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The reason [the US economy] isn't doing better is quite simple - excessive government spending. Federal spending in 2000 was about 18% of GDP. Today it is close to 24%. This means that 6% of private sector GDP has been "crowded out." It's simple - a bigger government = a smaller private sector = slower job growth. Just look at Europe in the 1980s and 1990s. Liberal economists have argued that recoveries from financial crises are always slow. But this covers up the fact that government always grows in a crisis - no matter which party is in power. And it is this growth in government that slows the recovery, not the crisis that preceded it.

Brian Wesbury & Robert Stein
FT Advisors

This week we republish an important article by Christopher Laursen, NERA Vice President and Co-Regional Director of the Professional Risk Managers' International Association's (PRMIA) Washington, DC Chapter, on bank trading under the Volcker rule. This is a timely discussion that we decided to feature because of the growing dependence of the largest banks on principal transactions to hit Street earnings estimates.

This week in The IRA Advisory Service by no coincidence we talk about the earnings results forJPMorgan Chase ("JPM"/Q1 2011 Bank Stress Rating: "B") and the operational areas where we see pressure in upcoming quarters. We also provide an update on the settlement of $35 billion in 1933 Act securities fraud claims by Wells Fargo ("WFC"/Q1 2011 Bank Stress Rating: "A") for a mere $125 million. If you have a dog in this hunt, do give us a call. The WFC settlement is cents on the dollar of par value and reeks of conflict, in our humble opinion. WorldCom settled at 50 cents.

In a post on Reuters.com last week, "On debt ceilings and conforming loan caps," IRA co-founder Chris Whalen juxtaposed the debate over the debt ceiling with the impending roll-back of the conforming loan limit for FHA, Fannie Mae and Freddie Mac. While the change will only affect a fraction of the communities in the country, 80 million Americans live in these communities. The majority of the HELOC and private mortgage insurance exposures are also in these high-cost real estate markets as well. Notice that JPM has worked its HELOCs down to just $82 billion as of Q2 2011 from $94 billion YOY.

When asked about the impending drop in the conforming loan limit, Fed Chairman Ben Bernanke told the House Financial Services Committee yesterday: "As far as Fannie Mae and Freddie Mac are concerned, there is a tradeoff there between supporting the higher priced homes and weaning the housing finance system off of unusual limits it was put under during the crisis..."

Now by a remarkable coincidence, George Washington University just published a paper that takes precisely the same position as that taken by Chairman Bernanke. American Bankerreports that the paper was financed by Genworth Financial. "But nowhere is it disclosed that the paper was at least partially underwritten by the private mortgage insurance giant Genworth Financial Inc., which stands to benefit from a pull back in the market by FHA," American Banker reports.

We wonder if the folks at the Fed Board of Governors realized that they were, indirectly, being used by the private mortgage insurers during the HFSC hearing yesterday? American Bankerreports that one academic who was approached by Genworth to work on the paper was turned off by the proposition. "I thought it was very interesting, but it was funded by an insurance company," said Anthony Sanders, distinguished professor of real estate at George Mason University in Fairfax, Va, Alex Ulam of American Banker reports.

But it gets better. Bernanke went on to say that "I understand the private sector is taking at least a significant number of the jumbo mortgage market but at a higher cost." Again, more propaganda from the PMI lobby in Washington. Yes, there have been some showcase jumbo deals brought to market, but these are mostly hand-picked deals with premium, low-LTV loans that are unlikely to default. The drop in the FHA limit amounts to a de-facto reduction in the VOLUME of financing available to the US housing markets. Indeed, the change is already reflected in current bank financing offerings because the limit changes is in less than 90 days.

Just to add to the hilarity of these PMI lobbying operations, Mark Zandi of Moody's was also out with a report last month that likewise parrots the disinformation coming from the mortgage insurance lobby. In a June 21, 2011 report entitled "Reworking Risk Retention," Zandi displays an amazing lack of concern for credit quality issues. He writes that "The 80% maximum LTV requirement is also a very high bar for many households, causing about one-third of GSE loans in 2009 to fail QRM eligibility." 

