The Volcker Rule Will Come Too Late For Kaufman Bros.

If you're a more or less regular consumer of efficient markets hypothesis Kool-Aid then a fun activity is to handicap the probability of various public policy things based on market reaction.* So for instance Obama's budget is going to reduce the tax deductibility of munis! And the muni market didn't care! So, no, Obama is not going to reduce the tax deductibility of munis. You heard it here first, or last, or whatever. (Exercise for the reader: is Obama going to raise the tax rate on dividends?) Since today seems to be Volcker Day hangover it's worth pondering this:
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If you're a more or less regular consumer of efficient markets hypothesis Kool-Aid then a fun activity is to handicap the probability of various public policy things based on market reaction.* So for instance Obama's budget is going to reduce the tax deductibility of munis! And the muni market didn't care! So, no, Obama is not going to reduce the tax deductibility of munis. You heard it here first, or last, or whatever. (Exercise for the reader: is Obama going to raise the tax rate on dividends?)

Since today seems to be Volcker Day hangover it's worth pondering this:

Stand-alone U.S. brokerages hurt by 2011’s trading slump may struggle to raise capital or obtain adequate loans unless markets improve, adding to closures that imperiled more than 200 Wall Street jobs last month.

WJB Capital Group Inc. and Ticonderoga Securities LLC told employees in January that they would shut amid a shortage of capital, people familiar with their plans said at the time. Kaufman Bros. LP, the minority-owned investment bank that helped unwind U.S. stakes in bailed-out financial companies, ceased business Jan. 30. The New York-based firms each employed about 100 people or fewer.

Some firms’ capital weakened as equity trading stalled last year amid a downgrade of U.S. debt and concern Europe’s debt crisis could deepen. Investors are weary [sic, ugh, "wary"] of the long-term security of some smaller, single-business firms, said Paul Reilly, chief executive officer of Raymond James Financial Inc.

“A lot of firms aren’t big enough to have sustained earnings where they can go to the debt markets,” Reilly said Feb. 1 in an interview at Bloomberg’s headquarters in New York. “You’re investment grade or you’re not. That means you have access or you don’t.”

If you really believe that
(1) the Volcker Rule as written will substantially disadvantage existing US commercial banks from providing market-making services, and
(2) the Volcker Rule will be implemented as written,
then you should probably be buying lots and lots of stock in Ticonderoga Securities or whatever, because their franchises will be very valuable once JPMorgan has to get out of market making. The fact that these guys can't raise capital implies that you're not. Why not?

One move of the pro-Volcker-Rule camp has been to say "we love market making, we're all for it, we just don't want it to happen in government backstopped banks." Occupy the SEC (an Occupy Wall Street working group) says as much in its own comment letter**:

Market making is an indispensable component of liquid, efficient markets. This service, however, simply does not belong in banks. One of the most challenging aspects of our attempt to digest and comment on this Proposed Rule has been navigating the presupposition that banks have some inherent role in proper market making. We are familiar with the extensive lobbying efforts by the banking industry to present this idea as a fact, but we propose that the Agencies seriously reconsider this premise for both the safety and soundness of the industry and the simplicity of this Rule. ... The bank lobbying effort is certainly understandable: market making is a profitable business and one that banking entities certainly do not want to lose. It is well-known that the major dealers have always fiercely guarded their dominance of market making, particularly in the less regulated OTC markets. Despite the banks' desire to continue reaping such profits, their contention - that banking entities alone are able and willing to provide this valuable service to the market, and that regulation will cause irreparable damage to the financial system at large - is unfounded and nonsensical.

Volcker himself used a similar move yesterday, saying essentially "back in my day banks were banks and market-makers were non-bank broker-dealers." Well fine good for you Paul, tell us more about the 1950s.*** Here in my day all the broker-dealers have become banks, either by merger in the 9 years or so after the repeal of Glass-Steagall or by quickie bank holding company conversion on that one day in September '08. If you think that's a bad thing, well, go ahead and think that's a bad thing. You're probably right.

But that doesn't get you much. The world is pretty path dependent and what we have now is a huge concentration of financial product market-making in a bunch of big banks. If you want to reverse that you need to consider:
(1) the fact that Congress seemed to want otherwise (by specifically exempting market making from the Volcker Rule) and
(2) the fact that your plan to have WJB Capital and Ticonderoga Securities step in to fill the gap left by JPMorgan just ran into a bit of a snag.

Maybe that wasn't your plan. Maybe, for instance, your plan was for Goldman and Morgan Stanley to quit being banks, and for JPMorgan/BAC/Citi to spin out Bear/Merrill/Salomon. There's been speculation that Goldman Sachs and Morgan Stanley would un-bank-holding-company-ify themselves to avoid complying with the Volcker Rule. There's been even more speculation, though, that they wouldn't be allowed to do so, either because they're systemically important even without an FDIC guarantee or just because nobody trusts them and we gotta keep an eye on them. (Quick quiz: Was Goldman Sachs systemically important in 1998, before the repeal of Glass-Steagall? Show your work.)

More generally read that Bloomberg article, and the quote above from the Raymond James dude, who probably has some incentive to talk up independent broker-dealers. Think about the relative attractiveness, to debt and equity investors, of pure broker-dealers that make their livings on trading prowess versus broker-dealers contained within banks that make their livings on NIM. Spend some extra time thinking about pure broker-dealers that don't come with built-in M&A advisory or capital markets underwriting businesses, since a bank spinning out its broker-dealer might want to keep those non-Volcker-impacted businesses for their non-capital-intensive fee streams and synergies with bank lending.

If you think too long about those things you'll end up thinking about - well, about the wee standalone broker-dealers that are shutting down in an environment where they can't compete with the big banks. "Ah, fine," you say, "but when Volcker is implemented they will be able to compete, because they'll be making aggressive markets while Jamie Dimon is wasting time squeezing his employees' testicles." Sure, maybe. I've thought that too. I still sort of do. It's just that the market doesn't - or else those competitor brokers would be able to stay alive in anticipation of their Volcker-driven triumph.

Brokerage Firms Closing Shop Amid Trading Slump, Capital Squeeze [Bloomberg]

* If you enjoy this pastime you might be somewhat more supportive than the general public of Congressional insider trading.

** Felix Salmon correctly endorses this letter as a brilliant piece of work. Check out (pp. 16-17 of their "Annexure A") their slightly off-base but thought-provoking and appropriately cynical list of how most prop trading businesses could be replicated as "repo" trades to avoid the Volcker Rule. If the whole marching-and-chanting-and-living-in-tents thing doesn't work out for Occupy the SEC, I predict a bright future for them as derivatives structurers.

*** Did you know that Paul Volcker started working at the Fedsixty years ago?

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