It has not received much if any attention, but the Swaps Regulatory Improvement Act passed the House of Representatives on October 30. It received significant bipartisan support, including 70 Democrat “yeas.” As part of the original Dodd-Frank Act, banks were being required to separate some of their derivatives business from federally insured banks. It would have required a separate entity to house them; SRIA is designed to repeal that obligation, though it doesn’t look likely to pass in the Senate.
While this is a distinct (in more than a legal sense) matter from Footnote 513 interpretations, it largely falls within the same philosophical conundrum of modern finance. At issue here with SRIA, from the Wall Street perspective, is the ability to hedge risk. There is no arguing that these banks provide a beneficial service to the financial marketplace, particularly as it relates to the flow of funds via primary markets. Having big banks warehouse securities in order to “sell” them into secondary markets is absolutely a vital service that increases monetary efficiency in the real economy.
However, there is a very fine line between hedging and outright speculation. In the study of the systematic distortions leading up to the Panic of 2008, the line between hedging and speculation was all but obliterated. And it was not just the usual suspects like AIG and Lehman Brothers. Nearly every firm, including Morgan Stanley’s epic encounter with negative convexity, seemed to have taken the concept of hedging far afield.
From a regulatory perspective, there is no way to write a specific rule, or set of rules, that define the term. Banks will simply act in accordance with the rule(s) while still engaging in risky behavior because the regulatory system itself is set up to disguise risk. In a column from early October, I looked at the difficulties arising when intent is buried in beguiling complexity.
“So taken from a portfolio perspective, a bank’s inventory is really a complex risk matrix where there are securities from all sorts of places and classes. Risk management, then, has evolved with the complexity of inventories into a black box system – the banks have internal (and very secret) calculation engines and models that tell them how much to hedge and exactly where. The idea, again, is to be the most economical to keep costs down so that overall spread returns are positive.
“For example, if a hypothetical bank’s inventory included a mix of credit assets totaling about $10 billion, the bank would not hedge the entire carrying cost of that inventory. Instead, through its black box models, it will calculate expected ‘risks’, and determine just how much hedging will cover the most likely risks. This is called dynamic hedging, or delta hedging. The models incorporate many factors, but the most important are correlation, delta, gamma and vega. If the combined calculations of these risk estimates determine that the anticipated potential change in the underlying prices is only $500 million, then the bank will only hedge for the $500 million (at most).
“However, when does a hedge no longer become a hedge? Where does the line exist between hedging and speculation?
“Hypothetically, there is nothing stopping a bank from applying, in the situation described above, $1 billion in hedges instead of $500 million. Again, the idea is to be cost effective, but what if that additional ‘hedge’ position instead expresses an intent to profit off movements in the hedges themselves? If the bank ‘guessed’ correctly, the ‘losses’ in the $10 billion portfolio are not only recouped by the hedging positions, the bank would actually profit potentially to a greater degree.”
The last paragraph of that quoted passage describes, I believe, mostly what happened in the Morgan Stanley case, though I have absolutely no proof other than the losses that were incurred. Morgan Stanley can still argue that their intent was solely to hedge warehoused risk and there is no way to conclusively argue otherwise.
However, getting back to 2008, there is no way warehouse activities, hedging activities or the combinations thereof produced the scale of losses that nearly destroyed the whole modern bank design (it probably should have failed and forced a restart).
“Merrill Lynch, by the time it was ‘forced’ into Bank of America, had seen its prop trading swing from such a massive moneymaker to near insolvency. For the nine months ended September 26, 2008, revenue in principal transactions was minus $13.1 billion. At Citigroup, where the Smith Barney subsidiary was a much smaller part of the overall bank, losses on principal transactions totaled minus $22.2 billion. Citigroup could better absorb such losses because the integrated, multi-faceted conglomeration had $53 billion in total net interest revenue and a much larger liability structure to cushion the blow. Nonetheless, Citigroup was in dire straits by that November, nearly failing because its principal transaction losses were staggering.”
The warehouse function, and the risks it creates for banks, is an open-ended invitation into proprietary trading – even if prop trading is “banned.” There will be too many lawyers that can override the intent of any law or regulation, making any distinction between “legitimate” hedging and outright speculation too difficult to matter. That means that we should examine the entire premise of modern banking, from the ground up, rather than spin our wheels by arguing over the specific meaning of the word “branch” in the 513th footnote.
Modern banks, particularly the shadow/investment banking model, are engines of excessive financial risk. I say “excessive” because that has been shown conclusively via recent history, you simply cannot lose $22.2 billion in 9 months on warehousing with legitimate hedges. That was overwrought speculation, pure and simple. There is no reason to believe that has changed since Dodd-Frank, only whether regulations are still providing them cover and implicit guarantees. If banks continually engage in this kind of behavior, over and over, then the problem is not regulatory, it is systemic.
SRIA and Footnote 513 show that little has changed, particularly if Citigroup lobbyists drafted 70 of the bill’s 85 lines.
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