With Dodd-Frank Rollback, Even Bigger Banker Bonuses Are Ahead
As the Volcker Rule is targeted, banker speculation could run rampant and history looks set to repeat itself
At the end of last May, CNN Money headlined that, “American banks had their most profitable quarter ever.” Bank profits soared by 28% during the first three months of 2018 to $56 billion, according to statistics published by the FDIC on Tuesday. The author commented:
Although bankers have complained of excess regulation, the FDIC report shows that the industry is hardly drowning in regulation. The Dodd-Frank reform law was signed into law in July 2010 by former President Obama. Since then, bank profits have increased by 135% as the American economy climbed out of the Great Recession.
Corporate profits, in general, have also soared this year while wages have stagnated. The Center for American Policy, a Democrat think tank, recently published this graph demonstrating that the benefit of the Trump tax cuts flowed to corporations but not workers.
The announcement about swelling bank profits came at the same time Federal regulators announced proposals to roll back the Volcker Rule for some banks, a rule that bankers continuously complained was restricting their ability to earn bigger and better profits. Why are the Fed and associated regulators so eager to fix what ain’t broke? Because this is just another step in the goal of full retraction that began when Volcker first introduced his simple four-page set of regulations. Every weakening of Volcker means bankers will be able to earn even bigger and better bonuses.
Every analysis of the 2008 Crisis agrees that bankers buying risky investments was a significant cause of that near economic meltdown. These included the commercial banks using our depositor money to bet for personal gain. The practice goes by the abstruse name of Proprietary Trading (Prop Trading).
The drafters of Dodd-Frank recognized that bankers made more bonus money speculating in the high-risk derivative market than they did by, what bankers themselves call, plain-vanilla banking. Best of all for the bankers, they suffered no clawbacks when their gambles failed. Thus, Section 956 of Dodd-Frank directed that the regulators devise regulations to prevent this perverse pay incentive.
A Geek Interlude: Banks do not keep deposit money in trust or in any way separate from their own cash. As a matter of law, banks are free to use depositor money as they wish, including using it to bet in the shadow derivative markets— as they did so recklessly prior to 2008.
Separately, the Volcker Rule (pursuant to section 619 of Dodd-Frank) intended to stop Prop Trading — full stop. The banks immediately began lobbying and Volcker’s four-page simple set of regulations expanded to some 14 pages with multiple concessions and exemptions. Still, the banks were not satisfied and continued to press for more reductions.
The inner workings of banking are kept in a black box so that when banker sympathetic politicians introduce laws that give banks more ability to earn even bigger pay, the average member of the public has little understanding of what’s being done. Note how universities do not offer courses to explain how banks work.
Thus, a lot of background is needed to explain why the Volcker Rule is so important and how banker bonuses are made on synthetic profits gained from synthetic derivatives. Few are those who will work through the necessary, if nerdy, concepts.
To say that much of the huge profits shown on bank financial statements are artificial seems extreme. But, with an understanding of the new business model of banking and the role of derivatives, this astonishing proposition will become clear.
Into The Black Box Of Banking
British economist John Kay adopted, in part, a title from a book by a famous American bank critic, Louis Brandeis, who, when a lawyer, wrote Other’s People’s Money and How Bankers Use It. By this title in 1914, Brandeis called attention that bankers made their money by using our money. Kay has updated this notice showing how, today, they use our money to speculate on bank credit in the riskiest of markets for personal gain. Kay believes that the average citizen no longer has the slightest idea of what bankers actually do.
By The Way: One year after Brandeis published his critique of bank behavior, he was appointed to the US Supreme Court. Can you imagine an outspoken and effective bank critic getting that appointment today? What’s happened and how did it come about?
