Volcker Rule: Point of No Return

Volcker's rules: Any day now

Three years have elapsed since regulators proposed new regulation to restrict proprietary trading at banks (more specifically, depositary financial institutions).  Three years of discussion, debate, rule-writing and re-writing, dissension, lobbying, and procrastination. 

And now the new rule, better known as the Volcker Rule and named for former Federal Reserve chairman Paul Volcker, who first proposed limits on bank trading during the crisis, has reached a point of no return.  Regulators--the SEC, FDIC, OCC, CFTC and the Federal Reserve--have promised to sign off before mid-December.

Banks aren't surprised. They aren't caught off guard. They knew an old era of gun-slinging, wild, volatile, frantic, but overwhelmingly profitable proprietary trading at the major banks was coming to an end.  While regulators and their lawyers sequestered themselves for years to write hundreds and hundreds of pages of rules, banks tried to push back and soften the blow. But they knew they wouldn't win much of this tuggle, although they poured resources and time into the effort.  They had already begun to scale down prop-trading activity. 

New rules will prohibit outright proprietary trading (trading for banks' own accounts using their own capital), but will permit trading for clients, trading for hedging purposes and limited hedge-fund activity. And therein lies profound complexity.   

Regulators have spent the past three years trying to define all possible scenarios of client trading, hedging, and hedge funds with such fine-tooth clarity that banks won't be able to exploit loopholes in the way they can do adeptly and profitably to their advantage--and, in the eyes of regulators, at the expense of clients and individual customers.  Regulators, worried about how banks can exploit omissions in the rules, have tried to cover every base in hundreds of rules-making pages. 

Despite regulators' attempts at clarity, banks now prepare for the burdens and chores to remain in compliance.  Banks know well that trades that look like, feel like and were booked as client trades might evolve into prohibited proprietary trading.  New rules will allow "inventory" (securities and derivatives on banks' balance sheets) to exist on banks' balance sheets as items on a shelf to sell to clients.  But Volcker rules might define inventory exceeding a certain level or inventory maintained for more than a certain number of days as illegitimate "proprietary activity" (and determine it to be out of bounds). 

Banks that choose to remain prominent in sales and trading will need to invest in an army of compliance personnel and significant amounts of infrastructure to ensure they stay within client-trading or hedge-trading boundaries. A nightmare for some banks. An onerous cost of doing business at others. 

Volcker proponents say the new rules will reduce the likelihood of another round of "Whale Trading" losses at places like JPMorgan Chase, which lost over $4 billion from credit-derivatives trades in 2012. Critics and JPMorgan argued that "Whale-related" trades would have been permitted by Volcker rules. (JPMorgan launched the first phase of these trades for hedging purposes--to hedge credit risks in its large loan portfolio. But the trades piled on top of each other and the massive positions turned into something very "proprietary.")

Now big banks across the U.S. must decide (and have decided) whether (a) to stay in the game of securities and derivatives trading and eke out profits from client-driven flows or (b) to retreat, withdraw or just get out.

The bulge-brackets, such as Goldman Sachs, JPMorgan, and Morgan Stanley, are fully invested, have been adapting to a Volcker world. The big banks have resigned themselves to declines in trading revenues as much as 10% (25% at Goldman, one analyst contends). They hope to turn their once-magnanimous trading desks into humming, full-throttle plays on volume and flows.  Their desks have been reorganized and restructured.  They've shuffled talent, shut down some desks, invested in automated trading systems, and allowed many traders to seek employment at hedge funds.

Other banks have withdrawn and expect to engage in a token amount of trading at modest levels and minimal volumes--all client-related or tied to risk-management hedges.

In 2014 and beyond, critics, proponents, and regulators will watch banks closely.  Some say liquidity in certain sectors of capital markets will diminish, because large well-capitalized banks won't be able to buy, sell, and hold in large amounts of securities in the way they could before.  Some (municipalities, for example) say rates on bonds may increase because of diminished liquidity, because banks will nudge margins up to account for lack of liquidity, and because banks won't be to rationalize holding any inventory. 

