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Time For Banks to Stop High-Risk Trading

Companies / Market Regulation Feb 12, 2010 - 08:30 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleShah Gilani writes: When members of the Senate Banking Committee recently asked Paul A. Volcker how regulators would identify banks engaged in excessive, high-risk trading, the former U.S. Federal Reserve chairman quipped:  "It's like pornography - you know it when you see it."

Volcker wants to make it illegal for banks to engage in such high-risk activities as "proprietary trading" - when an institution trades for its own accounts, as opposed to making trades for customer accounts. But as Volcker's comment illustrates, the proposal - known as "Volcker's Rule" - the whole concept of high-risk trading is pretty hazy and hard to define.

Just as hazy is the definition of what now constitutes a bank.

Long gone are the elegant subtleties of form and finesse that once defined the bank. In recent years, the entire concept has been cheapened by the vulgar obviousness of grossly enhanced compensation schemes.

No company better embodies this transformation than Goldman Sachs.

I used to be a great admirer of Goldman Sachs when it was a private partnership. Now I just gawk at Goldman like an adolescent boy mesmerized by cheap pornography.

The bottom line is that Goldman Sachs Group Inc. (NYSE: GS) has become the centerfold for everything that's now wrong with banking.

So before the truth about the sordid state of banking gets dressed up and legitimized by the usual nexus of Wall Street and Washington pimps and panderers, we would do well to strip Goldman of its cloak of invincibility and lay bare the danger in its lust for money.

Let's be clear: Goldman Sachs is not really a bank.

A commercial bank takes in deposits, offers checking and savings accounts, and makes loans. Goldman doesn't provide those services.

The Transformation of Goldman Sachs

For 141 years, Goldman Sachs was an investment bank. But that changed on Sept. 21, 2008. Goldman had reached a critical point in the financial crisis, was facing a potential collapse, and needed government help.

Since only chartered commercial banks and "bank holding companies" can access the Federal Reserve's discount window for billions of dollars worth of cheap loans, Goldman begged to be converted to a bank holding company. The approval process usually takes months to complete - and the application can be denied. In Goldman's case, however, the process took only one day. The approval was granted on a Sunday, no less.

As a bank, Goldman could now borrow untold billions from the Fed's discount window. How much? No one knows because the Fed does not disclose how much any individual bank borrows from its discount window. The new charter also allowed Goldman to sell $28 billion of debt backed by the Federal Deposit Insurance Corp. (FDIC). Goldman also got $10 billion of Troubled Asset Relief Program (TARP) money, which it recently repaid.

In addition, at the time of the crisis, Goldman was receiving collateral, in the form of billions of dollars in cash, from insurance giant American International Group Inc. (NYSE: AIG). AIG had sold credit default swaps (CDS) to Goldman to protect the investment bank from falling credit default obligations, which Goldman had gambled on. Thanks to taxpayers, Goldman eventually got 100% of the value of the CDOs that AIG had insured, even though those they were nowhere near worthless.

And what did Goldman Sachs do with all the money it got from taxpayers? It traded. That's what Goldman Sachs does - it trades.

Goldman Sachs is giant hedge fund, not a bank. More precisely, it's like a fund of funds. It has multiple "profit centers," each with its own profit-and-loss statements. Each profit center is run like a hedge fund, securitizing asset pools, syndicating leveraged loans, writing credit default swaps, trading equities, bonds, commodities, currencies, real estate - or anything else it can make a profit on - and managing money for others, by trading for them.

Goldman Sachs is still an investment bank.

Goldman's investment-banking business is very lucrative. But the advice the investment-banking business sells for exorbitant fees is really just another means by which the firm can garner trading opportunities for itself. It manages the securities underwritings and bond offerings its investment bankers bring in from the giant corporations who are Goldman's customers. And then, of course, it trades all the instruments it creates for those customers.

