Financial Reform – Still on the Hook

In the wake of the financial meltdown, Wall Street and those that are “Too Big To Fail” have returned to business as usual with leverage levels and risk taking on par or greater than in 2007, including proprietary trading and the resumption of abusive derivative trading relative to their capital capacity.  To date, there has not been meaningful reform.

Proprietary trading occurs when firm’s traders actively trade stocks, bonds, currencies, commodities, their derivatives or other financial instruments with their own capital as opposed to its customers’ money, so as to make a profit for themselves.  It is estimated that 68% of all Goldman Sachs 2009 revenues were derived from this type of trading.

The issues with proprietary trading are fundamental and ethical.   While the most visible problems are the abuse called “Front Running” (proprietary trading desks trade for their own account  ahead of large blocks from pensions or hedge funds thus guaranteeing a riskless and undeserved profit) and the sale of products to clients while the proprietary desk puts on a short position in the same issue (the current Goldman probe), the biggest problem in the proprietary trading area is the over-leverage caused by bets (yes, bets!) using over-the-counter credit derivatives.  If you remember, this was the type of behavior that forced the U.S. Taxpayer to bail out AIG.  One would think that, given the magnitude of the risks to the financial system that can be caused by a few ill conceived bets, there would, by now, be some legal and regulatory safeguards to insure that the taxpayer would not again be on the hook for another large bail out.  But, so far, there has been no such movement, and, in fact, these types of contracts are the biggest profit producers (and largest risks) for the proprietary desks.

In the insurance industry, one cannot buy a policy on someone else’s life without having and “insurable interest”, like being a family member or a business partner.  Yet, in the derivative market, anyone can buy such a policy (called a Credit Default Swap or CDS) on say, the debt of another entity.   AIG went down because they issued CDSs that were several times the amount of debt that Lehman Brothers had outstanding, and the government stepped in to prevent a domino effect on Wall Street.  If AIG couldn’t pay off the CDSs at par, then a significant portion of the assets (and capital) of the other large Wall Street firms, like Goldman and JPMorgan, would have to be written down.  You see where this could have led!

In addition, it has recently come to light that Lehman used “unorthodox” accounting at each quarter’s end to “window dress” its balance sheet to hide toxic assets. (I wonder how widespread this practice is!)  Finally, it appears that the big U.S. Wall Street firms have been able to “fluff” their capital through various other accounting gimmicks, thus publicly reporting higher capital ratios (lower leverage ratios) that actually exist.

There are a lot of rumblings regarding “financial reform” on Capitol Hill these days.  The Volcker Rule is the hot topic.  Volcker has proposed that to control their capital ratios and prevent over-leverage, banks that accept federally insured deposits be restrained from investing in hedge and private equity funds and be restricted from operating proprietary trading activities.

For the sake of looking like they are doing something, Senator Dodd of Connecticut passed a “reform” bill out of the Senate Banking Committee on a strict 13-10 party line vote.  Since that time, all focus has shifted away from substance, i.e., correcting the issues discussed above, to form.  No longer are they arguing about what is in the bill, they are now debating which of their bureaucratic cronies (Fed, Treasury, or a new and costly Federal Agency) gets to have regulatory oversight of Wall Street.

It is clear that the original risks that caused the financial meltdown still prevail at the large Wall Street institutions.  With such large profit at stake, the lobbyist are in full gear.  As a result of that economic power, those lobbyists, and their political clout via their political contributions (which the U.S Supreme Court has now made unlimited), real reform will likely not be in the legislation. Without real reform, Treasury Secretary Timothy Geithner’s mantra, “we must insure that such a financial meltdown never again occurs” are just empty words.  America is still on the hook for significant major bailouts.

Robert Barone, Ph.D.

April 15, 2010