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President Obama has issued a number of ideas through the first part of his presidency that sounded good but only got whittled down and mutated into awful legislation. For example, the Consumer Financial Protection Agency Act of 2009 ("CFPA") could have done much to improve the safety of the financial system.

Folks that are not held captive by the financial industry such as former IMF Chief Economist Simon Johnson have repeatedly laid out the need for a CFPA law with real teeth. Unfortunately, lawmakers are owned by the financial industry and the aggressive lobbying has resulted in what will likely be a worthless bill. However, on Thursday, President Obama discussed eliminating the ability of banks to engage in proprietary trading ("prop trading") as well as own stakes in private equity and hedge funds. Given that Paul Volcker was likely the main proponent of this idea there may be the possibility that a more aggressive bill gets passed relative to prior initiatives that had to go through Treasury Secretary Tim Geithner and Director of the National Economic Council Larry Summers, both who are generally held captive by Wall Street.

The elimination of prop trading may cause some short-term pain for investors in bank holding companies but it's ultimately very healthy for the long-term health of the financial system. Here are a few reasons why prop trading is currently a problem:

1) Benefits and sustains Too Big To Fail ("TBTF") at taxpayer expense: TBTF institutions can access the Fed window while others cannot. This means a prop trader at a TBTF institution can have lower funding costs off the backs of taxpayers while a private, Non-TBTF institution has to fund its business at the true market rate. Indeed, the Wall Street Journal reported that S&P would rate Citigroup (NYSE:C) at BBB- if not for US backing, which makes it rated four notches higher in terms of credit quality (WSJ November 16 Heard on the Street)!

To use an example, assume you are as skilled a trader as Goldman Sachs (NYSE:GS) and are the same credit risk with the exception that you are not deemed TBTF. You and GS both have $1B in capital you want to invest on a leveraged basis. GS can fund its $1B capital at 1% while it costs you 3%.

As a result, GS can raise $19B at a cost of $190MM for total capital of $20B while you can raise about $6.5B which would lead to roughly the same $190MM in funding costs. Now as you and GS are equally skilled you both generate a 15% return on the total capital deployed (GS deployed $20B, you deployed $7.5B). After paying back the total capital raised and funding costs GS has $3.8B and you have $1.9B. However, GS's return on capital is 281% compared to your 93% and the entire spread, worth nearly $2B, is wholly due to GS's TBTF status being leveraged on its prop trading desk. And that $2B spread will be devoured amongst GS employees in outsized bonuses due to the "talent" of political connections and status.

Now consider what happens if things go wrong. For instance, if we have a systemic crisis and you and GS both lose 50%. In that case GS would lose over $9B while your loss would be nearly $3B. More importantly, you would have been put out of business long before that happened. As a TBTF firm, GS's losses on its prop desk would be spread over the rest of the financial system and taxpayers and the firm, by benefit of TBTF, would live to fight another day despite a monumental loss. So while some opponents may say prop trading had no tie to the prior financial crisis, the fact is we need to fix a number of dysfunctions across the board.

2) Prop trading may have made the financial crisis worse: Many critics of Obama's ban on prop trading say that prop trading didn't cause the crisis. Well in the same sense, derivatives didn't "cause the crisis" but they (and lack of regulation of derivatives) exponentially amplified the fallout.

Prop trading incentivized asymmetrical information by banks that were supposed to be advisers to clients but also principals of their own trading accounts. Without prop trading, banks would be strictly agency players. For example, if a hedge fund wanted to buy protection through a CDS on some mortgage backed securities, a bank acting as an agent would write the CDS for the fund and then find a counterparty for what they wrote and serve only as the middle man.

The bank could also assume the risk by holding the CDS and then hedge it by buying their own protection of an equal amount. However, in the case of banks with prop trading, banks could take information that a hedge fund is buying up CDSs and then double or triple down with its own prop desk. Even worse, banks should treat their clients as legitimate clients that banks treat with respect but it could very well be the case that a bank could be raising capital and advising a corporate client, say like General Motors ("GM") pre-bankruptcy, while its prop desk was buying protection (CDS) hand over fist in the hopes that GM would fail.

This is another transfer of wealth from taxpayer to big banks but because it's less direct, it gets less attention. The taxpayer funds the bankruptcy of GM while the banks with prop desks that bet against GM line their coffers. Dealbook even reported that GS acknowledged these conflicts of interest.

3) Prop trading and private equity increase bank risk: There is no reason for banks to have private equity (LBO) firms within the banks. This is a massive conflict of interest and increases bank risk. LBO firms borrow money to purchase companies and a bank-owned LBO firm, with a direct relationship to its parent bank can possibly get more leverage to buy a target. So the parent would lend more than it normally should to a bank-owned LBO firm which wins an auction for a company. The financing of LBOs are done with high yield paper so perhaps the bank extends too much debt to its LBO subsidiary to buy a company.

Now in the case of buyer's remorse, perhaps the deal is a bust as GMAC was for Cerberus. In the case of a bank-owned LBO firm, the bank takes a big hit to its balance sheet if the assets (the leveraged loans) perform poorly. This is always a risk for leveraged finance departments in banks but the point is that those groups take enough risk underwriting third party deals, there is no need to have a merchant bank/LBO shop within a bank to further increase risk, particularly because the key point really is the taxpayer subsidy and socialization of losses and privatization of any profits.

Critics of this plan will say that it will cause a talent drain and will cause banks to migrate to other countries. This is laughable because it first implies that there's actually "talent" on Wall Street. Asymmetrical information is not talent. Political connections are not talent. Taxpayer subsidies that reduce funding costs to virtually zero are not talent. Secondly, there is direct evidence that Wall Street has plenty of seemingly "talented" folks that can step in and take over when others leave. Just look at GS. Robert Rubin, John Thain, John Corzine, Stephen Friedman, Robert Zoellick, Henry Paulson, Duncan Niederauer, Eddie Lampert, Dinakar Singh, Eric Mindich, and JC Flowers are just a number of former GS stars that left the firm and GS plodded along just fine.

Critics will also point out that prop trading is <10% of sales. This obfuscates the main question which is what percentage of profits is attributed to prop trading. It could very well be much higher than 10% of profits and it's not unusual for a small revenue contributor to have an outsized profit contribution.

Critics will point out that liquidity will disappear. This is an even more damning statement if that's the case because it would imply that much of the liquidity is caused by prop traders flipping paper between one another, using taxpayer subsidies to earn high rates of return, but ultimately providing no benefit to society despite enjoying broad safety nets due to taxpayer backing. However, before getting too excited about leveling the playing field for non TBTF firms and the TBTF banks, we need to wait to see if real legislation can be passed that does what is intended rather than be twisted into a worthless law by the financial lobby.

DISCLOSURE: NONE

Source: An Obama Plan that Just May Make Sense