Is the Glass (Steagall) Really Half Empty?
by Brian Pretti CFA, Contrary Investor. February 19, 2010
As you already know, the pre-midterm election/post Massachusetts election get tough on Wall Street and the banks official Administration policy is now in play. Maybe. Sort of. Well, we’ll see. At least it was a short term sound bite the Street took seriously for about 3 seconds at this point. Conveniently attention has been diverted by Greece and friends. Whether it’s all for show or will really have teeth somewhere down the road is the question to be answered. Nothing “x” millions in campaign contributions can’t derail, no? The real issue is not the potential for separation in trading versus lending operations for the banks, but a much, much larger issue lies dead ahead if the Administration is really serious and simply not creating a perceptual show. (At least so far they get an A+ for creating very short term perceptual shows.) The big issue once again comes back to leverage. Here’s the deal. Despite the hurt meted out by the equity markets in 2007 and 2008, prop desk trading was the saving grace for financial institutions last year. And of course this prop desk trading was “facilitated” by cheap money from the Fed/Treasury/Administration. Additionally, and without question, the use of leverage at the prop desk level is more than alive and well. Point blank, one bubble that is still thoroughly alive and well is leverage. One of the few glimpses we get of this is looking at the banking system derivatives data. So here’s the question for you to ponder. IF the Administration is really serious about separating prop trading from commercial banking, will the process set off yet another massive wave of deleveraging? Let’s face it, if prop desks are essentially to be cut asunder someday from Government bailouts and taxpayer support, will they adjust their use of leverage to account for this new set of circumstances? And this is surely what has in part spooked the equity markets in recent weeks. Although short attention span theater on the Street is a reality.
As of the close of the third quarter of last year, we have witnessed one of the smallest YTD growth numbers in banking system derivatives outstanding really in what can be considered the history of derivatives themselves dating back to the early 1990’s. Given that interest rate derivatives by far make up the bulk of banking system derivatives exposure, this lack of growth is not surprising at all as it simply reflects the brick wall systemic credit expansion has run into in the last year plus. But, the issue is that the leverage still remains.
The following chart speaks to just how meaningful leverage still is to folks like Goldman. Over 55% of GS derivatives activities are related to trading for their own account, less than half being done for their clients. Again, two issues arise when we ponder the separation of prop desk activity from banking. First the unintended consequences of potential deleveraging, as that’s a given. But in conjunction the “liquidity” created by this activity is an issue of concern. The Administration is staring the two big “L’s” right in the eye in terms of even contemplating reform - leverage unwind and liquidity wind down. Neither of which are near term contextual positives for the financial markets.
I’m certainly not arguing that due to these facts the banking folks be allowed to run de facto massive hedge fund operations and have their results backed up by taxpayer money. Far from it. I’m sick and tired of the losses being socialized while the profits are privatized. Seems Americans are finally waking up also. We’ll find out just how much in November. The louder the regulatory reform drumbeats sound, the more uncertainty investors will face in terms of the potential for further deleveraging and macro liquidity diminution. And has not the last month or so already shown us point blank how markets deal with uncertainty?
While I’m on the subject, a few final charts and that’s it. First, yes indeed, banking exposure to CDS contracts has declined during the last year. But current levels of absolute exposure are still very meaningful relative to historical context. Only 2007 and 2008 saw greater exposure, and not by much. Issue being, there is still meaningful exposure to leverage in the system. I’m not arguing leverage in the system needs to go to zero. Not at all. Just within the context of a full deleveraging cycle (which we believe is occurring), we’re still just getting started. TIME is the key to healing.
Finally, and I never thought I’d see the day, total banking system hedging of their derivatives book hit a new record high in 3Q of last year. First, we need to remember that over the last year, derivatives heavyweight Goldman has been included in the data and was not prior to this time. You can see the spike up in hedging (bilateral netting) in 3Q of ’08. That was adding Goldman to the banking system derivatives roll call. But the new high in the number tells us that never has the banking system been so dependent on counter parties in terms of total derivatives risk management.
Now, of course, some banks lay off risk to each other, but total lack of transparency in reporting only leaves us guessing as to who else has assumed counter party responsibility for banking system derivatives risk management and ultimate solvency in this line of business. Apparently the AIG debacle has been ignored completely in terms of the whole issue of counter parties, and the risk assumed in dealing with such entities. So far, that’s our legacy of non-reform. Resolving the issue of too big to fail among the US financial system heavyweights? Just the opposite seems to be what is occurring. And the Administration believes cutting trading from banking will be a benign exercise? There is simply too little information available in the public venue to properly assess risk. It’s one of my major macro pet peeves of the moment. Just how are investors, businesses and the market as a whole to properly price risk when so much key information to properly assess risk is hidden? I have no idea.
You understand the key issues. IF politics reigns supreme and reform does entail cutting proprietary trading out of the commercial banking space (this will only happen if political survival becomes the issue after November), we need to be on the lookout for the potential unintended consequence of a second round of deleveraging of some magnitude. At least so far, comments coming from the Senate Banking Committee are soft pedaling the whole issue. Has the banking lobby already done its job of derailing this? If so, it's just another black eye for the Administration. Again, the market will price in any reality of reform long before it becomes a known fact. Wall Street for now can take comfort in the fact that investors have already laughed this one off. The ultimate question really becomes, is the Administration serious and will reform really have teeth? So far we've seen zero in terms of reform. Although this sounds sarcastic, a key watch point is Goldman itself. To separate their prop trading from the information they control in terms of order flow, etc., would be a major negative issue for them. If Goldman takes themselves private, the Administration is serious. If not, it’s just simply more political hot air. And who better to know exactly what reality is than GS themselves?
© 2010 Brian Pretti