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Brown Steagall

By Daniel M. Ryan
web posted January 25, 2010

Some people assume there are no coincidences in politics. Although the downside to this assumption is falling for conspiracy theories, it does impart some insight into political goings-on. Politicians are people people, and are quick to sense changes in the wind that may threaten their position. When one of those events comes around, it's an easy guess that further shifts in the wind have been precipitated by the initial one.

The surprise victory of Scott Brown is one of those catalyzers. To go from 30% behind in the polls to a five-point victory, winning Ted Kennedy's old seat, is nothing short of amazing for a Republican. For a Democrat, particularly an incumbent, a different word comes to mind. Hence the proposal, and its timing. The lack of details suggest a rush job, hastily assembled from an outsource.

Wind Shift

The largely Volcker-inspired proposal to cleave off proprietary trading, hedge fund ownership, private equity and real estate investment, plus limit the size of any bank to 10% of funding instead of just 10% in insured deposits, marks a shift in the wind. Prior to the Brown win, there was always a "pay for the privilege" aspect to even the most punitive Obama-Administration-proposed bank reforms. Those measures seemingly carried the stamp of Tim Geithner, who's been shunted to the side recently. That sidelining has prompted speculation that he's on his way out, but there have been none of the typical signs of someone being put out to pasture other than the shunt-aside. Obama has not stepped out to defend Geithner, which has been the usual prelude for someone being thrown under the bus. Such defenses could be described as "giving the loose cannon a good reference." We haven't seen that as of yet, despite Paul Volcker getting the limelight for now.

There have been the usual protests, centering on what'll happen to the talent once this measure is passed and enforced. They may sound like boilerplate, or a broken record, but that's because they're true. The affected bank's earnings, and corporate-income taxes collected from them, will go down ceteris paribus.

Of course, the sharp decline in the U.S. stock market has been attributed to this new proposal. To be undiplomatic, that attribution is a bit of a stretch. On a long-term normalized P/E basis, the stock market is overvalued. Post-bear market relief rallies tend to overshoot. In 1975, when the market leapt up from a horrid year, the S&P 500 fell back about 12% after a seven-month run that carried the average up almost 46%. The longer-lasting 1970-71 recovery rally, which lasted nine-and-a-half months and carried the S&P up almost 43%, saw a decline of about 12% over the subsequent seven months. The present relief rally, if it be over, lasted more than nine months and pulled the S&P up 70%. It's hard to avoid the conclusion that, had Obama not triggered the decline, something else would have. As noted above, those two '70s post-relief declines took the S&P down 12% before they reversed.

The stamp of Volcker shows in the proposed bans of hedge fund ownership, private equity and real estate. The first two investment vehicles tend to get into illiquid investments prone to "fire sales" or no bids during a crisis; the last is illiquid in and of itself. All three bear an illiquidity risk that could get a bank into real trouble next time 'round. It's true, as "Mish" Shedlock has shown, that these measures would not have prevented the '08 crisis. On the other hand, it can be said that they don't close the barn door from which the horses already escaped. There's a certain regulatory proactivity in those bans, which does show the influence of Paul Volcker.

The other two, however, are more populist. Rather than problem-solving, there's an air of righting wrongs to them. This article shows that proprietary trading accounts for only a small fraction of revenues at JPMorgan Chase & Co. and Bank of America Corp. Morgan Stanley has booked about 3-4% last year, and Citigroup 5% . There is, however, one exception to the not-much rule: Goldman, Sachs. The same article attributes 10% of Goldman's revenues to proprietary trading last year; an analyst at Zero Hedge thinks it's higher. This measure seems aimed at Goldman, and is populist in thrust. The same Zero Hedge post alleges proprietary trading blends into the much seamier, and wrongful, practice of front-running clients.

This part, although Volcker has spoken up publicly for it, doesn't have the stamp of a former career Fed official to it. It's aimed more at assuaging public outrage. Goldman, Sachs has become the "Vampire Squid" in the public mind; a restriction that effectively takes aim at Goldman is likely there to mollify public anger.

The size-limitation proposal also has a populist flavor, despite it seeming to do something about the too-big-to-fail dysfunction. American populism has long insisted that bigger is badder, and the 10%-of-total-funding limitation speaks in its shadow. If Volcker is responsible for all of them, then he has a previously-hidden populist streak in him. My own guess differs.


Shunting aside Tim Geithner, however justified, will further fuel rumors that he's in the pocket of Goldman, Sachs. If this proposal dies in committee, he'll likely be blamed along with Goldman and the "Washington insiders."

One interesting aspect to the proposal is an American exceptionalism. America is going alone with respect to the bank pruning, as it's normal in Europe for banks to be fully-integrated financial institutions. It's also been the same for Canada since 1987. One of the selling points of the public option in health-care reform is that it's time for America to "join the rest of the world." With respect to this measure, though, America is departing from the "rest of the world."

Populist indeed. ESR

Daniel M. Ryan is currently watching The Gold Bubble.







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