the Ghetto Economist on the Volcker Rule
Read Time:2 Minute, 28 Second
Much of the talk regarding a financial reform package has involved the Volcker Rule, so Dulce and I thought we’d post on it. In order to better grasp what Paul Volcker, Chairman of the Fed under Carter and Reagan has suggested it helps to first touch on the Glass-Steagall Act.
Glass-Steagall separated commercial from investment banking. Commercial banks accept deposits and make loans, making their money off the interest spread between what they pay depositors and what they make from the money they lend out. Investment banks don’t take deposits. They create, broker and trade securities on behalf of their investors who will accept the risk of losses in order to possibly make a high rate of return. So working people like Bee or Mike deposit their paycheck or take out a car loan at a commercial bank. Tycoons like Stimpson or Truth101 sink their ill-gotten gains into hedge funds or private-equity hostile takeover services provided by investment banks.
Due to panicked depositors making runs on banks, the 1933 Glass-Steagall Act created the FDIC which guaranteed their deposits. It also separated commercial and investment banking.The deposits being insured by the govt stopped the bank runs and also gave commercial bankers security which balanced out their being prevented from engaging in riskier financial activity. Commercial banks were also able to borrow from what is called the Fed Discount Window. This means they can borrow at slightly above the Fed Funds target rate, what banks charge to borrow/lend between their reserves held at the Fed.
Glass-Steagall was repealed in 1999, allowing commercial and investment banks to merge and contributing to the Too Big To Fail phenomena.
Paul Volcker has suggested that institutions which accept FDIC insured deposits and are able to borrow from the Fed Discount Window not be allowed to engage in Proprietary Trading, which is using funds from their own portfolio rather than investing for a commission with a third party’s funds.
This is because FDIC-backed institutions are allowed to borrow at a cheaper rate than anyone else as part of the Fed’s “Lender of Last Resort” function as well having deposits backed by the govt. So should a bank make risky investments with their own capital which caused them to become insolvent, the taxpayer would be on the hook to bail them out. Investment banking services for a commission have no implied govt backing so would be allowed.
So while the Volcker Rule does not reinstate Glass-Steagall, it would provide a significant measure of protection for the public from being forced to bail out imprudent bankers.
Another part of the Volcker Rule is to limit bank size, possibly measuring deposits in relation to Gross Domestic Product (total spending on goods and services in our economy). The exact formula has not been spelled out.
The Ghetto Economist and his assistant Dulce have no economic training but will gladly speculate with someone else’s money.
Happy
0 %
Sad
0 %
Excited
0 %
Sleepy
0 %
Angry
0 %
Surprise
0 %
0
0
I confess to owning Exxon/Mobil stock. I’m a pinko commie capitalist. In fact if the preacher from my hometown comes up with enough bribe money “Pinko Commie Capitalist” may be my next moniker. My guilt at being a capitalist is masked by my excitement that Oso is back.
Thanks Truth!
I have what may be a stupid question but would this “rule” be used as far as credit unions or are those considered separate issues to be regulated.
=^..^=
Good question Jess,
it’s my experience that credit unions (like my own Patelco-well not my OWN, I mean I bank there)aren’t backed by the FDIC and also aren’t able to borrow from the Fed at a discounted rate so they wouldn’t come under the rule.
I don’t think most of them are big enough or risk enough to have become an issue, although that’s worth looking into.
Credit Unions work under a separate rulebook – and they tend to be safer than banks.
Oso, I apologize for the long comment lengths. I don’t want to come across as hijacking the post.
Krell,
Please never think that, your comments are illuminating and helpful!
After reading all that, I definitely blame Truth101 and Stimpson for ripping off Bee and Mike. One question: Did Truth101 and Stimpson get bailed out?
Holte,
Yes as I recall Paulson first bailed out Goldman-Sachs, then Truth and Stimpson.Both of them incidentally are well over 200 lbs hence “too big to fail”!!!
