Writing Down the Volcker Rule

Editor's Note: MarketMinder does not recommend individual securities; the below is simply an example of a broader theme we wish to highlight.

So our government is closed. But fear not! Some government officials deemed vital are still clocking in—like the 50 in-house economists (some on loan from academia) working round the clock to complete a cost-benefit analysis on Dodd-Frank’s Volcker Rule. All so the Treasury can reach its (arbitrary) goal of having the rule written by year-end, allowing banks some time to meet the (arbitrary) implementation deadline of July 21, 2014. As we’ve written in the past, we aren’t great fans of the Volcker Rule, which would limit banks’ proprietary trading—with the aim of preventing taxpayer-funded bailouts. There isn’t much (if any) evidence curbing proprietary trading improves financial system risk—but there is evidence it could whack banks’ profits, creating headwinds for Financials stocks if regulators don’t allow sufficient exceptions. Fortunately for Financials stock owners, though, the rule has lost some teeth since first proposed.

The urgency over the Volcker Rule seems based on a simple but difficult-to-prove assumption: Realized losses on proprietary trades could bring down the biggest banks, forcing the government to intervene with taxpayer money in order to prevent the entire financial system from collapsing. It’s another effort to accomplish the impossible: De-risking the financial system.

Consider Exhibit A in most arguments for the Volcker Rule: 2008’s financial crisis. Realized losses didn’t cause that cascade of bank failures. Those resulted from unrealized losses—writedowns on assets banks never intended to sell. Thanks to FAS 157 (mark-to-market accounting), banks were forced to mark illiquid assets to market value whenever a competing firm was forced to sell them for pennies on the dollar. Even though most banks planned to hold these assets to maturity, they had to take a paper loss.

Without that rule, banks’ balance sheets would have (accurately, in our view) appeared far healthier, and 2008’s troubles likely would have stayed confined to housing and mortgage markets instead of rippling through the banking system and panicking equity markets. Only the banks who realized losses by selling assets at rock-bottom prices would have felt the heat. The numbers back this up. According to a 2011 report from the Government Accounting Office (GAO), the six largest bank holding companies (as of 12/31/2010) realized $15.8 billion in trading losses from Q4 2007 through Q4 2008. Seems big! But not nearly big enough to take down the banking system with its $10.4 trillion in assets as of Q3 2007. Even the roughly $300 billion in total crisis-era loan losses weren’t sufficient. In our view, the $2 trillion in unnecessary and wildly exaggerated writedowns taken over the same period might have had a teensy bit more do to with the financial system’s woes.

Regulators have already fixed this. In the days surrounding March 9, 2009—the bear market bottom—they adjusted the guidance of FAS 157 to spare illiquid assets banks intend to hold to maturity. Yet Congress still included the Volcker Rule in the Dodd-Frank Wall Street Reform and Consumer Protection Act. In our view, it’s a solution in search of a problem, based on misapplied logic. For example, regulators say it would have prevented JP Morgan’s infamous “London Whale” trade—as if the trade threatened the bank’s very existence! Never mind JP Morgan earned a record profit that quarter.

Or, look more broadly at the banks included in the GAO’s report. GAO didn’t name any banks besides JP Morgan, but a list of bank holding companies whose core business is deposit-taking shows the top six banks (by assets) as of 12/31/2010 were Bank of America, JP Morgan Chase, Citigroup, Wells Fargo, HSBC North America and US Bancorp. Assuming those are the Magic 6, the $15.8 billion in trading losses represented 1.2% of total trading assets as of 12/31/2007. By contrast, net loan charge-offs in 2008 represented 2.1% of the prior year’s total loans. Total loans also dwarf total trading assets, so trading losses are a smaller percentage of a much smaller pool. That grew to 3.2% in 2009 and 3.5% in 2010 before falling to 2.1% in 2011. Banks lost far more—on a relative and absolute basis—on lending than trading! Yet we rather doubt regulators want to ban lending. (And again, even this lending didn’t cause the 2008 crisis.)

In recent quarters, trading revenues have helped shore up bank profits—profits that would otherwise be significantly slimmer due to slimmer net interest margins (courtesy of the Fed’s quantitative easing, which flattened the yield curve). Yank proprietary trading, and you further threaten Financials earnings—seemingly the opposite of what regulators would want, assuming their goal is a healthy, profitable banking sector.

Fortunately for those owning Financials stocks, the rule has lost some teeth since first proposed. Market-making and certain derivatives trades (hedging risk) will likely be exempt, and those 50 economists might recommend watering it down further to ensure the costs don’t outweigh the benefits. So there seems a reasonable likelihood the rule, assuming it’s ultimately imposed, won’t create huge headwinds for Financials stocks. And don’t worry—there is ample reason to believe a watered down rule doesn’t increase the likelihood of another financial panic.