Quite right Mark. These high-LTV mortgages do not deserve to be in the QRM standard. Part of the reason for the hundreds of billions of dollars in losses to banks and the GSEs since 2008 is that lenders used the canard of PMI to get underwriting approval for subprime loans. If you want to prevent future mega credit losses, we need to raise credit standards, not lower them back down to the level of the bad old days of the subprime boom. Let's make sure that the full amount of good loans can be made, but the subsidy for subprime and even most prime lending needs to end -- albeit over a period of several years.

We wonder if the folks responsible for Moody's credit rating operations appreciate that one of the most prominent and respected economists in the US seemingly is being used as a surrogate to lobby for the private mortgage insurers? How does it help the interests of the investors who rely upon Moody's for credit default ratings, we wonder, for their chief economic pundit to be advocating 90+ LTV home loans be included in the definition of Qualified Residential Mortgages? Zandi writes: 

"Fannie and Freddie have long been lending with LTVs above 80% when backstopped by private mortgage insurance. Even during the current crisis, with the housing and mortgage markets under severe pressure, losses on these high-LTV loans have been manageable. Given this experience, it would seem prudent to allow loans with LTVs as high as 95% to be QRM-eligible provided they carry third-party private mortgage insurance and provided the loans meet all other QRM restrictions." 

This comment from Moody's as well as the comments by Chairman Bernanke appear to be almost word-for-word the same message coming from the various propaganda organs of the private mortgage insurers. Instead of mouthing such erroneous nonsense, Chairman Bernanke and Mark Zandi ought to consider an alternative that preserves the volume of sound lending that is possible today but begins to move toward market pricing. For example:

1) Raise the conforming FHA limit to $1 million on a permanent basis. 

2) Maintain the QRM standard at 80 LTV. Restrict the use of PMI to non-conforming, non-QRM loans to help to bolster the private subprime loan market. 

3) Increase the FHA/GSE guarantee fees by 100% for QRM loans and continue raising the gfees for non-QRM loans to ensure that only premium loans will be covered by GSE insurance.

The secondary mortgage market in the US today is controlled by a cartel comprised of the New Deal era GSEs and their progeny, the top four servicer banks and the major PMI firms. Allowing the large banks to include high-LTV loans in the QRM standard only reinforces this monopoly and limits any possibility for true competition to evolve. By supporting the secondary market for residential loans in the short-run with a higher conforming limit, but deliberately pricing the GSE insurance cover higher to preclude subprime production by the GSE, we can encourage a more healthy private marketplace for lenders, investors and even the PMIs. Getting the GSE market share down to single digits should be the goal vs. 95% today. 

If the PMIs could charge reasonable spreads for their products, then they might be able to pay out on more claims and thus help reduce systemic risk. The old PMI model that is currently being pushed by lobbyists for Genworth and other industry participants merely resumes the pre-crisis practice of using no-pay PMI to enable subprime lending and GSE cover for same. The way to begin the repair of the mortgage sector is to restore market pricing to guarantees by the US government. Just as Congress and the FDIC have fixed the "free rider" problem with respect to large banks and FDIC insurance premiums, it is time for the mortgage market to reflect the true risks of lending on residential property. Then the statements made recently by Chairman Bernanke and Mark Zandi about the private sector carrying the load of housing finance might start to be true.

Banking Entity Trading Under the Volcker Rule 
By Christopher Laursen 
Click here to see version with footnotes: http://www.nera.com/67_7328.htm 

The Volcker Rule (section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act), depending on how it is interpreted and enforced by regulators, has the potential to significantly change the scope and scale of trading within federally insured depositories and their affiliates. A number of well-written articles by various law firms summarize the basic definitions and legislative requirements of the Rule. This article goes further, describing the relevant background of the Volcker Rule trading restrictions and offering insight on their likely implementation.

Volcker Rule Background and Motivation

It has been said that there were no significant issues with respect to bank proprietary trading during the recent financial crisis, and therefore the Volcker Rule does not go toward solving any problems. However, looking back to the fall of 2007, it is clear from SEC filings that significant financial company losses came from proprietary positions booked in trading accounts. More specifically, a large amount of trading losses came from holdings of mortgage-backed and asset-backed bonds that had been afforded high credit ratings (e.g., AAA) by NRSROs. Rapid mark-to-market losses on these trading positions led to the resignations of a number of prominent financial company CEOs during the fall of 2007.

