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Open letter to Senator Bob Corker: In response to the Senator’s question to Paul Volcker at the Senate Banking Committee hearing:

U.S. Senator Bob Corker
185 Dirksen Senate Office Building
Washington, D.C., 20510

Honorable Senator Corker,

In the Senate Banking Committee hearing on February 2, 2010, you asked if moving capital from one place to another within a financial institution would lead to lower the overall capital requirements for the institution. On not receiving a rebuttal from either the former Federal Reserve Chairman Paul Volcker or the current Treasury Department Deputy Secretary Neal Wolin, you assumed the answer was in the negative. Here is the response you should have received.

Consider the hypothetical situation of Albert and Tony who work for a bank holding company that is allowed to conduct prop trades.

Albert runs the trading operations at the bank holding company and is allowed to build up proprietary exposure as long as the risk limits are not exceeded. Albert manages many trading books that are allowed to have a predetermined set level of exposure towards any specific risk unless more capital is allocated to that book. Let’s see if Albert can somehow increase effective exposure to a source of risk in these books without having to allocate a higher aggregate level of capital to all these books.

Albert has a trader Tony who manages BookI. Albert instructs to buy a tranche of asset backed securities. This particular tranche that Tony buys sits in the lower middle rung of a ladder-type structure called a CDO. It pays a juicy 15% coupon as long as there isn’t a considerably high default rate in pool of US companies rated BB or lower making up the high yield index. But Albert, though no NASA scientist, has more common sense that that.

He instructs Tony to wait for an opportune time to construct in WS parlance, a negative basis trade. So Tony waits and, at a time when the CDS spread on North America corporate bonds shrinks because of say a broad based improvement in market sentiment. At such a time, the effective cost of insuring against a large scale default by US companies marked BB or lower by S&P’s is less than the juicy 15% coupon Albert is picking from the tranche. So Tony acting on Albert’s instructions, buys insurance by taking a long position on the CDX NA High Yield, a type of credit default swap called a ‘basket CDS’ that results in a cash inflow to the insurance buyer if the credit quality of a pool of companies that make up the US high yield index deteriorates.

Albert then instructs the head of the accounting department at his bank holding company to book upfront the profit from the spread (15% coupon from tranche less the cost of buying the basket CDS insurance). The accountants allow this as the tranche seems to be hedged by the basket CDS. Not to mention, Albert as a head of trading is literally in the unspoken hierarchy of the bank holding company, carnivores whereas the accountants as controllers languish much lower as herbivores in the hierarchy.

Albert, then instructs the controllers to allow him to construct NegBav II since NegBav I is ‘effectively hedged.’ The controllers agree that the trade is hedged since a potential loss on the tranche from too many defaults amongst the US high yield companies will trigger an offsetting cash inflow from the long insurance position in the basket CDS. So the controllers allow Albert to instruct Tony to create NegBavII in BookII. And since BookI is hedged with the long position in the basket CDS, the controllers are content to let Albert move 95% of BookI’s risk capital to BookII leaving 5% is BookI as a ‘prudent’ measure.

Thus Albert with Tony’s help is able to construct NegBavII with little or no increase in risk capital.

Over the course of the year, Albert and Tony make 20 such trades – NegBavI in BookI, NegBavII in BookII all the way to NegBavXX in BookXX.

So Senator Corker a mix of an allowance for prop trading, movement of capital and not-too-much smarts will potentially lead to a large exposure being built without the allocation of more risk capital.

You may wonder what happened at the end of the year to Albert and Tony?

  • If Albert worked for Merrill Lynch, the firm blew up.
  • If Tony created the long basket CDS position from AIG, Uncle Sam came to the rescue as AIG failed to honor the basket CDS commitments.

In both cases, Albert and Tony walked away with multimillion dollar bonuses as the firm was not allowed to fail.

Kind regards,

Aly Iman

Disclosure: None