LOL! You guys are killin’ me again 🙂
What the real downfall was the amount of leverage used in the housing market and mortgage backed securities derived from it. Leverage is a double-edged sword that is a powerful ally during boom times, but can quickly become your worst enemy during the ensuing bust. The collapse or bailout of some of our most highly regarded financial institutions – Fannie Mae (FNM), AIG (AIG), Lehman Brothers and Merrill Lynch (MER) – was squarely due to leverage.
What is leverage and how does it work? Below is a simplified example using three scenarios:
1. (No leverage) Assume I purchase outright (in cash) a home valued at $100,000. If that house increases in value by $10,000 in one year, my rate of return (appreciation) against my $100,000 cash outlay (down payment) is 10% ($10,000/$100,000). Not bad.
2. (Partial Leverage) Now assume that I purchase a home valued at $100,000 and only contribute $10,000 as a down payment and finance the remaining $90,000 at 6% (equivalent to $5,400 in annual interest). If the house increases in value by $10,000 in one year, my rate of return (appreciation) on my outlay (down payment plus the interest costs) is $10,000 / ($10,000 + $5,400) = 65%. So, through leverage of about 10 to 1, I was able to increase my rate of return significantly compared to scenario one where I had no leveraged debt.
3. (Maximum Leverage) Now assume that I purchase the same home valued $100,000 and only put down $1,000 as a down payment and finance the remaining $99,000 at 6% ($5,940 annual interest). If the house increases in value by $10,000 in one year, my rate of return is (appreciation in value) divided by (the down payment and the interest costs), $10,000 / ($1,000 + $5,940) = 144%! So through leverage of about 100 to 1, I was able to increase my rate of return by triple digits. Picture doing this for several years and as long as values rise, I would accumulate tens of thousands of dollars on an investment of $1,000 + interest costs. See how this could be so enticing for investment bankers.
But when things start to fall in value, you can see how your leveraged investment can lose enormous amounts. Take your maximum leveraged example. If the actual value decreased by 1% or went from 100,000 to 99,000, your leveraged asset based security lost 1000/1000 or all its worth. But wait, say the market dropped 25% or to 75,000, then your security drops a whopping 2,500 percent. You can see how the loses can become staggering!!
Krell,
Thank you that is a terrific illustration! So if we magnify it, one can choose to play it safe and hold more capital and decrease his relative rate of return, or if he believes home prices never come down merely purchase a derivative to protect his investment!
Osori…you can see how tremendous profits could be made. But when the fecal matter hits the rotary device, (shit hits the fan), the whole thing implodes rapidly. An investment bank using just 50 million can be so leveraged that they owe 1 billion dollars and have “toxic assets” that now no one wants.
That was when the TARP, toxic asset recovery program, kicked in to prevent that “Global Financial Meltdown” as Bush said.
In my opinion, it’s not much different from a mob guy taking someones money to the horse track. Pays great when it works, but throw the guy in jail if it doesn’t.
Banks get… “You are too big to fail, here’s some more money to try again. And don’t worry, same rules as before.”
Someday I’ll tell you guys how lawyers get themselves disbarred when the real estate downturns start. It’s a neat little shell game.
Oso, great post! You’re good at explaining the core crap of the financial world – good job!
And Dulce is looking particularly nice today.
Bee,
Don’t let the pic fool you. I just investigated some noise,saw she’d opened the drawer where all the paper and plastic bags to be recycled are kept.She’d pulled all of them onto the floor and when I cold busted her she just turned and strolled away. An animal of no conscience.
Love to hear about them dang lawyers someday!
🙂 at your cat getting busted. One of mine hides under the table on a chair whenever I bust him, in full view I might add. Ditto on the lawyers.
I never really understood the mechanics of the banking system. However, I learned a lot from this most informative post. There should be no doubt that The Ghetto Economist and his assistant Dulce know what they are talking about 🙂
Mike,
Dulce is the brains of the outfit. but since she lacks a thumb and has claws she needs someone to use the keyboard. Hence,me.
I misread that as ‘The Vulcan Rule’ for a second.
Might have been more fun mind you!