In the Dodd-Frank financial reform Act of 2010, financial firms in the U.S. are required to set aside higher reserves to cover losses on trades of securities, including those that “swap” the risk of default of a given security, such as bonds based on subprime mortgages. Almost immediately, the Wall Street bankers set about minimizing the new hindrance.
Traders in the banks set about getting around the “margin requirements” by treating the “swaps” as futures, which do not require the higher reserves in Dodd-Frank. Whereas a futures contract for corn to sell at a certain price limits residual risk, swapping the risk of the default of an investment puts a party on the line for the entire investment. Moreover, unlike futures contracts, swaps have significant systemic risk because claims can all be made at once, overwhelming the parties assuming the liability in the swaps (e.g. AIG in September 2008).
Managers at Wall Street firms have tended to not only minimize safeguards even though they protect the banks (from themselves), but also discount or even dismiss such high-risk, low-probability outcomes as come with risk to a bank as well as the entire financial system (i.e., systemic risk). Meanwhile, less money held in reserve means more money available to be lent or put into high-risk investments such subprime mortgages or bonds based bundles of such high-risk mortgages.
Accordingly, the gradual trajectory already as of the beginning of 2013 was toward yet another systemic collapse of the financial system should enough housing markets take a down turn. “As the market gravitates to the cheaper platform—and it’s cheaper because it’s unsafe—that creates risk for everyone,” said James Cawley, CEO of trade execution firm Javelin Capital Markets.[1] Put another way, market participants were operating according to the greatest profit, the greater risk notwithstanding. “In a distress scenario, you basically have what you had from AIG in 2008,” Cawley said; “Then someone has to step in, and we all know who that someone is: the U.S. taxpayer.”[2] So the question at the time was perhaps whether the SEC had the taxpayer’s back or was reflective of, or enabling a cozy revolving door between the federal government and Wall Street firms.
To be sure, the Volcker Rule, part of the Dodd-Frank Act, would, unless weakened, bar banks from short-term proprietary trading (i.e., on their own accounts, except for market-making), and from taking ownership states in private equity funds and hedge funds. U.S. Senator John Hatch speaking at Jack Lew’s confirmation hearing in early 2013 raised the question of whether Lew would act as U.S. Secretary of State to constrain banks’ risky proprietary trading, given that he had headed units at Citigroup that were involved in just such practices that would violate the Volcker Rule.
Traders in the banks set about getting around the “margin requirements” by treating the “swaps” as futures, which do not require the higher reserves in Dodd-Frank. Whereas a futures contract for corn to sell at a certain price limits residual risk, swapping the risk of the default of an investment puts a party on the line for the entire investment. Moreover, unlike futures contracts, swaps have significant systemic risk because claims can all be made at once, overwhelming the parties assuming the liability in the swaps (e.g. AIG in September 2008).
Managers at Wall Street firms have tended to not only minimize safeguards even though they protect the banks (from themselves), but also discount or even dismiss such high-risk, low-probability outcomes as come with risk to a bank as well as the entire financial system (i.e., systemic risk). Meanwhile, less money held in reserve means more money available to be lent or put into high-risk investments such subprime mortgages or bonds based bundles of such high-risk mortgages.
Accordingly, the gradual trajectory already as of the beginning of 2013 was toward yet another systemic collapse of the financial system should enough housing markets take a down turn. “As the market gravitates to the cheaper platform—and it’s cheaper because it’s unsafe—that creates risk for everyone,” said James Cawley, CEO of trade execution firm Javelin Capital Markets.[1] Put another way, market participants were operating according to the greatest profit, the greater risk notwithstanding. “In a distress scenario, you basically have what you had from AIG in 2008,” Cawley said; “Then someone has to step in, and we all know who that someone is: the U.S. taxpayer.”[2] So the question at the time was perhaps whether the SEC had the taxpayer’s back or was reflective of, or enabling a cozy revolving door between the federal government and Wall Street firms.
To be sure, the Volcker Rule, part of the Dodd-Frank Act, would, unless weakened, bar banks from short-term proprietary trading (i.e., on their own accounts, except for market-making), and from taking ownership states in private equity funds and hedge funds. U.S. Senator John Hatch speaking at Jack Lew’s confirmation hearing in early 2013 raised the question of whether Lew would act as U.S. Secretary of State to constrain banks’ risky proprietary trading, given that he had headed units at Citigroup that were involved in just such practices that would violate the Volcker Rule.
Lew had been the COO of Alternative Investments at Citi. MAT and Falcon investment funds were sold as low-risk even though those funds were actually hedge funds with high risk. As COO, Lew refused to offer the misled customers full refunds. At least fourteen arbitration panels subsequently gave the customers the full refunds they had sought. Although he had not been involved in selling the funds, he did manage units that engaged in risky proprietary trading. The public would be justified in wondering if they too would be left on the hook as taxpayers rather than protected should Lew favor Wall Street's incessant desire for profit over the government's role to place that desire in check for the good of the system/whole.
After Lew, during President Trump's first term, the Federal Reserve Bank voted unanimously in late May, 2018 to weaken the Volcker Rule. The move was consistent with the president's desire to deregulate Wall Street. The flip side of the move that would enhance Wall Street profits was that the government would be doing less to protect the financial system as a whole even though the systemic risk of the largest five banks had increased with their growth. As Senator Dick Durbin had said after the financial crisis when people were looking to Congress to protect even the banks from themselves, “Congress is owned by the banking lobby.” So looking to the legislative branch should the executive be in sync with Wall Street's financial interests may not play well. Even after semi-stringent regulatory constraints have been passed, Wall Street can still have the edge in circumventing or mollifying the speed-bumps even though they are in the bank's own long-term interest, which can come to roust even in the short term as in 2008.
See Essays on the Financial Crisis, available at Amazon.
After Lew, during President Trump's first term, the Federal Reserve Bank voted unanimously in late May, 2018 to weaken the Volcker Rule. The move was consistent with the president's desire to deregulate Wall Street. The flip side of the move that would enhance Wall Street profits was that the government would be doing less to protect the financial system as a whole even though the systemic risk of the largest five banks had increased with their growth. As Senator Dick Durbin had said after the financial crisis when people were looking to Congress to protect even the banks from themselves, “Congress is owned by the banking lobby.” So looking to the legislative branch should the executive be in sync with Wall Street's financial interests may not play well. Even after semi-stringent regulatory constraints have been passed, Wall Street can still have the edge in circumventing or mollifying the speed-bumps even though they are in the bank's own long-term interest, which can come to roust even in the short term as in 2008.
See Essays on the Financial Crisis, available at Amazon.
1. Eleazar Melendez, “Wall Street Setting Itself Up For Next Derivatives Crisis, Market Participants Warn,” The Huffington Post, February 14, 2013.
2. Ibid.
2. Ibid.
