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Updated Volcker Rule Published

Last night was a fairly news-worthy evening. In addition to Greece and Spain’s surprise bond issues, the text of the much discussed Volcker Rule was sent to Congress by the White House.

So how does it differ from the initial proposal that has been discussed endlessly, including on this blog?

  1. The bill does regulate non-bank holding firms (hedge funds, private equity, and probably sooner rather than later, Goldman and Morgan Stanley) by imposing “capital and quantitative limits” on these firms, but does not go so far as to allow them access to government funds in the event of systemically-risky collapse.
  2. Firms are prohibited from assuming by acquisition more than 10% of all liabilities in the system. This is a change from current rules which prohibit firms from owning more than 10% of deposits, and is a reflection of the move towards retail deposits being a smaller and smaller piece of the funding that banks use to do their business.

I made it clear in an earlier post that I was not a huge fan of the proposal as it was initially laid out. For an even better write-up of some of the issues, see Economics of Contempt’s excellent writeup.  However, I do feel that while the addition of these two rules do make the Volcker Rule stronger, it still leaves critical holes unplugged.

The largest hole here is that it still implicitly assumes that non-retail banks are not systemically important. Lehman Brothers conclusively proved that they in fact can be. The updated Rule imposes some restrictions on these firms (though what the specific “capital and quantitative limits” will be has yet to be clarified), but doesn’t go so far as to acknowledge that 1) these firms most certainly can be systemically important and 2) in the event of collapse of a systemically important investment bank or hedge fund, it’s going to need to be bailed out anyways lest we have a repeat of Lehman.

Furthermore, the moral hazard has already been breached, and I think that the market generally understands that these firms will be bailed out in the event of another meltdown. Why not codify this, put into place resolution authority, and make it well known the process by which these firms will be wound down?

I also have yet to see a good definition of what will constitute proprietary trading. This is a hard nut to crack, as the firm can trade onto it’s own book for many a legitimate customer transaction. It’s hard to separate this out. Making broad statements about banning it is fine, but actually enforcing it can get hairy when regulators try to determine what was legitimate vs what was not. I imagine that defining this will be an ongoing process, but it still needs to be addressed.

My final issue, and one common to almost any law, is that the language appears to be less than clear. Dealbook has quotes from several business and finance professors confirming what many have feared–that it will likely be easy to circumvent the rule through loopholes. I’m not an expert on the legal text by any means, but systemic financial regulation is too important to pass cursory rules that can easily be circumvented.

In the end, my feeling is still the same–the bill’s heart is in the right place, but it just doesn’t get it. It’s a good first start, and includes some solid points, but I haven’t yet seen enough that says to me that Congress and the White House are doing much more than making cursory attempts at regulation that address the symptoms, not the causes of the financial crisis. I hope to be proven wrong.

Changing the game of NYC apartment hunting?

This post will be somewhat unrelated to the fields of finance and technology, but is something no doubt of interest to anyone who has lived in New York.

As anyone who has lived here can tell you, there’s not much worse in this city than trying to find an apartment. Not only are prices astronomical, but you frequently have to pay a very large “brokers fee”, typically at least one month’s rent, to a broker who does nothing more than open the door of the apartment and ask you if you want it. They don’t help you search for a place, they don’t offer you advice, they don’t help fill out the paperwork–they do nothing more than turn the key, and for this are rewarded handsomely. Add to this that 9/10 of the listings they tend to place are grossly misleading and filled with enough grammar and spelling mistakes to make a kindergardener blush, and you begin to get some idea of the dread that fills New Yorkers when they think about the prospect of finding a new apartment.

Which is why I love the idea of Naked Apartments. Their idea is to essentially let renters post a profile of their income, preferred neighborhood, amenities, bedrooms, etc, along with an optional credit score and other data to establish your credibility as a renter, and to let the landlords come straight to you. This could work as it filters out a lot of the noise to both parties, renter and landlord. It’s something of an online dating site for apartments, and should help both parties more easily find an ideal match.