Commercial banks are given their privileged monopoly license to create money and lend it out charging interest. Their core activities are generally believed to be accepting deposits, making loans, facilitating payments for goods and services by checks and credit cards and such. However, while they still do that, according to Kay, some twenty years ago those core activities became a very small part of what they now do. Kay says that today banks spend 90% of their time speculating with our deposit money in the derivative markets. (John Kay, Other People’s Money: The Real Business Of Finance, Public Affairs, 2015 eBook loc 179)
Kay observed: …most of the companies that failed in the global financial crisis were brought down by activities that were not their mainstream business. Long-term commitment to institutions would be replaced by short-term opportunities in the pursuit of individual gain. (loc 677)
Lending money contributes to the economy; speculating in the synthetic derivative market contributes nothing, but puts it at high risk.
This last proposition requires the explanation of a number of financial system concepts little appreciated outside of banking circles, especially synthetic derivatives.
A derivative is a collection of investments such as 1000 individual mortgages collected into one bundle and given a name such as Abacus 2018. The derivative has no value in itself; it derives its value from the investments in the collection. So far so good, yet, there are derivatives that contribute to our economy and some that contribute not a thing -only put it at risk.
A simple but more complete introduction to derivatives here.
Economists have given us a helpful concept under an unhelpful term. Long ago they identified economic activity that could take without giving. Let’s consider the classic example: A stream that farmers use to bring their produce to market runs in part across a section of land. The landowner puts a tollgate over the stream to charge farmers for its use.
I suggested that the term “rent seeking” is unhelpful because rent is associated with landlords who give accommodation in return for rent. ‘Rent seeking’ is a purely parasitic activity. However, I also have to admit that I cannot think of a better phrase to describe this phenomenon.
Productive and Parasitic Derivatives
Our favorite farmer, Old McDonald, has 100 piglets that will be ready for market in two years. Today’s price is $100 for a two-year-old pig. The old farmer would like his money now rather than waiting. An investor is willing to pay $100 a pig today for the right to the future price of the pig two years, which he believes will be $200 per animal. Now, it might go down to $50 per pig.
This is a simplified futures contract, which is one type of derivative, but the benefit is clear. The farmer gets some money without waiting and reduces his risk of a drop in price; the speculator gets an opportunity to make the increased profit on pigs without having to shovel a single load of manure.
Derivatives are not necessarily evil. Productive derivatives can provide benefits such as the reduction of risk. However, there are nonproductive derivatives that may increase risk and can bring down our entire economy as happened in 2008. These are aptly called synthetic derivatives.
The famous Rogue Trader, Nick Neeson, who broke Barings Bank in 1995, speculated with bank depositor money in the synthetic derivative market. He bet a billion of Baring’s money that the Japanese stock market would go up on a certain Friday. It went down dragging the venerable old bank with it.
Neeson was perfectly authorized to bet in the synthetic market. In 1993, he made $15m — 10% of the bank’s profits for that year. What he did wrong in 1995 (besides losing) was go over his limits.
More on bankers trading in synthetic derivatives for big losses after 2008 here
The story of the London Whale in 2012 gives us another example of how useless much of bank investing is to anyone or anything except the bankers’ wallets. Bruno Iksil was a member of a risk management department at J.P. Morgan charged with reducing risk. Over time he bet and lost $6.2 billion of bank money on complicated credit default swaps and other high-risk synthetic derivative schemes.
The United States Senate Permanent Subcommittee on Investigations (Report, March 14, 2013) grilled Inskil’s boss, Ina Drew, on how a unit, whose role was risk management, could make spectacular profits. Iksil had made a presentation on January 26, 2012 that read: “Go long risk on some belly tranches especially where defaults may realize” and “…turn position over to monetize volatility.” Drew admitted that she couldn’t explain what it meant, but, in fact, approved billions of dollars of trades based on it.
The Motley Fool noted 49 damning pieces of evidence in that Senate Report. An Example: one Iksil trade netted a $400 million dollar profit. Yet not one senior executive admitted noticing that Iksil must have been speculating not hedging and thus increasing risk not decreasing it.