Somehow, all the inside knowledge about deals, mergers, underwritings and the firm's banking business is separated from all the traders by a "Chinese wall."  But a Chinese wall isn't a real wall.

It's an illusion.

It's All About Trading

There's nothing wrong with trading, or with taking on risk to make money. But there is a problem with risk-taking with money that really belongs to depositors, or to taxpayers. There is a problem with taking risks backed by taxpayer bailouts, with taking risks that leverage the hugely integrated worldwide financial system, with taking risks that ultimately hold the world's central banks hostage.

The kind of trading that is a problem is commonly called "proprietary trading." Prop trading is trading done on behalf of the "bank" and not its customers. In other words, the bank's traders use the bank's money to take risks by positioning themselves in trades they hope to profit from. The line between the bank's money and its depositors' money - or the money made available by taxpayers to bail out the bank if its trading losses jeopardize the banks' depositors or the banking system - is a thin and hotly debated one.

That brings us back to Volcker.

Right now, the $64 million question being asked is this: How, exactly, do you define proprietary trading? Volker, the esteemed former Fed chairman who is now the Obama administration's point man on financial reform, was asked that very question last week in hearings conducted by U.S. senators Christopher J. Dodd, D-Col., and Richard Shelby, R-Ala.

We already know how Volcker responded.

This focus on defining precisely what constitutes proprietary trading is nothing more than a ruse by the cabal of Wall Street and Washington interests who want to preserve the status quo of banking and trading institutions.

While it should be clear what is or isn't proprietary trading, the reality is that it isn't clear at all. And it isn't clear precisely because everyone engaged in it is trying to hide it. Why? Because that's where the fat profits come for to pay the giant bonuses.
It's another paper thin Chinese wall, only this one is actually transparent if you look at it from the perspective of what's really going on. Banks say that they have to trade in order to accommodate their customers. Because they are so altruistic, banks will take unnecessary risks to take the other side of a customer's trade, purely to facilitate the customer, of course. Then, they have to trade out of the position they took, hopefully for a profit. But, it seems the banks trade out of these positions quite well.

And no one trades out of them as profitably as Goldman Sachs. But, it's not proprietary or "principal" trading, just good risk management in the process of serving customers.
How does Goldman spin this web of obfuscation? According to atranscript of a call with analysts, David Viniar, Goldman's CFO, made the following comment about the firm's stellar 2009 results, which saw net revenues of $45.2 billion and net earnings of $13.4 billion.

With regard to trading to accommodate customers, Viniar said: "They need someone to provide capital to be on the other side and we are there for them. That, though, results in us taking risk and in us trading. The great bulk of what we do all day long in all our products for all our clients which hopefully helps them results in us taking risk and if we manage it well, results in us making a profit."

In other words, Goldman can take the other side of every trade a customer puts on and call it a customer-based trade it's taking, rather than a proprietary trade. There's nothing to stop them from taking the other side of a customer's trade in IBM, for that matter, and arguing that would not constitute a prop trade. But, whose capital is then at risk? Not the customer, the bank, or in this case Goldman's capital.

And here's where the rubber meets the road. Goldman is not a private partnership, whose partners' equity capital and years of prudent management are being risked on everyday bets. It's public shareholders being teed-up first, then taxpayers, then the Fed when it has to bail out the banking system (that would be taxpayers, again), then the U.S. Treasury when it has to bail out the economy (that would be the taxpayers, again), and then the world's central bankers who have to bail out countries afflicted by contagion (that would be us taxpayers, again).

It solution is really simple. Separate deposit-taking commercial banks backed by taxpayers from investment banks. End all prop trading at commercial banks. Allow them only to act in an agent capacity when they fulfill customer orders. Never backstop private risk-taking investment banks, hedge funds or private equity shops. Break up all the too-big-to-fail banks, starting with Goldman Sachs. And if any product, derivative or otherwise, is allowed to be launched after extensive academic review, make them transparent, traded and cleared through adequately capitalized and monitored exchanges.


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