NEW YORK ( TheStreet) -- Citigroup's ( C) primary federal banking regulator sounds an awful lot like a bank executive in explaining a cause of massive losses in the financial crisis. Comptroller of the Currency John Dugan, a former banking lobbyist who began his current role in 2005, echoed many banking industry executives in dismissing proprietary trading, or the practice of banks trading their own money, for fueling excessive risk taking that led to big losses during the crisis. The Obama administration's so-called "Volcker Rule" proposes banning proprietary trading from large national banks, one of the ideas being considered as Congress mulls reform of the financial industry on the heels of the health care bill's passage. The argument Dugan, Goldman Sachs ( GS) CFO David Viniar and others who oppose the proposed proprietary trading ban make comes down to the definition of proprietary trading. They argue that the majority of trading losses are not proprietary trading at all, but are actually trading on behalf of clients. Thus, banning the practice doesn't address the problems that led to the crisis.
"If you define proprietary trading in a way that gets at customer accounts you can go to the core of what money center banks do and that's something that really has to be looked at carefully," