Ladies and gentlemen, boys and girls, democrats and republicans, hold on to your hats. What I’m about to reveal will absolutely blow your minds. You will not hear this from Congress. You will not hear this from the regulators. You will not hear it from an industry being scapegoated, regulated to heretofore unforeseen levels and frightened to death that even more regulation is coming.
You’ve all heard about or read about the Volcker Rule. You’ve heard everyone from President Obama to Chairman Gensler denigrate the “outrageous” risk taking activities of big banks (namely prop trading, which is often described as taking directional bets or positions, especially through credit default swaps or by purchasing risky asset-backed securities) with other people’s money, which of course, in their view caused the financial crisis. They claim the Volcker Rule will stop banks from engaging in these activities and will prevent tax payers from having to bail out large banks in another financial crisis because they will not be able to engage in these risky activities and will instead be constrained to traditional bank activities like lending money and hedging risk. JPM’s recent missteps (as widely reported in the press) have called additional attention to this issue, which has been at the center of the regulatory debate since the Dodd-Frank Act was enacted.
So, here’s the startling revelation: extending a line of credit or otherwise lending money to an individual or an institution is a proprietary trade. Banks are engaged in the business of proprietary trading. Banks have always been engaged in the business of proprietary trading. The entire Volcker Rule and all of its premises are smoke and mirrors which do not address the fundamental underlying issues and root causes of the financial crisis. Don’t believe me? Think I’m blowing smoke? Think I’m a shill for the industry? Think again, this is cold, hard and simple logic.
Making a decision to extend a loan to an individual or institution is a proprietary trade because it is for the bank’s own account and it is a bet by the bank that the individual or institution will succeed sufficiently to repay the money (if it’s a secured loan, there’s less risk, but that doesnt alter the fundamental nature of the beast). In the case of an individual, it is a bet the individual will remain employed or will be able to find new employment such that he or she will be able to repay the loan. Indirectly, it is therefore a bet on an industry, a sector and perhaps even specific products vis a vis that individual’s role in the economy. Where it is something like a mortgage it is all of those things plus a bet that the value of the property will be suficient to cover any default, which is itself a bet on property values, which is in turn a bet on a region, which in turn is a bet on a portion of the economy, one or more industries, etc…
In the case of a loan to a large corporation, the same analysis applies on an extended basis. A loan to a big computer manufacturer, for example, is a bet on whether that enterprise will succeed or fail, which is in turn a bet on whether the computer industry will thrive or stagnate, which is in turn a bet on corporate and consumer spending, which is in turn a directonal bet on all or part of the economy or an industry or sector. Yes, some manufacturers will lead the pack and others will trail, but the point is that betting on any one of them to succeed is definitionally something of a bet on that entity’s businesses, which is a bet on many other things. It is thus indisputably, unequivocally and factually the case that such extensions of credit/lending activities, which are the historical bread and butter of banks, are proprietary trades, i.e. they are bets for the bank’s own account, using the bank’s (or, as lawmakers like to say, other people’s) money, that a particular individual or enterprise (along with related variables as mentioned) will succeed sufficiently to effect repayment, including the bank’s interest (i.e. its profit).
Selling credit protection on an entity with a $1B notional for a spread is likewise a bet on that entity’s performance and it’s ability to succeed in the market place, i.e. a bet that it will not experience a credit event–as well as a bet that the credit protection seller’s counterparty will pay it the relevant spread during the term of the contract (or that a credit protection buyer’s counterparty will surivive to pay the settlement amount). In the same way that people who loaned money to Greece made a proprietary bet on Greece’s ability to succeed in exchange for Greece agreeing to pay interest and repay the loans those who sold credit protection on Greece made a similar proprietary bet to earn a spread and those who bought such protection made the opposite bet (some players collateralized exposure just as some loans are secured while others did not just as some loans are unsecured). The substance was essentially identical, but the form of the bets was different.
In all cases (selling or buying credit protection, extending a loan, buying a bond or a common stock or a commodity or anything else for that matter), a directional bet is being placed. The issue is whether the risk represented by that directional bet is properly diligenced and properly managed not whether it is in the form of a bond, a loan or a swap. To focus on the form of the risk-taking and not the underlying decisionmaking and diligence processes absolutely, utterly and completely misses the point. Various government officials and certain pundits constantly whine that lending is stagnant and banks aren’t lending enough while at the same time chastizing them for engaging in risky proprietary trading.
Well, gee folks, with logic like that we might as well call it hocus pocus and see if Gandalf or Harry Potter can summon us a solution with a waive of the hands or a swipe of the wand. I submit that the reason it is impossible to create a workable definition of proprietary trading for purposes of the Volcker Rule is that banks are definitionally in the business of making proprietary bets whether in the form of a loan, a repo or, horrors among horrors, a swap. Focusing on the form of those bets rather than on the process by which the associated risks are managed is as pointless as it will be unrewarding. And, there you have it folks, startling revelations indeed.