By George Bailey, who has worked in senior compliance roles at Big Firms You’ve Heard Of and is also a member of Occupy the SEC
The first few legs in the in the Volcker Rule repeal relay race are now under way. The reporting of losses at Zion’s Bank, which management blames on the Volcker Rule (when the losses had long existed but remarkably cooperative auditors had apparently agreed with management’s decision not to mention them), was the opening shot.
In the bankers’ lane, the baton containing Zion Banks “unexpected losses” on their underwater CDO portfolio has been handed off to the industry associations who are running full bore to hand it off to potentially still-bank-friendly regulators who are expected to neatly dispose of it at the end of the race.
In the other lane, the Agencies’ baton is loaded with tough and reasonably unambiguous regulatory language, supported by extensive discussion and commentary in the rule that refutes the complaint that Zion and the community banks are unwitting casualties of an unintended result of the rulemaking.
Lining the edge of the track are bank-friendly Congresspersons poised to stick their legs into the Agencies’ lane, while the spectators are distracted by the mainstream financial press misdirection.
It’s hard to tell who’s winning.
The regulators appear to be in the lead according to Bloomberg
U.S. banking regulators provided advice on how banks should treat certain securities in a document quickly panned by industry groups for failing to address their concerns that the newly finalized Volcker Rule will force banks to take losses on the securities
In other words, the regulators basically reiterated the rule and its commentary and failed to “address the bankers concerns” by modifying the rule. The New York Times’ Dealbook, on the other hand, apparently misread, and consequently misreported the memo, declaring a victory for the banks while confirming the Agencies said nothing new.
However, the Regulators may not have their best runners in this race, and this is a cause for concern.
Bloomberg’s Matt Levine reported that the critical clause that snared “Volcker’s First Victim” was buried in footnote 1856. In very brief form, Zions was still a large holder of so-called TruPS CDOs, which were very attractive to banks due to the way there were treated for regulatory and capital purposes. Zions’ “victimhood” was more the result of poor accounting of these seriously underwater positions as Yves and Bloomberg’s Jonathon Weil, among others, have already clarified.
But Levine does raise one good point in his piece.
Always read the footnotes is the lesson here, and everywhere
As it happens, I have read a few of the footnotes (at least 284 of them). And one of them reveals that the Agencies chose to punt on an issue that is at the heart of the reporting of losses at Zions:
This commenter also argued that an important metric that is missing is a Liquidity Gap Risk metric that estimates the price change that occurs following a sudden disruption in liquidity for a product, arguing that there needs to be an industry-wide effort to more accurately measure and account for the significant effect that liquidity and changes in its prevailing level have on the valuation of each asset .suggested that entity-wide inflation risk assessments be produced on a daily basis. 2786
It is extremely curious that the Agencies chose to wave away the issue of liquidity risk as not worth bothering about and further stated that the commenter had recommended it be done to contend with inflation risk. Occupy the SEC was the source of that comment and did not mention or even imply that inflation risk was a serious concern, so the footnote looks to be either a remarkable misreading or straw manning.
Moreover, anyone who regularly read the financial press during the crisis could readily cite cases where liquidity dried up, to the degree that it created serious, even systemic, risk at institutions and in markets. For starters: asset backed commercial paper, auction rate securities, subprime mortgage backed securities, and CDOs. (Remember also that “illiquidity” does not necessarily mean there are no buyers, but what the buyers are willing to pay would lead to current owners realizing such large losses that few to no trades take place).
It is precisely this disruption in the liquidity of the TruPS CDO product that is causing Zions, due to its vastly outsized position relative to its peers, such immediate pain. The risk of an overly large position relative to normal trading activity is, or should be, well known to regulators; it was the cause of the demise of Long Term Capital Management (which astonishingly had interest rate swaps positions equal to roughly 1/10th of the total market) and the hedge fund Amranth, and was the reason the London Whale position was so costly to unwind.
Indeed, only 3% of Us banking assets are invested in the product Zions is suddenly forced to disclosed losses on. Zions’ disproportionate share of the loss is not in itself a systemic concern and the political blowback and industry groups targeting of the underlying rule requirement are disingenuous. The real fear in the bankers’ team is that the rule is now applicable to positions the banks previously believed were safe from much scrutiny.
The commenter (Occupy the SEC) urged the regulators to require the banks to provide information that would alert them to risks such as Zions has now disclosed to avoid potentially systemically disruptive events.
Unfortunately, the Agencies response to this comment was:
After carefully considering the comments received, these and other proposed metrics have not been included as part of the final rule.
Given that the Agencies appear to be standing firm in their initial response, there is a great urgency NOW for them to rethink their position and require disclosure of the liquidity impacts from positions that will have to be unwound as a result of the final rule. The products that are at the greatest risk are discussed in more detail in this summary at Lexology. And it’s a potentially very large list.
It would be an appalling lapse on the part of the regulators to continue to choose to remain uninformed of the potential for large and sudden liquidity disruptions that may result from the implementation of the final rule. The additional surprise element resulting from the dubious accounting for these positions should alarm the regulators enough to rethink their requirement for a useful pre-emptive reporting metric. Given that the London Whale fiasco was the reason for late-in-the-game toughening of the final rule, this omission is remarkable, particularly since the regulators cite the requirement for robust and continuous reporting as a key element in an effective compliance regime.
Zions’ disclosure could be the tip of the iceberg of embedded losses, and the immediate and urgent response of anti-regulatory army is a clear signal there are losses lurking. It’s one thing to engage in forbearance when a regulator thinks disruption is temporary or an institution can earn its way out of trouble. It’s quite another to choose to ignore an all-too-frequent source of trading losses and thus put yourself in a position to be blindsided. Again as we saw with LTCM and the London Whale, institutions that have taken large losses too often take even bigger bets to try to claw their way back, and wind up compounding the damage. If the authorities continue to punt on this issue, it may be an early sign that the Volcker Rule is destined to be Potemkin regulation.