Saturday, January 29, 2011

Will Volcker Rule Change Wall Street?

Financial FAQs

Paul Volcker, former Fed Chairman under Presidents Carter and Reagan and economic advisor to President Obama, has at 83 years of age coined a new term, the “Volcker Rule”. It is in the form of findings by the Financial Stability Oversight Council, set up under the Dodd-Frank Bill to consider rules that will rein in Wall Street’s speculative activity that was the main cause of the Great Recession.

The statute seeks to make explicit what types of proprietary trading will be permitted, but the section is open to interpretation by bank regulators. A key issue for regulators is whether they can identify whether a bank made a trade on behalf of a customer, which is permissible, or for its own account, which is not, says CBS Marketwatch.

Why such a need? Because congressional testimony revealed that traders such as Goldman Sachs regularly played both sides of a ‘bet’—i.e., order by clients to buy or sell an asset. They would tout the benefits of an investment to clients, while its own traders in many cases knew it was “crap”, and then bet against that same investment by shorting or otherwise taking out insurance that paid off if the investment failed.

That was particularly true with subprime mortgages, where its traders knew the default rates would be high, and its bond ratings not really the AAA ratings given by the likes of Moody’s and S&P. We now know Goldman Sachs and others made $ billions on such bets that those investments would fail.

The findings also recommended that banks do not own hedge funds or other financial entities that do high risk trading, and that chief executives attest to the effectiveness of their internal compliance efforts to enforce the Volcker Rules.

How liable were commercial banks and investment banks such as Goldman Sachs for the Great Recession, whose initial cause was the busted housing bubble? Subprime mortgages were only a small part of the problem, and real estate in general never made up more than 7 percent of economic activity. But the tremendous amount of overinvestment in housing—1 to 2 million per year were built in excess of actual demand—was multiplied by the unregulated derivatives’ markets that sought to profit from the artificial demand created by so much housing speculation.

And banks became so enamored with what they considered foolproof investments—housing prices had never actually dropped since WWII, and the mortgages backed by them were insured not to fail. Problem was that it was all borrowed money—even the insurance that backed those mortgages. And so the bubbles burst—first housing, then stocks, then the credit house of cards that supported them.

Was there actual criminal behavior that caused the house of cards to collapse? Of course, since derivatives’ traders in particular had a fiduciary duty to their clients to tell the truth, and avoid the conflicts of interest inherent in representing both their clients and their employers. Both are prosecutable offenses and fraudulent behavior.

But it is up to the Justice Department and SEC to prosecute them. Their actions are documented in the 500 plus page report and many accompanying pages of testimony by those involved. There are also tremendous damages documented in the report, which means injured parties can sue in civil courts as well. But we hope the Justice Department will lead the charge with criminal charges. Otherwise it will be business as usual on Wall Street.  If only civil penalties are levied, stockholders will again be picking up the tab.

Harlan Green © 2010

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