Shelby: When You Close Your Eyes You Cannot See

Shelby: “What were the root causes and how to prevent them in the future?”

That’s simple – it’s called willful blindness.

By you.  By Dodd.  By Frank.  By Bernanke.  By OTS.  By OCC.  By Paulson.  By Geithner.

Willful, intentional blindness to the outright scams that all of the above and more have been willfully and intentionally ignored over the space of more than two decades, including while Shelby was the Chair of The Banking Committee.

Never mind the outright lie that “prop trading didn’t take down any of these companies.”  Oh really? What was Merrill Lynch?  What was “Hvol4″?  That was a prop desk basis trade that blew up in Merrill’s face and literally killed the bank, forcing them into a shotgun marriage with a subsidized (by the taxpayer) Bank of America.  They weren’t alone either – Deutsche Bank took a huge loss on pretty much the same bet gone bad. The FT said this about the “final nail in the coffin” with regards to that prop trade that detonated:

Mr Cotty also gave his blessing to a $1bn writedown of credit default swaps involving investment grade companies. The markdown of a position on the “high vol 4” index transformed a gain of $100m into a loss of $900m, said a source familiar with the matter.

In short Shelby (and Corker!) you need to quit trying to run in an attempt to derail what should be a complete and total ban on ALL proprietary trading by US banking interests that have access to the government backstop.¹

Why?

Because these abuses killed one of them dead and nailed several others for huge losses during 2008.  Any claim otherwise are a bald lie.

There are rather simple ways to put a stop to the crap that led to this mess, and to prevent it in the future:

1. Prosecute fraud and claw back “gains” made on false claims.  Everywhere.  Start at the top and work down, simply because fraud at the top costs more people more money.  If you securitized something and didn’t disclose the fact that these “securities” were comprised of loans where incomes were overstated by 50% or more in half or more of the notes, you go to prison – because you either knew or could have checked (but didn’t) and represented these loans were of “prime” quality.  If you were shorting what you were selling then obviously you didn’t believe that the price at which you were selling represented good value, right?  Go join Bubba over there.  Keep going but start from the top.
2. Put an immediate stop to institutions that cannot cover their own mistakes. The poster child for this is the disclosure that Blackrock filed some 1800 13-G disclosures – because they took over a Barlcays unit.  No big deal as those are all customer funds in segregated accounts – they just manage it – right?  Wrong.  Blackrock (according to Yahoo finance) has some $3.5 billion in cash but is managing nearly 1,000 times as much in assets. Their market cap is a mere $40 billion.  Should they screw up in some fashion, get sued, and get a judgment against them that comprises a mere 1/10th of 1% of their assets under management their entire cash account would go up in smoke, leaving a debt hole (which they also have) of the same size!  At less than 1% the entire company’s market cap would go up in smoke and the firm would likely fail.  This is a company that makes a literal handful of basis points (4.7 billion in revenue?!) across their asset base.  Who among us has never made a mistake and been forced to eat it?  They’re not alone by the way – not only has Blackrock gotten much bigger but so has JP Morgan, Bank of America and Wells Fargo during this mess.  Every one of these firms and dozens more have dramatically too much under management for their capital base.  We have a 6% Tier 1 Capital ratio for banks and frankly I believe it should be 10%, held in cash, no exceptions if you want to run customer money.  You have to be able to survive an adverse event without a government backstop. Give all these firms one year to either raise that capital or break themselves up – period.
3. No more mark to myth. The whole point of mark-to-market is that if you have to sell it you know what you can sell it for.  You avoid capital crunches during asset devaluation by holding more in Tier Capital, in cash, than you need from a regulatory point of view and you unload early and often as prices deteriorate.  Yes, I know, people want prices high for various reasons, but the fact of the matter is that if you’re a buyer (of houses, of cars, of anything) you want prices low, not high.  Prices seek equilibrium and when there’s a crunch you find out what utility value actually is.  This is not a bad thing, it’s a good thing!
4. No more securitization.  All securitization accomplishes is obscuring reality and generating false ”profits” that never actually existed.  Securitization doesn’t transfer risk it hides it on purpose and by doing so is an act of robbery and fraud.  Portfolio every loan.  Lenders can sell undifferentiated bonds to raise funds which they can then loan to borrowers, holding the paper.  This preserves the intermediation function but stops the lies and obfuscation, since if you lent it you own it.  Allow the trading of whole loans, but no bundles or securities based on them.  If an insurance company or other “stable” investor wants to loan someone money for 5, 10, 20 or 30 years they can buy a bond issued by “Bank #1″ who can then make a loan with that money and portfolio it.  Levels of indirection?  One.  Skimmed funds?  Minimal.  The economy benefits from lower costs for productive borrowers while shutting down the scammers.
5. No more capital market activity for lending and depository institutions – that is, those with access to the federal teat in the form of deposit, loan, investor or bond insurance.  Period. And none means none.  It means if you want to act as a custodian of customer money (e.g. like a stock brokerage or bank) and have a lending function (e.g. margin accounts or a loan book) you cannot trade your own book – your first and only responsibility is to the customer.  If you’re a bank you cannot be in the markets at all.   You can clear a customer order but you can’t trade yourself – irrespective of why.  I know all about the arguments related to hedging one’s own positions - the solution to that, of course, is to bar these institutions from taking their own positions in the capital markets in the first place! There’s no reason for a bank to be “hedging” a customer position – only their own.  Make the banks and brokerages choose – if they want to earn commissions that’s fine but then they’re fiduciaries of their customers – not combatants in the market who are acting with superior information against customer interests. Those firms that wish to be present in the markets for their own purposes must be fully legally and operationally distinct (that is, not subsidiaries or owned by the same corporate parent) from any customer clearing activity, as to fill both roles is an inherent conflict of interest that simply cannot be resolved.  Trade with your own money, not your customer’s and definitely not with the US Taxpayer’s!

If you surmise that this proposal looks a lot like Glass-Steagall, that’s because it does.

It also solves the problem.

I would like to see things like “credit default swaps” all traded on exchanges and argue that they should be, as that’s the only way to guarantee margin supervision and mark to market, but if you do the above it doesn’t matter.  No regulated entity can write, buy, or trade in them – so it no longer matters what unregulated folks do.  Who cares if two hedge funds want to blow each other to bits with these things?  Not I, so long as they can’t infest the regulated insurance and banking landscape.  Have at it boyz but if you find your “counterparty” doesn’t have any money go tell the judge when you sue your counterparty for fraud – the rest of us will sit back and laugh at you both.

^1. For a full dissertation on the basis trade that blew Merrill to bits, see Zerohedge, which did a nice piece on it.