article

02.02.10

Wall Street Laughs at Volcker

Obama’s banking czar just delivered his reform proposal and the big banks finally have something to snicker about—because he’s leaving untouched the risky trades that played a leading role in the financial crisis.

Obama’s banking czar just delivered his reform proposal, and the big banks finally have something to snicker about—because he’s leaving untouched the risky trades that played a leading role in the financial crisis.

At first, at least, it sounded so promising: After months of being ignored by President Obama and his senior staff about how to prevent another financial meltdown, economic adviser Paul Volcker got his due. The former Fed chairman’s plan to prevent banks from having their risky trading activities subsidized by the taxpayer was being taken seriously, finally, by the man who matters most to Washington, the president, who has endorsed what is being called the Volcker Rule as the centerpiece of his bank regulatory agenda.

“If Volcker thinks what he’s saying is going to stop another financial collapse, he’s crazy,” one CEO recently told me.

But looking deeper, one soon discovers that “The Volcker Plan” isn’t much of a reform plan at all. (Congressional staffers cannot even get details of the proposal and have been directed by the White House to press releases.) Instead, what we are left with is a series of statements made by a well-intentioned but ultimately misguided Volcker about how he wants new legislation that would prohibit banks that are considered “too big to fail”—i.e., Citigroup, Bank of America, Morgan Stanley, Goldman Sachs, and JPMorgan Chase—from engaging in so-called proprietary trading activities. This means they would no longer be able to use firm capital to make wild bets in esoteric markets, the kind of stuff that allegedly caused the financial collapse of 2008.

I say “allegedly” because while proprietary trading did cause some big losses at some banks during the tumultuous years of 2007 and 2008, it was really a small player in the overall collapse of the financial system. Rather, it was those trades that served the firm’s customers—namely hedge funds and other big investors—that led to the massive losses and the ultimate government bailout of the big firms that has so much of the country up in arms.

And those customer trades—at least based on what Volcker is telling reporters and, as he spoke before the Senate Banking Committee on Tuesday, lawmakers—aren’t being touched in what appears to be yet another half-hearted attempt to make sure Goldman Sachs and the rest of the fat cat bankers don’t put the country into another fiscal crisis any time soon.

All of this has given the heads of the big financial firms—bruised by a vengeful public that can’t seem to accept how the firms are getting ready to dole out billions in bonus money just a year after being bailed out—something finally to snicker about, at least in the private conversations I am having with them. “Joke” is the most common word I hear coming from top Wall Street executives when discussing Volcker’s “reform” efforts.

“If Volcker thinks what he’s saying is going to stop another financial collapse, he’s crazy,” one CEO recently told me.

Here’s why: Proprietary trading—or trading that begins with an idea from an in-house trader using house money—represents just a small percentage of the firms’ activities, something like 10 percent. A much larger percentage of trades are made to “service” customers—large institutional investors that buy securities every day. Those trades are often just as risky for the firms because they use their own capital to complete orders, buying huge amounts of bonds, and holding them on their balance sheets until investors are ready to complete their purchase.

For years, those trades were pretty routine. Buyers were plentiful on the deals Wall Street was hawking, particularly mortgage bonds in 2002 through 2006. Then something happened in 2006: The buyers started balking. First it was because all those mortgage bond deals didn’t have enough “yield” or return to justify the risk that they carried—all those mortgages now being packed into the bonds were being sold to people with less and less means to repay them. So-called subprime borrowers were the fastest-growing segment of the mortgage market. With that the banks kept a greater and greater proportion of the deals on their balance sheets, pocketing the interest income, as they waited for the buyers to return.

By the early spring of 2007, when fears began to grow of a complete housing meltdown, the buyers weren’t just balking, they were boycotting, and yet Wall Street kept pumping out deals, hoping against hope that the buyers would return. As we all are painfully aware, they didn’t—and Wall Street was stuck with billions of toxic securities that would have made every bank, possibly with the exception of JPMorgan, insolvent were it not for the bailout measures.

The point here is that nothing Volcker is looking to impose on Wall Street in the coming weeks recognizes that it was customer trading—the stuff Goldman and the rest of Wall Street often tout as doing “God’s work”—that played the leading role in the financial crisis.

Why doesn’t Volcker know this? This is after all one of the world’s great economists, who as Fed chairman in the late 1970s and early 1980s defeated inflation. It may be old age (he is after all in his 80s) or it may be because he was out of the limelight for so long—Volcker hasn’t been involved in government since leaving the Fed nearly 25 years ago—he’s simply out of touch with the reality of the modern financial system.

Either way, no legislation would be better than bad legislation, which this plan seems to be. And that’s why Wall Street is snickering.

Charles Gasparino is CNBC's on-air editor and appears as a daily member of CNBC's ensemble. He is a columnist for The Daily Beast and a frequent contributor to the New York Post, Forbes, and other publications. His new book about the financial crisis, The Sellout, was published by HarperBusiness.