I wish them the best of luck, and hope that they can get enough traction to succeed. Luckily I am happily in a great apartment, but if I do need to find another place for some reason, I would certainly give them a shot.

I do see one downside here–it shifts some of the burden of finding an apartment onto the landlord. Currently, this is fine–the market is down enough that there is more supply than demand. However, this is not normally the case–apartment hunting here is an incredibly fast moving, aggressive experience, with many people competing for every decent apartment. Generally if you find a place you like, you’ve got about an hour to commit to it before someone else takes it out from under you. I’m worried that when the market returns to something of an even keel, that landlords won’t be willing to put in the effort and will revert right back to their old ways, where demand outstrips supply and lets them get away with just about anything.

In the interim though, best of luck. I do hope that they succeed.

Bill Gross’ March 2010 Investment Outlook

I absolutely love reading some investors’ investment outlooks. It’s a great way to get an insight into what some legendary investors are thinking about the markets and the economy, and can go a long way to expanding your knowledge and thinking about some key issues.

Bill Gross, co-founder of PIMCO, one of the world’s preeminent bond firms, has published his March 2010 investment outlook, and per usual, he’s got some great insights. Somewhat unusually, he makes quite a few irreverent jokes, complete with hilarious charting, but that only serves to make it an even more interesting read.

The subject is on the ability of sovereign governments to issue more debt to get themselves out of a debt crisis. It’s a very prescient read given the current issues in Greece. If you’ve any interest in the structure of the debt markets, it’s worth checking out.

Finance Industry Job Movement

LinkedIn of all places has posted a very interesting analysis of where employees from the three big collapsed investment banks (Bear, Lehman, and Merrill) went.

The really interesting thing here is how you can see the remaining firms consolidating talent. Finance is labor rather than capital intensive, and the quality of your people has a direct influence on your bottom line–hence some of the outsized compensation that is seen. This puts the surviving firms, in many cases originally less prestigious than their peers, at a real advantage as they poach top talent and expand their finance operations to a level unthinkable before the crisis. Barclay’s seems to be the real winner here, picking up by far the most number of employees from the three failed firms, and putting it in a good position to excel.

Another interesting insight–not many of these folks left finance. You’d think that with all of these firms going out of business and the market making historic declines, that many of them would have been unable to find work in finance and moved on to other fields, but that does not seem to be the case.

As with all analyses such as this, take it with a grain of salt given that the sample consists only of folks on LinkedIn that are reporting their career background, but it’s an interesting tidbit nonetheless.

See the original LinkedIn post for more.

With the Old Breed: Pro-Regulation?

The Times recently had a fascinating article talking about the opinions of some of the street’s “old breed”, guys like John Bogle (Vanguard founder), George Soros (billionaire investor, legendarily shorted the pound and earned >$1B in one day), and William Donaldson (cofounder of Donaldson, Lufkin, and Jenrette). Many of these players are very supportive of much of the regulatory reform proposals coming out of Washington.

This is much in contrast to many of today’s biggest players, most notably Lloyd Blankfein and Jamie Dimon, who have been strongly opposed to the majority of the proposals coming out of Washington. It’s fascinating to me how much of a split there seems to be between these two generations. Certainly, not everyone in the same field will have the same opinions, and it’s easy to say that the Old Breed is merely reminiscing, having made their money and gotten out of the game long ago–superannuated as I heard it so aptly called. But even so, the split here is very interesting.

Now, while I will say that I think the financial system absolutely requires some further regulation, I’m not sure that Volcker’s proposal, which Soros et al are throwing their weight behind, is the way to go about it. While it’s heart is in the right place, I don’t think it goes far enough, and make some dangerous assumptions. For one thing, it makes the assumption that only those institutions that take customer deposits are systemically important. I think that Lehman showed that to be patently false. Furthermore, because it focuses on these consumer institutions, it wouldn’t have stopped Lehman or AIG from collapsing, two of the events that did the most damage to the financial system. And third, it’s very easy to get around it–Goldman, seemingly everyone’s favorite whipping boy, would simply have to get rid of their nominal consumer bank in order to continue going about business as usual.

