E-piphany

Obama is the kind of guy who, if he was pulled over for drunk driving, would vow to drive faster so that he wasn’t on the roads as long.

The President’s speech today about bank proprietary trading operations – specifically, his desire that “no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit” – marks another overreach, another attempt to turn messy, capitalist enterprises into state-run utilities (see also: autos, student loans, health care). And this comes only a couple of days after his policies were repudiated by the very people who managed to see Ted Kennedy as sufficiently moderate to return to the Senate year after year.

The idea is also half-baked. It is an attempt to re-create Glass-Steagall, a Depression-era law (actually two laws, according to Wikipedia) that prevented commercial banks from owning investment banks. The problem is that the financial system isn’t as clean and simple now as it was then. Declaring that banks can no longer take proprietary positions will remove them from “trading” altogether, since an important part of the market-making function lies in the converting of certain risks (say, outright duration risk that I get when WAMCO hits me with $200mm long bonds) into other risks (for example, I might sell 10y notes instead of 30y notes to hedge that position, if doing so allows me to unwind the position at an eventual profit). If banks cannot do this – and it clearly is the taking of proprietary risk – then they can have no function as market-makers since my response if I am hit with $200mm long bonds is to … try and hit someone else with $200mm long bonds. That works if it is $1mm. It doesn’t work if it is $200mm.

So banks will become pure lending institutions, except burdened by a heavy taxation structure and regulatory oversight. It isn’t clear if they would be able to “ride the yield curve” by borrowing short and lending long, since that of course is a proprietary position and involves risk. Lending spreads will increase, and lending volumes will fall, in exactly the opposite way that Glass-Steagall’s repeal in 1999 contributed to narrower lending spreads and increased lending volumes.

Banks will have to spin out their “investment bank” arms, where the “proprietary risks” are kept. But these firms will face greater oversight and more-expensive capital, since they don’t have deposit bases to lean on (profits from commercial banking being more stable, they tend to lower the overall cost of capital that the capital-intensive side of the business, prop trading, faces). The result will be lower trading volumes and wider bid/offer spreads, in exactly opposite the way that the repeal of Glass-Steagall in 1999 led to increased liquidity and narrower bid/offer spreads.

And this will lead to lower asset prices. The level of asset prices embodies the value of liquidity – assets with lower liquidity trade at discounts (examples include closed-end mutual funds and limited partnership interests). Ergo, government actions which tend to lower liquidity will also tend to lower asset prices.

Investors know this viscerally, which is why the stock market today did exactly what it should have done in a circumstance where these ideas might become law unless grownups intervene (n.b., grownups are in short supply on Capitol Hill): they plummeted. Stocks ended the day at the lowest level of the year, down nearly 2% on the day. Yes, the market was and is overvalued…but isn’t it amazing that the President managed to take the one thing working in his favor over the last year, the rising stock market, and put it into jeopardy? He is making the mistake that Clinton carefully avoided during his two terms: you might think that only fat cats own stocks, but that’s no longer true. We are all investors now, and you’re ticking us off.

President Obama clearly views a populist rant as his best remaining idea, and this is part and parcel of that rant. In announcing this plan, the President said “If these people want a fight, it’s a fight I’m ready to have.” Really? Okay, tough guy. You’re on. I think that all employees at primary dealers ought to take their Fed-mandated one-or-two-week vacations…in unison. Go on strike, collectively. See what happens with Treasury auctions then. I hope TreasuryDirect is up to the challenge.

Somewhere along the line, President Obama and his previously-sane advisor Paul Volcker seem to have forgotten that Wall Street actually serves a function. They don’t seem to realize that it is competition of smart, profit-maximizing folks which has driven liquidity to ridiculous highs and spreads to ridiculous lows. Remove those folks (or cause them to give up and leave the industry), and replace them with bureaucrats who are neither smart nor profit-maximizing, and all of society suffers.

This is not to say that these bright folks labor merely to help the little guy. Of course not! To paraphrase Adam Smith, it is not from the benevolence of the NASDAQ market-makers or hedge-fund traders that we expect penny-wide spreads, but from their regard for their own self-interest.

Needless to say, in addition to the fact that economic indicators seem to be stalling in their improvement (although it is somewhat hard to tell when the BLS blames holiday short-staffing for today’s jump in Initial Claims and the concomitant understatement of them for the last few weeks) the actions of the Administration and Congress is becoming increasingly hostile to the economy and to investors. While bonds have their usual seasonal weakness to deal with, it seems dangerous to be positioning that way at the moment. We didn’t get the break to higher yields that I expected, yet. I would not be exceptionally long duration at this point, but crawling back into the low-risk shell is probably warranted until it becomes clear that this volatility isn’t blossoming into something more. It isn’t as if stocks are so cheap that one need fear missing a lot of upside!

On a completely different note: I am so far enjoying writing this commentary (again). Please reward me by passing the URL (http://mikeashton.wordpress.com) on to your friends and neighbors who may find it illuminating. It doesn’t cost anything to sign up! And I am also enjoying the comments that are being posted in response. Keep them coming.