Depending on the state of the markets, mark-to-market values have something, but not everything, to do with repayment prospects of a debt issuance. Though some mortgage security values declined as a result of unexpected home price declines and increasing mortgage delinquencies and defaults in 2007, significant changes in mark-to-market values over this period were also driven by major shifts in supply and demand for a broader set of asset-backed securities. For example, markets saw a rapid flight from virtually all US private-issue mortgage-backed securities (PIMBSs) during the second half of 2007. Weak demand for PIMBSs and widespread deleveraging within the financial system served to depress mortgage security market values, regardless of ultimate repayment prospects.

The 2007 market turmoil provides clear evidence that mark-to-market proprietary trading exposures have the potential to cause rapid and significant harm to bank earnings, liquidity, and capital. Such damage can contribute to a system-wide reduction in traditional banking services (e.g., commercial lending) needed to sustain the health of the so-called "real economy." Ultimately, a lack of credit availability from traditional financial intermediaries was a crucial factor behind the Federal Reserve's creation of several unprecedented lending programs. With programs such as the Commercial Paper Funding Facility (CPFF) and the Money Market Investor Funding Facility (MMIFF), the Federal Reserve effectively loaned funds directly to non-financial firms as diverse as Harley Davidson and Verizon, when banks could not.

As should be clear in the above discussion, an implicit concern of the Volcker Rule trading restrictions is the mark-to-market focus of trading books. The trading book accounting choice tends to be popular with financial firms holding predominantly long positions while markets are trending up. Trading books have historically allowed firms to recognize earnings and traders to realize compensation quickly. However, in declining markets, previously-paid dividends and bonuses are not available to absorb mark-to-market trading losses, which immediately reduce capital levels. Beyond the trading account itself and beyond the reach of the Volcker Rule, the increasing use of fair value within financial accounting more generally, poses similar risks in terms of the potential for rapid market moves to bring about insolvency or illiquidity in banking entities.

While the full consequences arising from the Volcker Rule's new trading restrictions remain unclear, legislator's rationale for the Rule is simple: Reducing insured banking entity exposure to significant and unexpected changes in financial markets should allow these entities to more consistently provide traditional maturity transformation (e.g. short-term deposit-taking and long-term lending) and other banking services, even during periods of market crisis.

Key Volcker Regulation Interpretations

The following section discusses three key areas of forthcoming Volcker Rule regulations, including likely interpretations and required actions. The discussion is informed by the legislation itself, the Financial Stability Oversight Council ("FSOC") study, and related legislative and regulatory comments.

I. Designation of "Trade on Behalf of Customer"

Any proprietary trading exposure that is undertaken to specifically meet the demands of a customer is permitted under the Volcker Rule. Given this, and the need for an audit trail, trading tickets and systems of record will need to include fields that allow the designation of customer-initiated trades. Designation of hedges to customer-derived trading exposure is also likely to become common practice.

The interpretation of what constitutes a trade on behalf of a customer must be broad. Market-making, which is largely a customer-oriented enterprise, and customer-mandated underwriting, are specifically allowed by the Rule. The concept of "customer-solicited trades" as a potential safe-harbor is discussed in the FSOC study; however, "customer-solicited" will need to be defined loosely. If a banking entity representative facilitates a customer trade, or even makes a recommendation to a customer regarding a particular trade that is ultimately undertaken, the trade (and resulting exposure) should be considered customer-initiated. Essentially, whenever a customer-whether a hedge fund, retail investor, or other party-authorizes a trade, any resulting banking entity trading exposure should generally be allowable under the Rule, at least in the immediate term (see risk and conflicts discussion below).

II. Robust Trading Risk Systems and Conservative Suite of Limits

For more significant trading firms, Volcker Regulations will effectively require highly robust trading exposure and risk systems that can drill down to the underlying positions and calculate a number of metrics, some on an intra-day basis. Ultimately, each firm will likely be required to propose a set of modest net trading exposure and risk limits for regulatory approval. For each firm, the levels of allowable exposures and risks, deemed consistent with insignificant proprietary exposure, are expected to be based on factors such as financial condition, customer trading volumes, and quality of systems, risk-management, and governance. In summary, banking entity trading under the Volcker Rule is likely to be constrained by a conservative set of firm-specific limits. The Federal Reserve, as the supervisor of most consolidated banking entities, will effectively set constraining limits for each firm. The above conclusion is supported by the following points:

