VOLCKER PRESCRIPTION CURES THE WRONG DESEASE / BARRON´S ( HIGHLY RECOMMENDED READING )

THURSDAY, FEBRUARY 4, 2010

Volcker's Prescription Cures the Wrong Disease

By RANDALL W. FORSYTH

IN PRESIDENT OBAMA'S STATE OF THE UNION address last week, one of the few themes that brought cheers from both sides of the aisle was when he declared he hated the bank bailout. By extension, banks and bankers are about as popular as the New York Yankees around New England.

Similarly, there is general agreement that banks are in dire need of reform, ostensibly to prevent a recurrence of the near-meltdown that required the trillions expended by the Treasury and the Federal Reserve. And the urgency appeared to increase in the days following the upset victory by Republican Scott Brown for the Massachusetts Senate seat formerly held by the late Ted Kennedy, a result widely ascribed to voter discontent about the economy.

Entirely by coincidence, a few days later Obama announced support for financial reforms centering on the so-called Volcker Rule, named for the former Fed Chairman. The rule would forbid big banks that can, in essence, tap public funds to gamble by engaging in risky proprietary trading.

"He's right but it's beside the point," writes David A. Goldman at the Asia Times internet site (www.atimes.com), where he uses the nom du plume of "Spengler" (or as he puts it, he "channels" the late author of "The Decline of West.") Goldman, whom I've cited here on several occasions, is a former research director on Wall Street (head of credit strategy at Credit Suisse in 1998-2002 and head of fixed-income research at Bank of America in 2002-2005) who has moved on to larger intellectual quests. A true Renaissance man, he now is senior editor of First Things, a magazine devoted to religious matters (www.firstthings.com.)

"What brought the banks down was not speculative bets in volatile markets but what appeared to be ultra-safe investments in the most conservative assets available, namely medium-term bonds rated Aaa/AAA by Moody's and Standard & Poor's, the major rating agencies," David points out.

Banks could leverage their balance sheets by holding pennies of capital against dollars of assets that were supposedly bullet-proof, such as triple-A-rated mortgage-backed securities. And if banks could own them off balance-sheet, Enron-style, in so-called special investment vehicles, or SIVs, they could lever up even more. That is, if the assets were accorded that magic triple-A rating.

"The ratings agencies 'sold their soul to the devil,' as a Standard & Poor's analyst admitted in an e-mail later brought to light by a congressional investigation, in order to rubber-stamp riskier assets with the AAA label," he continues.

But why did banks resort to this legerdemain? "That's because the banks couldn't find enough prime assets in which to invest and had to find subprime assets to replace them," Goldman answers.

Asset returns were driven down in the early 2000s by an influx of foreign capital from Asian central banks that bought dollar assets to cap their currencies. That made prime dollar debt securities "useless" to American pension funds looking for 8%-plus to fund their future liabilities, he explains.

Meanwhile, foreign central banks bought Fannie Mae (FNM) and Freddie Mac (FRE) securities. They assumed -- rightly it turned out -- the federal government would stand behind the agencies' liabilities. The housing agencies bought more mortgages, driving down their yields.

"That's why investors went to subprime." Structured securities with "undeserved" triple-A ratings provided yields of 20-25 basis points over the London interbank offered rate, or Libor, banks' basic cost of money. The likes of Citibank would vacuum up these securities and stuck them in SIVs "with a paper-thin margin of capital," he notes. Triple-A securities weren't supposed to have any losses, so the Fed and other regulators went along.

"This created egregious mis-pricing of the whole credit market," David continues. As he wrote back in January 2006, "We do not value pigs by the attractiveness of their physique, nor for the nobility of their character, but for their suitability for sausage. In a credit market dominated by the CDO (collateralized debt obligation) bid, the most valuable securities are the ones that offer the most yield relative to default rates projected by the models that rating agencies use to rate CDOs." And, it should be noted, those models assumed that house price rise in perpetuity.

This reach for yield to fund what Goldman describes as the greatest wave of retirement in history continues. Thus, everything that offers yield is bid up to a bubble.

At the same time, the American banking system is seeing its business-loan portfolio contract at a 20% annual rate. (And credit conditions show scant signs of easing. (See "A Scoop of Double Dip," Feb. 2.) As banks earn less interest, their delinquency rates have tripled since 2007. Meanwhile, banks can't find mortgages to buy given the depression in the housing market.

What's left, he observes, is for banks to buy Treasuries. They can pile on intermediate Treasury notes yielding 2%-3% funded with deposits paying a pittance and collect the fat spread. Lever that 10 or 20 times and why do banks have to make loans? That's how the massive federal budget deficit will be funded, David slyly says.

"There is nothing wrong in principle with Paul Volcker's call for banking caution," he contends. "But the problems of the banking system can't be separated from the larger economic picture.

"Without a way to match the aging savers of the industrial world with the young workers and entrepreneurs of the global south, banking problems will persist no matter what regulatory regime prevails."

Put another way, Volcker has presented a credible plan to prevent cancer in the patient, which is the U.S. banking system. The problem is the patient has been stricken with heart disease.

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved