Saturday, April 24, 2010

Why is trading being allowed to drive securities underwriting?

The traditional securities underwriting business of Wall Street at least had some rhyme and reason behind it that made sense for Main Street businesses. Main Street companies needed to raise capital and Wall Street helped them do it, and in the process Wall Street was quite profitable on the fees they earned from helping to underwrite new securities that provided Main Street with capital. This process help build both Wall Street and Main Street and was a prime contributor to the size and health of the American economy. So far, so good. But then Wall Street got lost in the wilderness and began constructing artificial, "synthetic" securities that had the distinctive pair of qualities that they provided enormous profits to Wall Street without providing even a single dime of capital to creditworthy Main Street companies and consumers. What happened? Enter trading, specifically proprietary trading (also known as prop trading), or more specifically, creation of securities whose primary motive was to provide a trading vehicle for Wall Street to generate a continuous profit stream from in-house proprietary trading, all funded by "witless" customers who were sold a bill of goods when they bought the "securities" that funded the trading vehicles.

Although many of the specific details of Wall Street actions have been recounted endlessly (and mindlessly) by the media, nobody has bothered to connect the dots and simply point out that the core problem behind the crisis was the concept of securities which are created primarily for the purpose of Wall Street to trade (endlessly) rather than to provide capital to creditworthy businesses and consumers on Main Street.

Granted, these new-fangled securities did provide a lot of capital, but so much of it was targeted to the least-creditworthy businesses and consumers. It simply wasn't capital that had any chance of helping to build a better and stronger economic base in America.

That's why the so-called sub-prime crisis occurred. Wall Street did not care even the slightest bit about the credit quality of the debt behind any of its new securities. In fact, the shakier and riskier the security, the greater the chance of higher volatility, which is the primary quality of interest to the new breed of trader on Wall Street. Okay, so Wall Street did care about credit quality - they preferred the worst credit quality. That was the primary reason for the sub-prime crisis.

Actually, that was half of the problem behind the crisis. The other half of the problem is that mere bankers, without any great insight into the new Wall Street bias towards bad credit misguidedly loaded up on a lot of these new securities (MBS, CDO, et al) as a major component of their asset base without realizing that it really wasn't AAA quality or even close. This asset-quality deterioration is what caused the bulk of the financial crisis in 2008, but it could not have happened without the deterioration of credit quality on the securities side of the fence.

In the old days, trading was a relatively minor side business for investment banks, needed primarily to "support" the main security underwriting business. Any profits from such trading was mere icing on the cake and not the cake itself. Today, the situation is reversed and trading is the cake and actual securities are the mere icing.

That is why in the latest Goldman Sachs case a mere "trader" is the boss of the guy doing securities deals. Trading is in charge - because trading is where the lion's share of the profits are.

This is also why the big issue for reform is not whether banks should be allowed to engage in investment banking and the underwriting of securities, but that banks should be forbidden from engaging in the kind of trading that led to the whole sub-prime-fueled financial crisis. This is why repeal of the real of Glass-Steagall is not enough and that the Volcker rule is needed to address the trading bias in the securities business.

Where is the media on this? Asleep at the wheel, AWOL, pick your favorite metaphor.

-- Jack Krupansky

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