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January 24, 2012

More False Arguments Against Volcker……….By Those Who Should Know Better

Joining a long list of industry allies, Senator Bob Corker today made yet another argument against the Volcker Rule, which bans proprietary trading by bank holding companies.  He claimed today that exempting Treasury securities from the Volcker Rule’s prohibition on proprietary trading is unfair because trading in Treasuries is just like trading in other debt instruments.  From the MarketWatch story: “I don’t know why trading in U.S. Treasuries would be different than buying a GE [General Electric Co.] bond?” asked Sen. Bob Corker, Republican from Tennessee, at an event at the U.S. Chamber of Commerce. “If you bet the wrong way on a U.S. Treasury you can lose just as much money as trading a GE bond.”

He made this claim at a Chamber of Commerce’s latest event convened for the purpose of bashing the Volcker Rule.  No one who supported the Volcker Rule was invited or spoke at the event.  The one-hand clapping event-machinery of Wall Street and those who do its bidding continues unabated. 

Senator Corker’s criticism is, at best, misinformed.  While the senator does not see a difference between Treasuries and other debt instruments, financial markets do.  For one thing Treasuries have zero default risk.  So a trader’s loss on Treasuries will not derive from the discovery that the full principal won’t be repaid.  This means that Treasuries as an asset class will continue to trade even if a trader takes a large loss and, importantly, other traders who own Treasuries can continue to use them as collateral.

During the financial crisis a large part of dealer losses came from bets on over-valued mortgage-backed securities, which collapsed in value as the underlying mortgages defaulted.  Trading in these assets dried up, and important dealers faced a liquidity crisis because they could not use them as collateral for borrowing.   In stark confirmation of the fundamental differences between Treasuries and other debt instruments, the Federal Reserve Board swapped Treasuries for dealer collateral so the dealers could raise funds without having to take big losses and amplify asset price declines.  (This was done via the Fed’s Term Securities Lending Facility.)

Thus, even a very significant loss on a Treasury trade is extremely unlikely to produce the spillover effects similar to those that threatened financial stability during the crisis, unless it is big enough to take a large bank holding company down with it, a truly rare event if it ever occurred.   Big losses on other debt instruments are entirely another matter, as everyone observed in the financial crisis.  The senator, who was on the Banking Committee when the Dodd Frank Act was written and continues on that Committee today, simply must be aware of these facts.

If Senator Corker is genuinely concerned to remove any residual, indeed theoretical, threat posed by trading in Treasury securities, he should advocate a more restrictive version of the Volcker Rule.  If he doesn’t, his criticism of the exemption the in rule should be written off, just as bank traders wrote off all those subprime securities, or discounted very heavily.

One final thought. Treasuries are the equivalent to GE debt? Not



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