Wednesday, June 30, 2010

Volcker Rulz

So, anyone who can help me out with this one earns my undying loyalty.  I'm trying to figure out if this Volcker Rule thing will make any difference at all to the big banks.

Now, you remember the Volcker rule, right?  Tall Paul said that we shouldn't let the shadow banking system gamble with the house's money -- in other words if you are a bank with access to the Fed's discount window, effectively a state guaranteed bank (which we already know is broader category than a deposit taking institution), you would not be able to engage in proprietary trading.  Sounded pretty smart to me.  The devil is of course in the details.  How do you define proprietary trading and distinguish it from market making?  I didn't see this problem as insurmountable, just something requiring definition.  In fact, I imagined that if you pushed most of the stuff that the banks want to claim they are just "making markets in" onto exchanges, this would nigh unto solve itself.

But one of the things that seemed would be obviously off limits was explicitly sponsoring an in-house hedge fund.  I mean, if Goldman puts up their own LP capital alongside the LP capital of other investors, and then goes out and leverages this up and tries to make a fortune trading some reverse-credit-default-swap-strangle strategy that only a former string theorist could love ... well this would appear to be obviously against the rules.  After all, that's state guaranteed capital they're playing with.  Nobody believes that if this fund blows up and threatens to sink GS as a whole, the Fed would hesitate in coming to the rescue. 

The whole point of the Volcker rule was to eliminate these "heads I win, tails you lose" bets.  The banks screamed bloody murder of course, and when they first proposed it, I was convinced that there was no way they would ever enact any reform this strong.  That was before Congress decided they had to look tough on the banks though, and I was anyways naive in thinking that the banks would oppose the idea completely rather than just rewriting the details so that it appeared as if there was some reform despite business continuing as usual.  The back door solution makes everyone happy.  Banks keep trading and congress keeps its pockets lined, all the while being able to put on a populist face. 

And that's exactly what the banks did.  Instead of not being able to sponsor in-house funds at all, they now have to whittle down the equity they put up until it is only 3% ... of total ... capital, by ... 2022 ... at the ... latest?  Wait.  Does anyone else think that maybe this is "reform" designed exclusively for the midterm elections?  And anyway, just how much whittling is there to be done here.  I mean, how much of their capital was in these in-house funds to begin with?  Such numbers are a little vague, and hard to come by, but the estimates I've seen peg it at less than 10% of capital for most of the big banks, and maybe slightly more than that in the case of Goldman.  So reducing it to 3% does something I guess, but hardly seems like some revolutionary reform to me.

But then this brings up a whole nother question.  Why did Goldman sponsor these funds to begin with?  If these are such money making machines, why did they only put 10% of their capital into them?  When you start to think about this more, you see that the equity in these funds is really beside the point.  Sponsoring these funds is really Goldman selling the equivalent of subprime to the other LPs.  They don't even really want to put up their own money.  They only do this to convince the other LPs, who are endowments and wealthy families and pension funds and the like, that they have "skin in the game" so that they can raise funds.  These LPs are not typically the sharpest tools in the shed, because I can tell you from personal experience that it's really quite obvious that these things are the dog food of the fund world and you wouldn't want to go near something so riddled with conflicts of interest.  The real purpose of the fund is not to make money, but, as so often in finance, to take management fees on someone else's money. 

When Goldman sponsors one of these funds, it will own a chunk of, if not all of, the GP, who is charging 2% of the assets under management, and taking 20% of any profits.  From their perspective, the less capital they have to put up, the better; if the other LPs only want them to invest 3%, then in 1.5 years they have made back all of their initial investment in fees.  Now, even if the fund blows up and the LPs get zero, Goldman has come out ahead. 

But wait, there's more (if you're a vampire squid).  On top of the management and incentive fees, it's pretty obvious that Goldman's fund will trade through ... Goldman.  And given that most of the money in this in-house sponsored fund is in fact coming from outside Goldman, this prime brokerage type relationship is likely to be, ahem, under-negotiated.  To top that off, Goldman is famous for front-running it's clients trades and taking a little extra off the top, and trust me, they don't have an in-house fund where other LPs can invest in this part of the business (that's what GS stock is, essentially).  One would have thought that Volcker really meant curtailing this type of proprietary trading that masquerades as "market making" for "third party" clients.  This is not 3% or even 10% of Goldman's business -- it's more like 70%.

But wait, there's even more!  Because undoubtedly, this fund is going to want some leverage to generate the first couple years of really juicy returns that attract LPs like moths to flame.  Luckily, they have abundant access to leverage because they have a great relationship with their prime broker, who in turn has a great relationship with the Fed and Treasury!    We don't seem to have done anything about this problem, which falls outside the Volcker rule completely -- it's entirely possible that the bulk of the capital in the fund is actually debt, and not equity, and this rule doesn't say anything about how much you can lend to the fund.  Some of you may recall a little operation called Long Term Capital Management.  Goldman and other banks invested a little of their money in the name of "optics", stroked the egos of some Nobel prize winners, went out and convinced a bunch of other LPs to invest with these geniuses, and then fronted them 100-to-1 leverage.  When the fund blew up, they were forced to bail it out, and the Fed was in turn forced to bail them out (recall that the bubble supercycle was not coincidentally kicked into overdrive at about this time of the asian/russian crisis -- 1998).  When times are good this leverage is a normal banking spread business which contributes nicely to the bottom line.  And when times are bad ... well that's what the Fed is for.  This isn't proprietary trading, it's just too big to fail shadow banking, but it has the exact same effect, systemically speaking. 

So now, you tell me, is Goldman upset that they are forced to reduce their investment in this fund?  As long as they can continue to convince the other LPs to pony up, it seems to me that they should be very happy indeed.  In fact, it reminds me of a great joke I recently heard:

So there are these two beggars in Mexico with a bowl in front of each of them... one has a cross in front of his bowl, and the other a star of david.

Anyhow, people walk by and put money into the bowl with the cross.  The bowl begins to collect a lot of money... No one puts any money into the bowl with the star of david.

Finally, a nice man comes by and explains to the beggar that "Mexico is a Catholic country, no one is going to give money to a Jewish beggar."  He goes on to tell him that, "In fact, people are pretty religious here and they might even give more money to the guy sitting next to you just to prove a point and spite you, what do you think of that?"

One beggar turns to the other and says, "Morris, looks who is trying to teach marketing to the Goldberg brothers!"

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