Likely there’s a good reason for this blind spot. Iksil’s team of six got $105 million in bonuses in the year before the Whale beached. These “profits” from the synthetic derivatives flowed into synthetic bonuses. Of course, there was not even a suggestion that these bonuses be clawed back.
The Whale’s trades have the hallmarks of a synthetic derivative. Nothing Iksil did contributed anything to the economy nor was of benefit to anyone but himself— and his fellow bankers and their bonuses.
JP Morgan maintained in its defense that it didn’t have the slightest idea that Iksil was speculating not mitigating. He was just another ‘Rogue Trader.’ However, in 2013 the Whale surfaced within the safety of his native France (which will not extradite him) and wrote an open letter to the press:
“My role was to execute a trading strategy that had been initiated, approved, mandated, and monitored by the CIO’s [Chief Investment Office] senior management.”
After reading the Senate Report and its voluminous amount of evidence, it is highly probable that senior management must have known, despite their pleas of innocence, that Iksil was clearly in breach of the Volcker Rule. So to understand what loophole the executives used to escape sanction, we have to look at the exemptions in Volcker.
Expanding the Freight Train-Sized Loopholes
In 2010 Volcker introduced a four page set of rules that highly restricted the banks’ ability to speculate in the derivative markets for profit. As noted above, the banks immediately began their attack and by the end of 2013 the regulations became so complex that today the banks can righteously complain that they need relief from all this red tape and hence the present justification for the need to weaken Volcker.
The original Volcker Rule set out two main exemptions: risk management (hedging) and market making. The banks made immediate successful attacks that expanded these exemptions and are succeeding again. As Bloomberg reports of the present proposed changes: “Regulators also want to give firms more leeway to take advantage of exemptions in Volcker that permit trades that hedge market risk and are done for market-making purposes.”
A Geek Interlude: The Volcker Rules were designed to apply to commercial banks, but it also applies to bank holding companies. Because the investment banks were in need of extra cash injections in 2008, they became bank holding companies. Bank holding companies are permitted to get secret low-interest loans from the Fed. So while the banks publicly got some 700 billion in bailouts, they also got, and continue to get, cheap loans from the Fed.
JP Morgan justified Iksil’s trades under the risk management or hedging exception to Volcker.
The term hedging comes from the common garden hedge that puts a limit around our property. The idea is to put a limit on loss. For example, a person has $200,000 to invest. They put $100,000 in the stock market hoping to make dividends of, say, 10%. That investment may yield nothing. They want to make some gain for certain, so they also invest $100,000 in government bonds that pay only 2%. They have hedged their risk of making nothing.
Yet, how do we identify when a trader is actually hedging and not speculating undercover of hedging as Iksil did? A solution would be to prohibit any trader, who is supposed to be hedging, from making any personal profit by way of commissions or bonuses because of the trades. A rule might also prohibit bank hedgers from trading in the synthetic derivative market. If they are indeed hedging, the investment should be in safe securities.
When you want to sell a stock, there is usually an immediate buyer; this does not come about by happy coincidence. Certain large institutional firms take on the obligation to ensure that there is a market for certain investments. When you sell a stock, you may be selling to one of these Market Makers; when you’re buying, you are likely buying from one.
Market Makers charge a minimal fee for this service. You may see a stock listed as “bid $100; ask $100.05.” This is the bid-ask spread. The five cents is the Market Maker’s profit. It seems an infinitesimally small amount, but with high-volume and the efficiency of electronic trading, the pennies add up.
There is a serious risk. Market Makers assume the risk of the loss in value of the investment that they undertake to support.
We face the same problem with this exemption as with hedging. Is the bank buying to make a market, or using that as a cover to speculate? The present Volcker Rule assumes that if an investment is held for longer than 60 days, it is for speculation. The new rule will remove this assumption and make it much easier for banks to conceal speculation as hedging or market making. The new great peril: they may make their easiest profits again betting with each other and hedge funds in parasitic synthetic derivatives—as they did pre 2008.
