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.