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Volcker is Right. Prop Trading Kills

In a recent BankThink post challenging the rationale behind the Volcker rule, Richard E. Farley suggests that not a single bank collapsed because of proprietary trading in the last crisis.


Responding to Paul Volcker's public comment letter on the proposal named after him, Farley complains, "What he does not tell us, because he cannot, is the name of a single bank that went under and required taxpayer support because of proprietary trading gone bad."

Paul Volcker is a busy man, but I can name at least four institutions that effectively "went under" and required taxpayer support because of proprietary trading gone bad: Citigroup, Bank of America, Morgan Stanley, and Royal Bank of Scotland.

The question of whether the three U.S. firms could have survived without Washington's support is succinctly answered in the Oct. 5, 2009 report by the Special Inspector General of the Troubled Asset Relief Program. The title says it all: "Emergency Capital Injections to Support the Viability of Bank of America, Other Major Banks, and the U.S. Financial System."

The government has also provided the details of the desperation at these and other institutions in a huge disclosure of daily borrowings by 1,305 institutions from the Federal Reserve.

The data consists of every transaction reported by the central bank as constituting a "primary, secondary, or other extension of credit" by the Fed. Included in this definition are normal borrowings from the Fed, the primary dealer credit facility, and the asset backed commercial paper program. These borrowings did not include the Trouble Asset Relief Program announced in October 2008.

My firm sifted through more than 200 pdf files and compiled a database of daily borrowings and their respective maturity dates from Feb. 8, 2008 to March 16, 2009. We calculated the maximum and average borrowing for selected institutions after deducting matured amounts on the maturity date.

It is obvious from the results that Citibank, Bank of America, and Morgan Stanley were hurting for funding during this period.

Citigroup's borrowings, even after capital-raising attempts, were $24.2 billion at its peak. The consolidated borrowings for Bank of America and the two troubled institutions it acquired, Countrywide and Merrill Lynch, peaked at $48.1 billion and averaged $14.1 billion in outstanding balances. Morgan Stanley had peak borrowings of $61.3 billion and average outstanding borrowings from the Fed of $16.1 billion.

Even the reputedly exceptional JPMorgan Chase, when consolidated with Bear Stearns and Washington Mutual, had astonishing borrowings, peaking at $101.1 billion and averaging $23.6 billion. 

What about Royal Bank of Scotland? Most of its borrowings from the Fed came through a different program, the commercial paper funding facility. Even while the U.K. government was injecting 45.5 billion pounds sterling of equity capital, RBS’ borrowings from the Fed facility peaked at $20.46 billion.

Let's not get hung up on semantics, though. Suppose we concede that, since the rescues prevented failures, the institutions did not technically "go under." The more important question is whether proprietary trading caused their near-failure.

What is "proprietary trading?" The plain English explanation would not be "trading for one's own account" because banks have done that for decades. In the current context, the phrase means "trading in high risk instruments." Former Fed chairman Volcker's rule is based on the premise that the effective subsidy of deposit insurance should not facilitate a large New York bank’s attempt to manipulate the silver market, for example. 

The causes of Royal Bank of Scotland's nationalization were stated clearly in a report published in December by the board of the U.K. Financial Services Authority. On page 21 the report cites "substantial losses in credit trading activities, which eroded market confidence" as one of the key factors in the bank's unraveling.

In the case of the three U.S. institutions, the instruments responsible for the losses were collateralized debt obligations, credit default swaps (often insuring the value of CDOs), and subprime mortgages held directly or indirectly. Just read some of the ticker headlines from the height of the crisis:

October 5, 2007 Merrill Lynch writes down $5.5 billion in losses on subprime investments.

October 24, 2007 Merrill Lynch writes down $7.9 billion on subprime mortgages and related securities.

Nov. 5, 2007: Citigroup CEO Chuck Prince resigns after announcement that company may have to write down as much as $11 billion in bad debt from subprime loans.

Nov. 7, 2007: Morgan Stanley reports $3.7 billion in subprime losses

Dec. 19, 2007 Morgan Stanley announces $9.4 billion in write-downs from subprime losses. (FT)

Jan. 15, 2008: Citigroup reports a $9.83 loss in the fourth quarter after taking $18.1 billion in write-downs on subprime mortgage-related exposure.

Jan. 17, 2008 Merrill Lynch announces net loss of $7.8 billion for 2007 due to $14.1 billion in write-downs on investments related to subprime mortgages.

July 29, 2008 Merrill Lynch sells $30.6 billion in CDOs for 22% of par value.

I could go on and on and on. You get the picture.

Donald R. van Deventer is the founder, chairman and CEO of Kamakura Corp., a risk management firm in Honolulu. He is a former treasurer of First Interstate Bancorp in Los Angeles and a former vice president of risk management at Security Pacific National Bank.



(4) Comments



Comments (4)
One of the great sins of the Volcker Rule is using the name "bank" for every entity affiliated with a bank. Were the problems mentioned above in the holding company or an affiliate or the federally insured bank?

Another problem with this analysis is the failure to distinguish between mark to market losses and actual loan or investment losses. I know of one bank that had some significant write downs of its loan portfolio because it booked all its loans as held for sale. The actual loan losses were negligible. Eventually all but one loan in a $7 billion portfolio paid in full as agreed.

The whole debate over Volcker is muddled because Volcker made it that way. He wanted people to think -- wrongly -- that proprietary trading desks at large securities companies were using federally insured deposits to take big risks. The weren't. When the trades actually made by the federally insured banks are better understood Volcker's real agenda becomes clear -- to reinstate Glass Steagall through the back door.
Posted by gsutton | Tuesday, February 21 2012 at 5:42PM ET
The blame-game surrounding Dodd-Frank has had little to do with who and what actually caused the financial crisis. It sure wasn't the debit card fees the Durbin Amendment caps. Fannie/Freddie are likely suspects, but so far they remain unscathed by Capitol Hill's intervention. As for the rest of us, we're drowning in bureaucratic complexity. As The Economist notes [], the Volcker Rule alone weighs in at 848 pages--23 times longer than Glass-Steagall--383 questions and 1,420 sub-questions. Such flights of unworkable gobbledygook have only one likely advantage: they'll keep making work for Washington & Co., where home values have risen 80% since 2000, even as in many parts of Real America they've sunk. Neil Weinberg, Editor in Chief, American Banker.
Posted by Neil Weinberg | Tuesday, February 21 2012 at 5:31PM ET
Some banks use their swaps desks, as I know first hand from another large intitution that is not named above. Sometimes Reverse Repos were used. A fire burning in one side the house will eventually engulf the entire structure. While not insured, MF Global stands as a striking example of what goes wrong, even with relatively "low risk" trades. Collateral call anyone?
Posted by Old School Banker | Tuesday, February 21 2012 at 1:52PM ET
Can you please articulate how your observations on proprietary trading activity had a direct effect on the subsidiary entities which availed themselves of FDIC insurance? It is not clear from your post that deposit-taking banking subs were used in these activities
Posted by txc8675309 | Tuesday, February 21 2012 at 1:18PM ET
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