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"President Obama wants to limit the scope of risk-taking by barring banks with federally insured deposits from trading securities for their own accounts and from owning hedge funds and private equity funds. The plan, policy makers said on Friday, would effectively require bank holding companies -- which Goldman and Morgan became at the height of the financial crisis -- to divest themselves of these lucrative operations." -- New York Times, 1/21/10
One wonders if there's more to the collective howl that hovers over Manhattan this weekend, like the deadly smoke in Cormac McCarthy's "The Road," than simple concern over the loss of "lucrative operations."
The first, and most obvious, question is:
If organizations like Morgan and Goldman are forced to divest their huge proprietary trading positions, who is big enough to assume them?
-- And, if there's no one to take them on, or available counterparties simply don't want them, then they will have to be unwound.
-- And, If they have to be unwound, systemic risk will once again be in the headlines as disaster moves from one balance sheet to the next: From bank to bank, from bank to hedge fund and from hedge fund to hedge fund and back to the banks again.
-- And, in short all the systemic risk that the federal government hoped to bury through its bailouts will resurface. Only this time around, given the national mood, it is unlikely there will be any federal rescue measures.
This opening of "Obama's Box" might tow disaster in its wake.
From the same New York Times article:
"Allowing Goldman, or other institutions, to abandon their bank charters carries risks. Such a plan could create a two-tier system, where Goldman could pursue business activities different from its bailed-out peers like JPMorgan Chase. Goldman would lose access to the Federal Reserve's overnight lending program, which provides emergency financing. But investors may still assume that the government would bail out Goldman if it had trouble, elevating the risk of moral hazard.
Simon Johnson, a former chief economist at the International Monetary Fund, said allowing either bank to revert to a securities firm would do little to address the underlying problem. They are so large and interconnected that a collapse would imperil the global financial system, he said. 'You can call them an investment bank, a hedge fund, or a banana, but they are still too big to fail,' Mr. Johnson said."
It must be that Mr. Johnson has spent the past fortnight on a desert island somewhere. He seems to have missed something. The other side of the Hudson River -- the rest of the country -- has had it with bailing out the "banana." Behind the Obama/Volcker proposal is the notion that no bank would be too big to fail.
If the past is an indicator then gold might be in for some heavy sledding in the days to come as the unwinding of positions spills over to the gold market. At the same time, as the numbing effects of the Obama/Volcker proposal settle in, we might find that this correction has already run its course.
Beyond the short term, the market will begin to take into account the fact that the gold positions of proprietary traders like Goldman and Morgan are very large, on the short side of the market, and would need to be unwound under the Obama proposal. The problem comes when you begin to consider who might be willing to take them on. The proposal closes the door on spinning off subsidiary, bank-owned funds to which the short position might be transferred.
That leaves the hedge funds, other private equity organizations and possibly foreign banks to pick up the slack, and whether or not they have either the massive capital required and/or the incentive remains an open question. The trend among hedge funds at the present is to take the long side of the gold market, not the short, with many of the biggest fund operators, market leaders like John Paulson, leading the way. If anything, the Volcker Rule is likely to solidify this trend and recruit new members, not discourage interest in gold.
Messrs. Obama and Volcker with their press conference on Thursday may have inadvertently lit the fuse for the second leg in the financial crisis by creating a great deal of uncertainty in the multi-trillion dollar derivatives' business. Some will see Volcker's Rule as an act of courage; others something foolhardy. The market will be a harsh and uncompromising judge, and there will likely be some unforeseen repercussions.