Economics of Contempt has done a great writeup of some of the issues with the Volcker proposal for those interested.

Centralized Derivatives Clearing: Increasing Systemic Risk?

After the unprecedented events of the last 18 months, there has been a gathering tide that points to more regulation on much of the financial industry. Much of this has been hotly contested, but the one piece of regulation that seems to have avoided much of the hubbub is derivatives clearing.

The idea of centralized clearing is nothing new. Equity and option trades already flow through a centralized clearing agency (the DTCC and the OCC respectively) whose job it is to act as a neutral third party, guaranteeing that the purchased securities and proper payment are delivered to both parties. In the event that your counterparty goes out of business or otherwise fails to deliver what you are owed, you will still receive your half of the transaction. This counterparty risk caused tremendous concern for many market players in the depths of the market crash, when no one was sure that the firm to whom you just shipped millions worth of securities would actually deliver the money that was owed to you (or vice versa).

However, not until very recently has the idea of centrally clearing derivatives, the shadowy cousin of equities and options, gained traction. This is not particularly concerning until you consider the astounding values of these contracts: according to the Bank for International Settlements, there were $604.6 trillion worth of over-the-counter (OTC) derivatives outstanding as of June 2009. Of these, the vast majority ($437 billion, or just over 72%) were interest rate swaps, which are a fairly standardized form of derivative. Adding fuel to calls to regulate and centrally clear these instruments are the outsized role they played in this financial crisis: AIG was brought down by the large number of credit default swaps (CDS)  it had written that it was unable to pay out with the CDSs were called in. From a regulator’s perspective, centralized clearing makes sense because it forces the market to standardize many of these contracts, making them easier to understand by market participants and allowing the regulator greater latitude over what types of derivatives can be traded.

Given the outsized role and astounding notional value of these instruments, the case for central clearing seems to be a slam dunk. And in many ways, it does. A consortium of industry players has already gotten together to establish their own central clearing party which is already clearing many interest rate swaps. But there is still a lot of talk of making such clearing mandatory, and for additional asset classes, through establishing additional regulatory rules that all market participants must adhere to.

However, it seems to me that there is one big issue here that I haven’t seen addressed, and that could actually lead to increased systemic risk. Clearing agencies are able to guarantee transactions because they operate like an insurance company, charging each market participant a small fee on each transaction, and using these funds to pay out claims in the event that a counterparty defaults for whatever reason. The problem comes from two things:

  1. The tremendous value of some of these contracts that would have to be paid out in the event of default
  2. The relatively small number of transaction for the less common (i.e. non-interest rate swaps) instruments

These two things combined together mean that the clearing organization would have to collect a much larger fee per transaction from market participants in order to cover the risk of having to pay out in the event of default–more than may even be reasonable, or possible without completely gutting the market. Additionally, as we have seen with recent market events, particularly AIG, these derivatives tend to come due all at once, and in astronomical values, further increasing the risk that the centralized clearing agency would be unable to cover a failure to deliver.

If such an event were to occur, this would cause even further turmoil in the markets. Not only would there be the obvious issue of the failure to deliver rippling through the markets similar to what happened with AIG, but such an event would severely undermine confidence in the market. Additionally, market participants may likely have been lulled into a false sense of security by the presence of the central clearing agent guaranteeing the trades. Volumes (and notional values) would likely have gone up due to this sense of security, leading to an even larger downside in the event of an inability of the clearing agent to deliver. Firms may also be under-prepared to deal with this counterparty risk, given that they were under the assumption that the clearing agent was guaranteeing the trade. Combine all of these elements, and the systemic risk that these regulations are aimed at preventing still seems to be very much alive.

