Bloomberg’s Max Abelson today reports on Goldman Sachs’s Multi-Strategy Investing unit — in effect a hedge fund within the bank that bypasses the Volcker rule’s limits on proprietary trading. It’s a great story. It also raises a question: Is prop trading really the problem with Wall Street?
Before you answer, remember what caused the collapse of Bear Stearns Cos. and Lehman Brothers Holdings during the financial crisis, as well as the massive losses at Merrill Lynch and other banks. Obviously all of them took stupid risks with their own capital. It’s just that the risks didn’t come from the sort of trading the Volcker rule addresses.
An excellent succinct discussion of the pattern comes in Jake Bernstein and Jesse Eisinger’s 2010 Pro Publica article about the huge mortgage losses at Merrill, now part of Bank of America Corp. Merrill’s loss came from CDOs that the bank itself had packaged from mortgage-backed bonds. As Bernstein and Eisinger make clear, Merrill’s mortgage traders were the buyers of last resort for derivatives that Merrill bankers had created and no one else wanted.
That’s not the proprietary trading that regulators fear. If anything, it’s the opposite. Instead of letting traders freely choose their own investments, Merrill, like Bear and Lehman, had them stuff their portfolios with the mortgage bonds and CDOs that came out of the bank’s own underwriting and derivatives business.
In their Atlantic cover story this month, Eisinger and Frank Partnoy take apart bank income statements and focus on hat kind of risk with a discussion of “customer accommodation” trading, dryly pointing out that
“at many large banks, customer accommodation can be a euphemism for “massive derivatives bets.”
If banks want to disguise proprietary trading as “hedging,” it’s easy enough for them to do it. Maybe worse, if they want to build up massively risky positions in the service of banking fees, as they did with mortgage bonds, they can do that too. No variant of the Volcker rule stops them.
Before the mortgage meltdown, it was feared that a big hedge fund (like Long Term Capital Management) or a bank prop trader could set off a chain of dominoes that took down the financial system. The Volcker rule responds to the fear, and it’s a legitimate one. It’s just not the crisis that actually happened.