(Imagine scenarios where banks can rationalize economically holding large amounts of securities/derivatives in inventory even for eventual client sales, but will choose not to build up inventory for clients to avoid the risk of penalties of not complying with Volcker restrictions.) 

Some say the best talent for managing trading volumes, risks, portfolios and positions will no longer reside at banks. Some say new rules will discourage financial innovation, because banks often trade and make markets in new products in large volumes to generate interest and liquidity. (Banks don't push new trading products if the profit dynamics don't make sense.)

Yet others contend we won't see those periodic billion-dollar trading losses because banks' "prop desks took a view" of the market or tried to guess interest-rate trends, commodity prices, or economic indices in their efforts to make gobs of money from proprietary positions.

At least for a while in 2014, banks will routinely convene troops of lawyers, traders and compliance officers to figure out this new world. It won't be easy. What happens if a bank amasses a position with intents to sell to a client, but the client decides not to pursue the trade? Will a regulator slap the bank's wrist right then and there? What happens if the bank purchases certain derivatives to hedge a portfolio, but volatile markets abruptly change the hedged position into an huge, unhedged derivatives position?   

Somebody within the banks' troops will be required to spend all-nighters trying to determine the  section in the hundreds of rules pages that cover these scenarios.

Tracy Williams

See also:

CFN:  The Volcker Rules, Here They Come, 2011
CFN:  Volckerized, 2010

At JPMorgan Chase, Is $13 Billion a Lot of Money?

The $13 billion: It can handle it.

A question has lingered for much of the past week, one that hasn't been asked often out loud or asked pointedly. Is $13 billion a lot of money for JPMorgan Chase? 

Will it crush the bank's growth plans and business opportunities in the periods to come? Will it strangle a banking empire and cause it to retreat into a shadow of its post-crisis self?

Announced in business headlines everywhere, the $13 billion is the total amount in the bank's settlement with the U.S. Department of Justice, all related to the bank's mortgage-securitization business in the 2000's and the businesses it inherited from its acquisitions of Bear Stearns and Washington Mutual. 

The government claims JPMorgan and affiliates improperly and unfairly structured mortgage securities, leading to billions in losses to investors who had purchased the securities. The settlement puts an end to one chapter in the bank's efforts escape the mortgage nightmare of that decade. 

For a financial institution with market value and book value in the hundreds of billions and with billion-dollar earnings announced every quarter, is $13 billion a lot? Let's decide.

Of the $13 billion, about $7 billion is tax-deductible.  Hence, the bank will have a benefit on its tax books (reduction in tax liability, e.g.) of some kind for about $2-3 billion, effectively reducing the "pain" of the settlement by that amount. 

Of the $13 billion, about $4 billion is slated for mortgage relief for homeowners.  Banks and investors who hold those loans or hold securities backed by those loans have likely written them down, charged them off, or set aside significant reserves.  If JPMorgan continued to hold some of those loans and securities on its books, the settlement amount captures assets that the bank had previously written off or planned to write off. In effect, the settlement number acknowledges and accounts for write-offs the bank already took (related to mortgage securitization).

The rest comprises payments to state regulators and to investors who bought mortgage securities and suffered substantial losses.  In the $13 billion, the net cash payments due to organizations, regulators, and investors amount to something less than $8-9 billion (estimated). 

In 2012, the bank (consolidated) reported $21 billion in earnings. It operates at a pace of generating about $6-7 billion each quarter (or about $24-28 billion/year). Hence, a gross $13 billion settlement doesn't result in fiscal-year losses (comprising about half of expected annual income).  The bank will continue to be profitable, expecting to report profits above $15 billion in 2013 and above $25 billion in 2014. 

Even more, the bank indicated it has already set aside reserves (and adjusted financial statements) to account for the entire $13 billion--including about $9 billion in legal reserves (including write-offs and loss provisions) in the third quarter in anticipation of various legal settlements. 

