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

Why Financial Reform?

Financial FAQs

It is becoming clearer that economic self-interest under the guise of trickle-down economics no longer rules in the debate over financial market regulation. There must be regulations that protect the self from itself, and the predatory behavior of others. The SEC’s charge that Goldman Sachs committed fraud in marketing Collateralized Debt Obligation insurance on the worst of subprime mortgage pools is the opening salvo in a campaign to make the players who almost drove financial markets over the cliff responsible for their deeds.

“The SEC suit again Goldman, if proven true, will confirm to people their suspicions about the total selfishness of these financial institutions,” said Wall Street historian Steve Fraser, as quoted in the New York Times. “This is way beyond recklessness. This is way beyond incompetence. This is cynical, selfish exploiting.”

Even President Bill Clinton said recently on ABC’s “This Week” that had he known the damage that unregulated derivatives could wreak on an unsophisticated public as well as sophisticated investors, he would never have backed the 1999 legislation that deregulated them. “I have said many times since then, I made a mistake.”

And even economists are beginning to see the light. A Cambridge, U.K. conference sponsored by currency trader George Soros is looking for other systems that might take us away from economic self-interest. Britain’s chief regulator said, "We need a fundamental challenge to recent conventional wisdom…a dominant conventional wisdom that markets were always rational and self-equilibrating."

Some of the difficulty in pinning down responsibility has been misconceptions about a capitalist economy, said 2001 Nobelist George Akerlof. There is always an element of ‘snake oil’ in all financial markets, which tend to be overlooked even by regulators. What is overlooked is their agenda, such as the ratings’ agencies underestimation of risk, or regulators’ inability to spot a Bernie Madoff. Regulators such as the SEC were either too overworked, or too unsophisticated in not looking under the covers of many offerings. And rating agencies were paid by the companies issuing the securities, hence tended to soften their risk analysis so that even some subprime-based securities were rated AAA.

Secondly, no one seemed to even understand the consequences. A string of unprecedented financial innovations created institutions that “don’t take into account the kind of communities we want to build”, said economist Robert Shiller in a recent New York Times Op-ed. Yet as leaders of their respective institutions it was certainly their job to foresee any downside consequences. There were certainly precedents, such as the creation of extreme asset bubbles in Japan. In fact, the Federal Reserve had worried about Japanese-style deflation in the early 2000s, the result of Japan’s own busted real estate and stock bubbles.

On the contrary, the biggest players only saw the upside. Greenspan in fact trumpeted the advantages of exotic (and unregulated) derivatives that spread the risk more widely, that he thought lessened the dangers of default. Yet Greenspan of all people should have foreseen the crash.

I remember well that he encouraged risky mortgages by recommending adjustable rate mortgages as preferable to fixed rates because their interest rates were lower, even though he admitted at hearings he only borrowed at fixed rates! A housing bubble was most unlikely, he said, because home owners couldn’t buy and sell their homes like stocks. Their transaction costs were higher, the housing market was less liquid—and moving costs were considerable.

This was when the Fed had been holding down short-term interest rates in 2003-4 almost as low as today in a bid to fight Japanese-style deflationary fears, and boost a recovery that hadn’t yet added one net job from the end of the 2001 recession. Because inflation was so low then—below 1 percent—the cost of money was in fact less than zero, which made it advantageous to mortgage with little or no down payment.

Why could some of the “smartest guys in the room” so miscall the worst downturn since the Great Depression? Greenspan for one, a disciple of Ayn Rand, believed that free markets embodied the highest moral order (his words). What made it moral? Greenspan, as Ayn Rand, et. al., believed that free market forces were the most efficient and impartial allocator of resources. So when crises did occur, they functioned as a market clearing device, and any attempt to mitigate their effects only prolonged the adjustment to new circumstances. Such crises embodied the forces of ‘creative destruction’ and shouldn’t be tampered with, in other words.

This is why many conservative economists who decried the stimulus spending said “let the banks fail”, so that bad debt can be wiped out. Creative destruction—the replacement of failing businesses with more vibrant ones—happened in nature, so why shouldn’t it be allowed to happen in the urban jungle?

The problem was that Greenspan’s ideology was outdated, and had become group think. The invisible hand of Adam Smith was no longer sufficient to control market forces that had become complex beyond understanding. Bubbles were caused by ignorance of fundamentals, including fundamental market forces that could go easily out of control when greater risk taking was encouraged, with no limits on borrowing.

Household incomes had been steadily shrinking in real (after inflation) terms since the 1970s, except for a short while in the 1990s, so the housing bubble and easy credit encouraged many households to spend borrowed money to keep up their standard of living, a standard that was now beyond their means.

A sustainable economic system in today’s world has to take more than individual self-interest into account, since more than the individual is affected. Financial markets are today intimately linked, so that markets may collapse world-wide if leaders are not held accountable for their risk-taking. Alan Greenspan made a choice of individual gain without regard for its consequences when he chose to ignore the housing bubble. But the captains of industry-and government-have to be held accountable for the welfare of all those affected by their actions as well.

Harlan Green © 2010