A. The Volcker Rule allows, and in fact expects, hedging of exposure derived from customer trades. Most of the hedging undertaken within trading books is performed at a portfolio, sub-portfolio, or risk-bucket level. This is recognized by the FSOC. However, it also recognizes that the lack of hedging of certain customer derived exposures can serve to circumvent the prohibition of proprietary trading. The FSOC study states, "However, hedging, or alternatively, the flexibility not to hedge a position, also presents a potential avenue to evade the proprietary trading prohibition�." This should be read to mean regulators will not allow the existence of relatively large or concentrated trading exposures simply because they arise from customer-derived exposures, which the bank has elected not to hedge. Similarly, imperfect hedging of customer-derived exposures, which results in significant proprietary exposures, are also implicitly targeted. Robust systems and adherence to conservative limits will be necessary to convince regulators that these "back-door" proprietary trading exposures are not being undertaken.

B. Though market-making is understood to entail some long and short position-taking in an attempt to effectively service expected customer demand, regulators recognize that such open positions represent proprietary trading risk. The FSOC makes clear that this form of trading exposure should be limited to what is necessary for performing the market making function. Again, for a firm to prove there is not excessive proprietary position-taking within the business of market-making will require robust systems and adherence to conservative limits.

C. The recently released bi-partisan report by the Senate Subcommittee on Investigations specifically recommends that regulators "narrow proprietary trading exceptions" under the Volcker Rule. The executive summary states, "any exceptions to that ban, such as for market-making or risk-mitigating hedging activities, should be strictly limited in the implementing regulations to activities that serve clients or reduce risk." To prove that risk is strictly limited, firms will need robust systems and conservative risk and exposure limits.

D. Finally, the FSOC recommends that each banking entity CEO certify that prohibited proprietary trading has not occurred. If adopted, such a certification will create significant incentives for banking entities to maintain relatively tight risk controls, since outsized trading gains or losses would likely result in heightened regulatory scrutiny.

III. Material Conflict of Interest Disclosures

The section of the Volcker Rule dealing with material conflicts of interest may be the least understood. "Under the Volcker Rule, permitted activities are prohibited if they involve or would result in a material conflict of interest." The FSOC study did not suggest a definition of material conflict of interest and did not provide significant interpretative guidance.

At a basic level, almost every transaction involves some inherent level of misalignment or economic conflict among parties. However, beyond this, in most situations it is not possible for a banking entity to know if it is providing a client with a security or contract that results in a meaningful conflict of interest. Such a determination would require employees to have both ongoing and complete knowledge of their banking entity's own net positions, and complete knowledge of each client's net positions. Given this hurdle, the material conflict of interest prohibition is likely to be both subjective and difficult to enforce.

To mitigate regulatory risk, banking entities may bolster existing compliance programs with initiatives such as:

A. Providing standard disclosures to all clients affirmatively stating that the firm's own positions may currently or in the future conflict with an individual position provided to the client, or the client's net positions.

B. Establishing additional policies and training for traders and firm representatives that prohibit the implicit or explicit communication of trader, desk-level, legal entity, or consolidated banking entity positions or exposures.

The above methods may help ensure that clients are informed of potential conflicts and avoid allegations of unfair and deceptive practices. However, the safest way for a banking entity to ensure that its proprietary trading portfolio is not deemed in "material conflict" with a customer may be to conservatively limit the exposure and risk of the firm's own trading portfolio, sub-portfolios, and meaningful risk-buckets. If a banking entity itself has no "material" trading exposures, it should not be possible to be in material conflict with a client, at least in terms of its trading book.

Conclusion

The motivation for the Volcker Rule is rooted in the simple idea of protecting traditional banking functions. Its regulatory interpretation is likely to push banking entities with significant trading operations further in terms of the robustness of their trading and risk management systems and processes. The Rule is also likely to require heightened coordination between trading risk managers, compliance personnel, and regulators. Given recent commentary by various government entities, it appears the Rule's proprietary trading restrictions will be interpreted and enforced in a relatively strict manner. This will present trading risk managers with ongoing challenges, but may also increase their status within organizations.

(c) Institutional Risk Analyst

www.institutionalriskanalytics.com

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