JPMorgan's equity base exceeds $206 billion, an amount that has already netted out much, if not all, of the $13 billion. A $13 billion settlement comprises less than 7% of equity, if it had not already made equity adjustments for such charges. As massive as the number appears in headlines, $13 billion won't put the institution in financial peril. 

Has the bank's market value (share value) suffered because of the settlement?  In recent weeks, as the public heard rumors and eventually learned about a finalized settlement, the bank's share price didn't plummet and even flirted with record levels.  That's because the market, whether it's partly or fully efficient (depending on which finance theorist you believe), had already accounted for all possible losses related to the settlement.

Equity markets, too, like companies that flush out losses and start anew.  Markets like companies that erase vast amounts of uncertainty (especially related to lingering legal issues).  Markets appreciate and value companies when they clean the slate and eradicate such hangover. 

Then there are regulators, who have applied an increasing burden of capital and liquidity requirements to big banks. Does the $13 billion jeopardize regulatory compliance? Not really.  The bank had already begun to retain, boost and increase capital to comply not only with capital requirements of today, but the progressively increasing requirements over the next few years.  Its regulatory ratios were in good shape.

New regulation has certainly annoyed JPMorgan (and its peers) and has stifled business activity in certain segments (trading, the best example).  The bank continues to grapple with new rules regarding trading, leverage and liquidity.  But the settlement hardly influences the scenarios the bank confronts on these fronts.

Still, $13 billion is still a mind-boggling total, so it has to hurt somewhere, if capital ratios, earnings, balance sheet, and stock price have not felt pain.  Moody's, the ratings agency, in November downgraded the holding company a notch, but the downgrade had little to do with settlement figures, more to do with systemic issues and how Moody's suspects big banks can manage through crisis scenarios. 

Some "hurt” or injury should exist, contends the Justice Department, which wants the bank to comprehend the impact of its past actions.  The bank has weathered public embarrassment, glaring headlines and threats to gilded reputation, but all that could be short-lived, as regulators and the media move on to the next big issue plaguing financial institutions. 

For now, the "pain" of the settlement is not financial. Could there could be a cumulative, damaging effect from having to ward off the slings and arrows of many legal issues at once? They include (a) the time commitment and distractions involved in legal wrangling and legal negotiation, (b) the possibility, even if remote, of criminal charges arising from any of the past activities, and (c) other legal issues (including any related to last year's "Whale trading" derivatives losses that exceeded $6 billion. 

Don't forget, too, the expected "pain" of explaining to senior managers, deal-doers, and business leaders how inappropriate it might be in 2013 to pay eye-popping bonuses in the wake of a $13 billion shakedown, an internal corporate message that always results in the risk of losing talent. 

And $13 billion is an amount of missed opportunities--new investments in business expansion, product growth and new technology that the bank could have made, but didn't.  The bank, nonetheless, would counter that it has ample resources, people and capital (from retained earnings) to make all the investments it needs in the post-crisis era. 

At JPMorgan, the "pain" will be bearable.  CEO Jamie Dimon will sleep at night. The $13 billion was, well, not too much money. 

Tracy Williams

August: No Time for Doldrums

Market events mean no time for rest?

If history repeats itself or if tradition rules, then the waning days of summer in finance and markets should be marked by doldrums, inactive markets and dreading Labor Day.

But once again August has thrown a soft curve ball--with market volatility, big institutions confronting legal issues, and a band of activist shareholders causing havoc in boardrooms. Nothing that has caused market nightmare, but enough to cause a little upheaval in what should be dull days before mid-September.  The Augusts of 2011-12, recall, were upended by disgusting debates in U.S. Congress about government deficits and debt. 

The tale of the "Whale" and the $6 billion in trading losses at JPMorgan from 2012, events we thought had faded from everybody's attention, plopped up again when government regulators and law-enforcement officials decided to place criminal charges against some banks officials for hiding information about the losses and acting in deceitful ways.  The irony is the "Whale" himself, the JPMorgan trader in London who presided over the disastrous trading positions, is not a target.  JPMorgan likely suspected some action of this kind would occur, but it didn't expect the whole matter would resurface in late-summer business headlines, forcing the bank once again to rehash, review and remember the whole dreadful episode.

