V is for Volcker, and Also Vendetta

In what is being coined "The Volcker Rule," President Obama introduced a sweeping agenda yesterday aimed at limiting the size and scope of activities of the nation's largest banks. With former Federal Reserve Chairman Paul Volcker at his side, the President railed against the banks and promised the American taxpayer that we would no longer be held hostage by banks that are too big to fail. Although the specifics of the plan have yet to be outlined, the basic premise is that that banks would no longer be able to own hedge funds and private equity funds nor engage in prop trading. As many analysts have already pointed out, it will be extremely difficult to differentiate between customer-driven trading and proprietary trading. Take Goldman Sachs for example. The investment bank claims that only 10% of its trading profits come from prop trading. But then take a look at its balance sheet, which carries $882 billion in assets. If Goldman was strictly buying on the bid and selling on the offer, then it would carry no inventory. Clearly that is not the case, as the bank carries a tremendous inventory of financial assets. How much of it is related to customer trading? Is it hedged? (Obviously not all of it, as it wouldn't be making so much money) What about all the carry it is making holding that inventory while lending it out at zero percent? That is considered taking interest rate risk, so does that count as prop trading or customer trading? Making a distinction will be extremely difficult and banks will figure out ways to get around it.

The really big question is the following: What was the true significance of Paul Volcker's presence behind Mr. Obama as the President delivered his speech? Sure Mr. Volcker has been wandering the press circuit, calling for the repeal of Glass Steagall. But that might not be the whole story. For those who aren't familiar with Mr. Volcker, he served as Fed Chairman from 1979 to 1987. He is widely credited with stamping out the runaway inflation of the late 70's and early 80's by hiking short term interest rates to a peak of 20%. Politically, this was an extremely unpopular move, and he reportedly received death threats while in office. So you've got to hand it to the guy, he sticks to his guns, and isn't afraid to piss people off and ruin presidencies if it means doing the right thing with monetary policy.

Meanwhile, Bernanke's confirmation hearing in the Senate has been postponed and the Senate Democrats are not sure they can get enough votes to reconfirm him. Who would be a likely nominee in the event that Mr. Bernanke is not reconfirmed? Paul Volcker. Having proven himself to be perhaps one of the greatest inflation hawks of all time who doesn't bow to political influence, Mr. Volcker's possible nomination could tank the bond market. And if the bond market tanks, the stock market will follow, particularly financials. All of this is pure rampant speculation and probably unlikely, but worth considering. Next week could get interesting...