Volcker Rule Unabridged

NEW YORK (MarketWatch) — Not since Lady Gaga was slated to appear at the Grammys has there been this much anticipation about a performance.

With Paul Volcker expected to visit Capitol Hill on Tuesday, Wall Street will get its first detailed glimpse into the former Federal Reserve chairman’s thinking about the Volcker Rule, the controversial reform plan for the financial industry.

To say that the rule, unveiled Jan. 21 by President Obama, is vague is like saying that J.D. Salinger enjoyed a little private time. Though the rule outlines new restrictions on such businesses as proprietary trading, hedge funds and private equity, it’s unclear how the reforms would treat products at the heart of the financial crisis.

Something seems to be missing, but there shouldn’t be. Volcker has been clear about his disdain for many Wall Street practices. He’s spoken candidly about structured securities and other financial innovations, famously saying that the best innovation of the past two decades was the automatic teller machine and that there isn’t a “shred of evidence” that financial innovations have helped the economy. See earlier column on Volcker Rule.

And now, Volcker, chairman of the president’s Economic Recovery Advisory Board, is suddenly in the limelight.

So, in an attempt to clarify and buttress the reform plan, here are some suggestions. Consider them talking points, Mr. Volcker — a fantasy page two, if you will — of the flimsy one-page document that introduced us to the rule that bears your name.

• Start by saying mortgage securities dealing would be curtailed. The primary buying source would become Fannie Mae  and Freddie Mac . . Banks would no longer be able to sell mortgages to be sliced and diced in Wall Street’s factories unless they keep 50% of those loans on the books. The explosion of these securities created the housing bubble; shrinking the market will help bring it back in line with historic pricing.
• Conforming loan standards would be strengthened. For instance, Fannie and Freddie would only buy a single-family loan under $400,000 that has a 20% or more equity stake by the borrower. Subprime loans would be phased out. See current loan limits at Fannie Mae.
• A Consumer Protection Agency must be formed to ensure that junk isn’t being passed on to the government, banks or investors.
• Ratings-agency reform is needed. An investor-paid model would be built to eliminate conflict of interest.
• Banks will not be allowed to short securities that they underwrite. Call it the Goldman Sachs Group Inc.  rider to the rule.
• The credit-default-swap market would be moved to an exchange where prices, bids and offers, are transparent. CDS sellers would be required to carry the same level of reserves as insurance companies. Naked CDS positions would be outlawed. Banks could buy CDS protections for their bond investments, but could not be CDS underwriters.
• Counterparty risk would be nearly eliminated from commercial banks. Prime brokerage units would need to be spun off or shuttered.
• Mark-to-market accounting would be reinstated to pre-April 2009 standards, erasing lingering doubt about balance sheets since accounting rules were relaxed.
• The Federal Reserve would be the main bank regulator in the U.S. market.

It isn’t a stretch to say that Volcker is on board for some of these proposals. Indeed, some of them, including the role of the Fed and the treatment of derivatives, come from statements he made during the six months before the Volcker Rule was unveiled.

As Volcker told CNBC in November, banks should focus on “taking deposits, making loans, moving money around, helping people invest their money, do some underwriting. They’ve got plenty of things to keep them busy.”

Volcker hasn’t chimed in with specifics when it comes to mortgage derivatives, but he clearly feels the market doesn’t need the volume these securities now support. Mortgage securities make up nearly a third of the $30 trillion U.S. bond market, five times the level they did in 1999.

‘Skin in the game’

To achieve bank safety, Volcker could make banks more vigilant about risk by making them eat their own cooking. It’s what Wall Street calls keeping skin in the game.

That means more mortgages on the balance sheet, tougher underwriting standards, less interconnectedness between banks and other financial institutions.

Volcker also needs to convince Washington and Wall Street that he understands risk has a place in the market. Goldman and Morgan Stanley can shed their bank-holding company status. Then, they can trade and pay bonuses to their hearts’ content.

J.P. Morgan Chase & Co. and Citigroup Inc.  have harder decisions to make. They’ll have to shutter, unwind or sell businesses. Shareholders will own both, so they can choose between boring old bank stocks and their brokerage spin-offs, or keep both.

The Volcker Rule won’t be easy or pretty. Everyone from consumers to banks will feel some pain. These suggestions are just a starting point, and they’re certain to fuel a debate. So let it begin.

David Weidner covers Wall Street for MarketWatch.