go up ~10-12% a year on average, you are giving that up, or “paying that out”).

The separation between commercial banks and investment banks ended in 1999.  President Bill Clinton and a Republican controlled Congress approved the Gramm-Leach-Bliley Act, which repealed the Depression Era Glass-Steagall provisions of the 1933 Banking Act, put in place expressly to separate such activity.

1999 forward, what this did was it allowed for banks to engage in riskier investing and trading, raising capital at a cheaper cost by using our deposits.  The banks could now use our savings deposits to do things riskier than make some loan to a business or consumer.  In other words, it mispriced risk.  They could now raise capital at a cost that did not account for the risk.  There was a reason why investment banks had to pay more for their capital.  They did riskier things.  Now, since 1999, they don’t have to pay more for taking more risk.

Banks (and most businesses) lever.  In other words, they have more stuff than money they have.  So they borrow the rest.  If investors give me $100 million to buy a basket of securities, I can buy $100 million in securities.  But what if I want to buy $1 billion in securities.  I need to borrow the other $900 million.  Say I can borrow it at 7%.  That means I owe $63 million every year to borrow ($900 x 7%).

So what if the $1 billion of securities I now own earn 11% in a year?  That means I made $110 million.  But I paid out $63 million to borrow, so my net return is $47 million.  That might sound like I’m not left with much of that $110 million.  But remember, I only have $100 million in actual funds.  So through levering, I actually earned 47% on my money by borrowing to invest in a butt-load of securities that really only appreciated by 11%.

Such is the power of leverage.  Not bad, huh?  Well it can be.  As leverage magnifies potential returns, it also magnifies potential losses.  If those securities dropped 10%, my funds would be entirely wiped out (before even paying for the cost of borrowing).  Indeed, if the securities just went nowhere that year, I lost $63 million of my $100 million fund just to pay for borrowing.

So lenders to funds that will engage in this sort of activity will charge a higher rate to protect themselves from the risks of their borrowers’ investing activities.  Charging a higher rate does two things.  It provides the lender more cushion or payment for the risk the borrower is taking.  And it eats up more potential profits of the borrower who is using the loan to lever.  The higher the cost to the borrower, the less they are incentivized to lever a lot, as it eats up too much profits at some point.

If I could now borrow at 3.5% instead of 7%, I could borrow twice the amount while still just paying that same $63 million.  But now my entire fund will be wiped out in just a 5.2% swing on the $1.9 billion of securities I now own, v. the previous 10% swing on the $1 billion.  Leverage and risk has become mispriced, because 3.5% does not adequately reflect the risks that I am borrowing to engage in.

Off the top of my head, earlier in the 2000s, bank leverage (I define as tangible investment assets as a multiple of tangible equity) was ~5-10x.  A $1 change in the stuff they were invested in, lost or made them ~$5-10 of their own money.  By 2007/8, it was ~25-35x.  Earlier on, they would invest in securities that might earn ~6-8%, but losses might be flat to 1%.  By 2007/8, they were in all sorts of esoteric crap that might earn 15-25%, but also might drop by 20% or more.  And that’s BEFORE the effects of levering.

So if a bank can now use really cheap deposit accounts to do this sort of stuff, they can lever up a whole lot and in really risky investments.  That’s what they’ve been able to do for over a decade now.  There were also a handful of significant dislocations of accountability for risk that allowed this to perpetuate.

In the 1980s, the investment banks all started going public.  As a result, the owners were now a bunch of public shareholders that really had no clue what was going on inside, especially given that regulation concerning public disclosure is really rather poor to this day.  Before this, the owners were a bunch of partners risking their own money.  Everyone was constantly looking over each other’s shoulders on the inside.

The other dislocation is, no one really understood or “owned” the risk of these complicated mortgage-related investments, as the bank or broker originating the loan would instantly securitize them and pass it on into a pool owned by many investors that really had no transparency and had nothing to do with the origination.  The creator of the investment did not care about how risky or transparent it was, because they earned a fee to create it, and then instantly passed their Frankenmonster on to anyone else.

Today’s now-approved Volcker Rule attempts to unwind some of that mispricing of risk.  It prohibits banks from using bank deposits to engage in deemed riskier investing and trading.  They can no longer invest in or form private equity funds (which borrow funds to acquire businesses) or hedge funds (which engage in a wide variety of sophisticated and generally riskier trading and investing).  Banks can no longer use their own capital to directly engage in that form of trading and investing.

But they are allowed to continue to use capital in market-making activities for their clients.  Which should be the case, but is generally misunderstood by the unsophisticated public.  When market-making, banks compete with each other to get the trade order and earn a commission or mark-up.

So for example, client Fidelity might suddenly call up Bear wanting to sell 20 million shares of Apple, unbeknownst to Bear a moment earlier.  If Bear can’t do the trade at the best price and in the time Fidelity wants, Fidelity will pass and go do it with Merrill who will.  So in order to be able to suddenly take down 20 million shares on a moment’s notice for one of the biggest clients around, Bear needs to be able to use its capital to set up various types of hedging trades to safeguard having to suddenly own 20 million shares of Apple.

This activity generally has a depressive impact on the share price of its client’s Apple position.  Which runs counter to the interests of the client, as they will have to sell the shares lower.  But if no market maker engaged in this hedging, no market maker would aggressively offer the best possible unwind for Fidelity.  And Fidelity would have to sell those shares ultimately at a much lower price over a much longer period of time, as they awkwardly pound the market lower trying to get out.

So Bear’s trading practices to protect itself is a necessary evil of sorts that client Fidelity accepts in order to get the best possible result, given the weight of the order.  And none of that is illegal.  Because as a market-maker, the bank does not have a fiduciary duty to the client, irrespective of the various front-running rules.  In fact, it’s only duty in market-making is to “know the client”.  That means make sure they are sophisticated, adequately capitalized and confirm that they aren’t running money for Al Qaeda.  All of these duties are to protect the market-making bank, not the client.

Fiduciary duties to the client only exist when securities subject to the Securities Act of 1933 are being issued in the primary market.  That means basically only for US stocks and corporate bonds being IPOd, or issued for the very first time.  For anything else issued for the first time – really complicated mortgage-related instruments for example – no such duty exists.  For the everyday market-making activity they blather on endlessly about on CNBC, that duty is not really there.  And institutional clients fully understand and accept that... Until they have to blame their own irresponsibility on someone else.

So sprinkle some loose rules and regulation, mispricing of risk, investing in misunderstood instruments, dislocation of accountability all allowing for banks to take on way too much risk and leverage using your life savings all relying on home prices going up forever but really went down ~20-50% perniciously since 2006… and you get the worst financial crisis of perhaps ever.

All they had to do was make all investment instruments subject to the 1933 Act.  It would shine all the sunlight that a common stock is exposed to on all those weird mortgage-related instruments, and it would force banks to apply the same duty of care when issuing them for the first time.  And they need to fully separate commercial banks from investment banks.  Salomon Brothers did just fine before it was a subsidiary of Citi.

But none of that happened really with Democrats Chris Dodd and Barney Frank’s namesake 2010 legislation which is supposed to right these wrongs, and which spawned this Volcker Rule.  Because it wasn’t really written by Frank or Dodd.  It was written by the banks.  A Republican couldn’t have asked for more.

And the banks are bigger than ever.

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