Ultimately, I do think that regulated centralized clearing for derivatives makes sense, particularly in the case of interest rate swaps, which make up the bulk of the market and are fairly standardized and high-volume, liquid assets. However, I do think that it must not be seen as a panacea, and that firms (and those that do business with these firms) should be aware that counterparty risk could still rear its head, particularly in a “perfect storm” event the likes of which we have witnessed over the last 18 months. As with all things–caveat emptor.

Why I am underwhelmed by the iPad

Steve Jobs announced the much-anticipated Apple tablet a couple of days ago. Despite the epic amounts of hype (or perhaps because of the unrealistic expectations created by this hype), there has been quite a lot of disappointment about the device.

I happen to be one of those people.

Before I go into why I was underwhelmed by the announcement, let me talk about what did impress me:

  1. The engineering. Apple has now gotten back into the silicon design business, and custom designed the ARM chip that powers this thing. And from the reviews I’ve read from the folks that have played with the iPad, it’s a rocket ship. Very fast.
  2. The price. That they managed to fit that very large screen and this new silicon, along with 8-10 hours worth of battery, into a case that slim, all for $500, is very impressive. I can’t wait to see iSupply or one of the other sites do a teardown of one of these to see if Apple is eating it on the hardware costs to spread adoption.

However, these two things are technical in nature, and if there is one thing that Apple’s success has taught us, it’s that technical achievement alone won’t get you the widespread adoption or astronomical profit margins that Apple enjoys.

There have been many sites detailing what went wrong with the iPad. Here is a particularly good one. However, most of these focus on features that are missing. I don’t think that the primary problem with the iPad is features. Sure, it would have been nice to see a webcam, or a fantastically tiny bezel, or Flash support, or any of 100 other things that one could ask for. While I do feel that multitasking is truly required on a device like this, one must keep in mind that this is the first revision of this device, and all of these are things that could be easily updated.

No, in my book, the biggest problem with the iPad is this: what does one use it for that isn’t better done on another device? If I want something mobile, the iPhone or another app-phone is much smaller and is something that you would already be carrying around with you in the first place. If I want to surf the web, or look at pictures, or write emails, a laptop (or desktop) is far more capable, and can do much more, much faster, than the iPad can. So where does the iPad fit? There is nothing that I can see one using it for that isn’t better served by another existing device. It’s missing it’s killer application, like the spreadsheet was for PCs or the mobile app-store was for the iPhone.

Furthermore, while the iPhone replaced several devices that people had to carry around and made folks’ lives easier, this device doesn’t replace anything. You’d still have to carry your iPhone, or Blackberry, or other phone around to do voice, and these devices can already do light emailing, calendaring, and web browsing. And you’d still have to carry around your laptop if you needed to do any serious email, spreadsheet, word processing, or other heavy lifting. The iPad doesn’t replace, or even enhance, any of these devices. It’s an extra thing to stuff in your bag or leave lying on the coffee table. It doesn’t make my life easier, it makes it more complicated, a decidedly un-Apple idea.

Now, I will say that perhaps I just need to use one. I’ll have to reserve my final judgement for now until I can truly play with one and see what I think. One definitely must keep in mind that this is the first revision, and that future revisions could be much, much improved, and truly prove their value proposition.

But until this happens, until I’ve played with one or figured out what this truly can be used for, I’m going to stick with this: I don’t see this device changing how very many people use computers. I don’t see how it adds any value to the computing experience.

One more note on the new processor that Apple designed: this is significant because Apple got out of the chip design business a couple of years ago when they moved to an Intel architecture. Apple now controls the design for what appears to be one of the faster “mobile” ARM chips out there. As for why Apple felt the need to design new silicon rather than adapting an existing design (such as the Snapdragon chip that powers the Motorola Droid) I don’t know, as it isn’t cheap to design these things–but if they felt the need to invest that time and money into the process, they must have felt that there was a lot of headroom to grow with in the ARM architecture, and felt that they could be the ones to figure it out. From first appearances, they have. This is some pretty significant intellectual property for Apple, and if they play it smart, this could be the true benefit for Apple from this device.