William Ackman, the tenacious shareholder activist whose bold charges and boardroom moves attract constant media attention, raised his surrender flag this month with J.C. Penney.  Ackman and his Pershing Square Capital fund were instrumental in implanting Apple-groomed CEO Ron Johnson, who was supposed refashion JCP into the retail-industry version of Apple-like merchandising. The Ackman-backed experiment failed miserably, the JCP CEO resigned, and Ackman became a pariah in that boardroom.  He gave up in August, resigned from (or was shoved off) the board, and resumed his shareholder fights elsewhere--at Herbalife. 

Ackman has charged that company (Herbalife) in running a Ponzi scheme in selling its product, and various sides have taken up the debate:  Is Herbalife a legitimate company, a reasonable growth investment? Or is it administering a fraudulent marketing scheme? The skirmish continues.

Commodity activities have plagued big banks Goldman Sachs and JPMorgan this summer, and unexplained volatility is not the reason.  Business reporters (first at the New York Times) discovered questionable practices by Goldman in aluminum markets, where Goldman receives fees for warehousing aluminum before final sales to end-users. Goldman is alleged to conduct a practice of delaying the transport of aluminum by transferring it from warehouse bin to bin for no apparent reason except to prolong fee collection.

The wreckage of mortgages and assembling mortgage securities won't go away for many top banks. This summer, Bank of America, still being knocked over for acquiring Countrywide in the midst of the crisis, is wrestling with legal accusations and possible settlements--in the tens and hundreds of millions. 

Elsewhere, regulators accused JPMorgan for deceptive pricing behavior in West Coast electricity markets.  Energy regulators accused the bank of unfair mark-ups in electricity prices in related trading activity.  JPMorgan and regulators agreed to a settlement, but the entire episode was enough to spur the bank to move quickly, reorganize and rethink its commodities-trading business. It opted to withdraw from physical-commodities businesses--businesses it had inherited from Bear Stearns.

After a remarkable first-seven months run, equity markets have begun to rumble and shudder, mostly because market-moving investors prefer to pay much attention to hidden messages coming from the Federal Reserve.  Every hint that the Fed plans to stop purchasing bonds that will keep interest rates low leads to gyrations in stock markets. That's the way the markets move these days.

And while it was transforming itself into a model citizen for regulators, JPMorgan was pummeled once again when the SEC announced it was investigating the bank for nepotism, hiring sons and daughters of well-connected Chinese executives and government officials.  No doubt senior bankers in CEO Jamie Dimon's circle are puzzled about a finance-industry practice that has taken place since, well, stock-market traders consummated transactions around a tree in downtown, 19th-century Manhattan.

Perhaps these days, it's all  the new normal--abetted by the Internet, technology, immediate access to market updates and everybody's ability to reach out to anybody anytime.  There might have been a time when all bankers, traders, compliance officers, deal-doers, and research analysts escaped en masse in August.  But nowadays regulators and enforcement officials don't take a break.  High-frequency traders and hedge-fund managers don't let up in summer.  Shareholder activists don't ease the pressure, and board rooms, CFOs, and investment-managers don't have the luxury of summertime doldrums anymore. 

Tracy Williams

See also:

CFN:  Delicate work-life balance, 2010
CFN:  Market volatility: Can you stand it? 2011
 

Derivatives: Making Sense of Where We Are

The world of derivatives is in a purgatory state--a prolonged holding pattern until regulators finally finish new rules that will govern how they will be sold, traded, valued, cleared and reported. Regulators and financial institutions in the industry have dragged their feet in annoying, painstaking ways. What will eventually happen to how they will be traded?  How will be big banks respond? What will they do? When will the industry decide?

How will banks compensate for the billions in revenues that could evaporate when the derivatives playing field is re-landscaped?

