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Economics

Haziness and the Volcker Rule

The Volcker Rule is a bit hazy...

Over the past couple years there has been a lot of talk about the Volcker Rule. Basically this rule prohibits banks from taking safe assets and putting them up against liabilities as a result of proprietary trading. Essentially, the idea is that if you deposit money in the bank, you shouldn’t have to worry about the FDIC backing your deposits as a result of your bank engaging in trading that may tumble. The problem with this is defining what’s market making and what’s proprietary trading.

When it comes to equities, most equities at least, is that there is generally a good market for them. And for the ones that are illiquid, it doesn’t require much capital to hold to them. But with bonds and and other instruments, it requires a large amount of capital to hold on to these positions. By limiting the amount of money banks have to hold these positions, you will be holding back the amount of money they can spend on certain instruments, most notably municipal bonds and non-US sovereign bonds.

The latter is a significant problem because holding back on holding back certain instruments may upset some countries. How would large growing economies respond if the US started to suddenly sell their bonds? Given that it will actually increase their interest rates but decrease exchange rates. This helps because it makes their exports cheaper but also increases their borrowing costs. For smaller emerging economies, the effect on their interest rate will be less, essentially making it a good thing because they are more able to compete with the US while not raising their borrowing rates dramatically.

This isn’t calling the Volcker a complete disaster. There are solutions. Instead of making banks sell these positions, why not require them to hedge against them? Make them buy credit default swaps on some of the riskier debt. Now the problem with this being that to purchase credit default swaps, which is essentially a put option on interest rates, is that someone has to take the other side. Plenty of mutual funds now will also have a problem with the Volcker Rule. But they could also engage in the CDS market to take the other side of trades. Which saves AIG from drowning again.

Maybe it’s not a perfect solution, but it’s a start.

Links:
http://www.cfainstitute.org/newsletter/advocacy/volcker_rule.html
http://www.cfainstitute.org/Comment%20Letters/20120215.pdf

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I meant to post something Sunday night or Monday morning on CAPM and Warren Buffet’s letter to shareholders, but I’ll get to that soon.

Right now, the most prominent news is that S&P has official rated Greek debt to be in selective default. In my previous post, I had mentioned how Greece was having problems collecting taxes. Also I mentioned this was beginning to spread into other countries, specifically the UK.

While taxes may not be the only source of revenue, it goes to show that some countries need to be more aware of their financial situations. I brought up the UK as an example because I saw an article on it. Last August, S&P had downgraded US debt, not because of our ability to pay but more on where the funds were coming from.

Now I’m not saying the US is having the same problems as Greece. In Greece, people are protesting out on the streets about wage reductions while the politicians are freaking out trying to figure out what to do. In the US, we have people complaining about a 99% and the politicians are going through the same motions. Not freaking out, but certainly much closer to a solution than in Greece, as long as people can get their egos checked.

That being said, I have a much more positive outlook here as long as people are willing to collaborate and compromise.

I had a finance professor, Yiorgos,  who after confusing everyone with crazy valuation methods, he would say “It’s all Greek to me!” and laugh. The funny part about it was, he was Greek. So to him it made sense. He was a smart guy.

I would also say he’s smart because he decided to leave Greece to teach at the University of Virginia, given the mess going on there today. And there’s been recent news about the bailout going on this week. Originally this post was going to be about that until two of my friends shared links that really caught my attention.

It’s on how tax revenues in the UK fell. 

Now from what I’ve read on Greece in the news and from Michael Lewis’s Vanity Fair article which you can read here, a major problem was people who have their own businesses not reporting income tax. This is a common thing in many emerging markets, but to see it happening in the EU is kind of scary. I’d be more worried if it were Germany but at least the situation is contained to one of the weaker countries in the EU.

But now, we have that problem happening in the United Kingdom? I find this to be very scary.  Why the country isn’t checking up on people paying taxes is beyond me. Look, we all hate tax collectors. It’s an international thing. But you can’t argue that we don’t need them because when you look around the world that don’t have enforcement on paying taxes, it just doesn’t get done. Once that starts happening is when you see emerging markets become more stable. But now, in some of the more powerful countries this is happening?

It’s all Greek to me.