Water Down the Volcker Rule at Markets’ Peril

The Wall Street Journal reports that the federal financial regulators may yet again carve a  loophole in the Volcker Rule. This time, the issue is whether banks subject to the rule’s proprietary trading prohibitions can hold collateralized loan obligations (CLOs)—structured products engineered out of commercial loans, just like good old collateralized debt obligations were engineered out of residential mortgage-backed securities during the last boom.

The reason to prohibit positions in CLOs obvious: it was portfolios of similarly complex, opaque, risky, and illiquid securities that torpedoed Bear Stearns, Lehman, Citigroup, and other megabanks during the financial crisis. The counterargument is one we’ve heard many times before: If banks are forced to sell their CLOs, they will have to do so at a discount, which will “have a material negative impact to our capital base,” in the words of one banker.

 

But think about it for a second. Why would selling CLO tranches reduce a bank’s capital? Capital is defined as assets minus liabilities; if you sell a CLO and get its value in cash, you have just exchanged one asset for another, and your capital is unchanged. The dirty not-so-secret is that the banks are afraid of having to sell their CLOs for less than the values at which they are carrying them on their balance sheets, which will reduce their capital (and, more importantly to their executives, their current-year accounting profits).

But this is one of the things that everyone should have learned back in 2008. If you sell something for less than its stated book value, it’s not the sale that’s making you economically worse off; it’s the fact that the thing is already worth less than you paid for it. If a bank is carrying a CLO at 100 cents on the dollar, and no hedge fund out there is willing to pay more than 90 cents, then it’s only worth 90 cents. The bank’s capital is already impaired; it’s just lying about itusing accounting rules to avoid admitting it. If forcing banks to sell their CLOs is the only way to get them to recognize their actual value, then that’s a feature, not a bug.

Then the other argument is, you guessed it: prohibiting banks from holding CLOs tranches will reduce demand for the underlying loans, making it harder for companies to get credit. But again, that’s a good thing. Right now, banks are willing to overpay for CLOs (or, rather, they are unwilling to sell them for their actual market value, which amounts to the same thing in economic terms) because of accounting reasons. That means that we have too much demand for CLOs, which means we have too much credit. As we again should have learned in 2008, too much credit can be just as bad as—or sometimes much, much worse than—too little credit. It’s a distortion, and as any free market economist should tell you, getting rid of it is a good thing.

If CLO issuance is down, you can blame it, as Morgan Stanley does, on “regulatory uncertainty.” But what it really means is that the investors who only care about making money—such as hedge funds—don’t want to fund these loans, at least not at the terms on offer. That means that the economy will be better off if the loans do not happen. This is all the way things are supposed to be—except in that twisted fantasyland of bank lobbyists.

This piece is cross-posted from The Baseline Scenario with permission.