The stories have  been told often over the years how derivatives markets have surged and soared, how derivatives have become a market of trillions (measured by the "notional" or face value of the derivatives traded globally).  The credit-default-swaps market is said to be over $25 trillion. (That would be "notional" face value, not actual market value or market outstandings.)

The story is also told often about how derivatives markets are opaque, sometimes illiquid, often misunderstood or too complex and how markets are dominated by banking behemoths that dictate pricing spreads, trading procedures, collateral requirements and who gets to join the inner circle of dealers.

WHAT REALLY IS A "DERIVATIVE"?

"Derivatives" is a financial term that today encompasses a wide range of financial activity. The term was rarely used before the mid-1980s, although some forms of derivatives have existed for as long as there have been viable trading markets.  In current times, a derivative might include almost any financial instrument that is influenced by market risks and credit risks, but is not a director investment into a corporate entity.  In other words, it encompasses all that is not an equity investment, a plain-vanilla bond, or a loan. 

Derivatives, by convention, include options of all kinds (puts, calls and collars), convertible bonds (and other "hybrid" instruments), interest-rate swaps, credit-default swaps, equity-linked swaps, commodity swaps, index trading and index swaps, and currency swaps.  They include futures trading--those traded on

exchanges and those traded "over the counter."

Frequently, derivatives will include forward foreign-exchange transactions.  For most in finance, the term will include mortgage-backed securities, CDOs, CLOs, IOs, POs, CDOs squared, synthetic CDOs, and synthetic CLOs, And if we dare get fancy, they include swaptions, "knock-out" swaps, and CAT (catastrophe) bonds.

Derivatives creators adore acronyms, complexity, quantitative analytics and the lure of something new and different.  Derivatives managers enjoy the open-round gush of profits.  Financial theorists and financial engineers embrace whiteboards of equations and calculus that try to define the behavior of these instruments.

Derivatives, the term, captures just about any complicated instrument that doesn't sound like a stock, bond or loan.  The finance media define derivatives as financial instruments "the value of which are based on other securities and instruments"--a catch-all phrase that often doesn't explain exactly what they are or how they perform in live markets.

THE APPROACH OF BIG BANKS AND DEALERS

Here is how large banks and hedge funds that have dominated prominent segments of the market define and approach derivatives--at least until now, while the global business model for trading derivatives is under threat:

1.   The first institution to conceive, create, build a model, sell, and trade a new derivative gets to determine and mark the playing field or the "rules of the game."

2.  The first few firms, usually large banks, that leap into the arena of a new derivative product determine the profit dynamics--how profit margins and spreads are determined, how positions are valued, and how prices are reported. Therefore, they become the core of large dealers that dominate the new market at the outset.  They will behave in ways to ensure they maintain control of the market--especially the lucrative pricing spreads.

3.  The large dealers who control the market decide when and how to open it up to new clients and counter-parties.  This permits the new market to grow, boosts liquidity, and spawns a large number of "end-users," who often use the derivative for risk-management or hedging purposes.

4.  The large dealers and their inner circle will design the marketplace such that the growing number of "end-users" (corporations, manufacturers, small funds, and individuals) must arrange trades by going to one of the large dealers.

5.  Large dealers, banks and hedge funds are able to maintain control of markets (and profits) because of advantages in capital resources, systems and technology, and information.  They can survey, see, comprehend and act upon all the activity that occurs around them.

6.  Large dealers, because they control pricing, spreads, and profits, have little incentive to change the status quo, except to increase activity and liquidity and reduce counter-party risk (the risk of clients and counter-parties defaulting on trades).

7.  Once they understand the new product and market behavior, speculators abound and will pounce on any opportunity to take advantage of market abnormalities or inefficiencies. They will likely be specialized hedge funds and funds that house "quant-jocks," but they may also (at least in the past) be the proprietary trading units of large banks and dealers.

8.  Large dealers, because they control the market, can determine the price reported among themselves, prices reported to other interested end-users, and prices reported to the public.