Another Geek Interlude: Banks do a significant amount of their Prop Trading and hedging with each other. This phenomenon goes by the obfuscating term of ‘Contagion.’ Who did the banks owe the money to in 2008? Each other and the hedge funds. This interconnectedness was not a result of a virus, but the new business model by which banks make synthetic profits in wild casino style where they not only bet, but bet on other banks’ bets.
Advocates supporting this deregulation argue that a small bank’s failure due to speculating in the markets should be allowed because it cannot affect the entire system. Yet, history shows that because of contagion, banks do not fail individually but by groups in tangled webs. About five small bank failures at the same time would be a threat to the financial system. But, the real question is why should they be allowed to use bank assets to speculate for their own bonuses at all?
Parasitic Synthetic Derivatives: Bets on Bets
In The Big Short movie, Michael Lewis gives us an example of how a complex synthetic derivative works. A man and a woman are at a roulette table. Behind them are several rows of other people. The man and the woman place their bets. In the first row behind, a man bets on the woman at the table, and a woman bets on the man at the table. In the second row, a man bets on the woman in the first row who bet on the man at the table; a woman bets on the man in the first row who bet on the woman at the table. And so it goes on row after row. Sometimes a gambler doesn’t take the whole bet but bet’s 50%; another bets 10% and so on and so. This is actually not far-fetched, but is a fairly realistic abstract model of what happens in some complex synthetic derivatives.
Former bank lawyer Richard J. Isacoff offers a brilliant if seemingly out of this world example. He says to imagine a fantasy football team based on selecting members of a real team; then imagine forming a second fantasy team by selecting members of the first fantasy team. If you can do that, you have the mental preparation to understand some of the complex synthetic derivatives.
If we go back to a simple futures contract such as the one Old Farmer McDonald negotiated for the sale of his pigs, we can see how a synthetic derivative can be piggybacked (sorry, couldn’t resist) on a productive derivative. A speculator then bets that the investor will lose $50 per pig on the deal. Another speculator takes the bet. After that, just like in the lottery table example, other speculators bet on the bets of those speculators, and so on. This is not a dramatic and unusual example, but a common pattern in synthetic derivatives. You will even run across descriptions such as CDO squared. It is a CDO based on speculating the success or failure of tranches (parts) of a CDO that does contain assets. Wild? No, quite a common investment type in today’s financial markets.
Why do we let bankers continue their new model of banking using depositor money as security for betting in the synthetic derivative market? Why, indeed, when there is no possible benefit to our society or economy, but there is the risk of damage to our banking system.
A Voice Crying in the Wilderness
One regulator, Commissioner Robert Jackson Jr., objected to the rollbacks before controls were put on banker pay as required by Dodd-Frank. I cannot put the argument against relieving the Volcker restrictions at this time better than he did:
But there’s another clear, common-sense reason why I cannot join today’s majority. There is a simple way to prevent people from doing something: don’t pay them to do it. If we want to make sure bankers don’t gamble with taxpayer money, we should make sure they’re not getting paid to gamble with taxpayer money. Rolling back the Volcker Rule while failing to address pay practices that allow bankers to profit from proprietary trading puts American investors, taxpayers, and markets at risk. That is a risk that I cannot accept, so I respectfully dissent.
It’s hard to convince the average reader that government regulations actually permit bankers to make their big pay in the totally unproductive way that they do. It’s just too unbelievable. However, it gets even wilder next article when I discuss Credit Default Swaps.
Acknowledgment: I must credit Janet Tavakoli as author of the insightful phrase “synthetic profits made on synthetic derivatives.” Tavakoli is one of the Cassandra’s of the crisis. She cried in loud and clear terms that there was something seriously wrong in the derivative markets pre 2008. She wasn’t listened to then, and she’s not being listened to now.