9. Large dealers determine, as they see fit or with guidance from regulators, how the transactions are "cleared" (settled, paid for, or consummated formally) and how they protect themselves from "default risk" by setting rules for how end-users participate (for example, by pledging collateral or requiring they meet certain capital standards).

Large banks and dealers claim they haven't managed these markets ruthlessly. They argue there has been sufficient self-policing and adequate oversight from regulators and industry-related organizations.  (ISDA, for example, is an industry association that continues to set common standards for trading, documentation, reporting, and collateral-pledging. Markit is an independent company that offers pricing services.)

Then came the financial crisis.

Then came the public's charges that improper selling and trading of derivatives explains why the crisis unfurled and infected much of the global economy. 

Then came Dodd-Frank legislation and regulation.  Dodd-Frank was a comforting anecdote to the crisis. It had the right themes and provided outlines to make markets safe. But Dodd-Frank didn't stipulate tough  deadlines. 

Armed with Dodd-Frank powers, regulators have a blueprint and a vision for how derivatives markets should be overhauled.  They have been tardy, however, in writing the thousands of rules, line by line, that will redesign markets from front to end.  Because derivatives are amorphous financial instruments and don't fall easily into categories, regulators fuss among themselves about which body should have the most oversight.  The debates among the SEC, the CFTC, the securities and derivatives exchanges (NYSE, ICE, NASDAQ, CME, etc.) are part of the reason for delays.  The Federal Reserve, FDIC, FHFA, and OCC have opinions, too.  An alphabet smorgasbord of sometimes conflicting input.

In  spirit, regulators seek to require most commonly traded derivatives be bought, sold, traded and reported on a major exchange with pricing and dealer transparency rules.  Commonly traded derivatives must be cleared and settled (all post-trade operations) via an approved, recognized arrangement, usually funnelled through large well-capitalized banks and overseen by established clearinghouses.

Regulators knew, too, large dealers and banks weren't going to sit still and let millions/billions in profits wither away. Until banks figured out a way to re-engineer their business models to generate profits while strapped by new rules, they would stall the implementation of regulation and continue to squeak out profits. Or they would retreat to their finance labs to craft other ways of making money from derivatives dealing.

WHAT'S ON THE HORIZON?

Where are we now? Where do we go from here? Will reforms do what they are intended to do--reduce risks in the system, reduce the likelihood that trading won't implode into market nightmares, and prepare institutions for the next crisis?

1.  Banks are rebuilding their derivatives-trading desks, reorienting them toward customer activity and customer flow and allocating proper amounts of capital to support them, as required by Basel III regulation. Some banks are downsizing their desks, not able to make economic or regulatory sense from the wave of regulation.

2.  But big banks won't go away sheepishly.  Revenues from derivatives soared until the late 2000s. They will continue to eke out profits until the economics and capital requirements dictate that old models make no sense.  The biggest and best dealers (including Goldman Sachs and JPMorgan) will develop new, different business models to generate profits. 

3. Massive regulation, oversight and public concern will discourage banks and hedge funds from creating new derivative products--at least not as rapidly as the 1990s and early 2000s, when new products flew off the shelves.  Not long ago, large banks seemed to roll out a fancy new acronym for a new product every other quarter, always a moment of pride for them and for the quantitative experts they had hired to think them up.

4.  Regulators, in an effort to come to a conclusion soon, will unveil new rules (thousands of them), but will probably soften some of them, compromising with banks and hedge funds, yielding to some of their unrelenting lobbying efforts.

5.   "Pain vanilla" activity (basic swaps, basic forwards, will thrive, even with thinner profit margins. The big banks will compensate with volume and take advantage of other banks exit derivatives activities.

It will have been a long haul, and it won't be over soon. Derivatives markets are huge, impactful, and complex.  This story still has many chapters remaining.

Tracy Williams

See also: 

CFN: Cliffs, Reform and Recovery, 2013

CFN:  Libor in Crisis, 2012

CFN:  High-frequency Trading: What's Next? 2012

CFN:  The Big Short and Credit-Default Swaps, 2010

CFN:  MF Global:  Too Small to Save, 2011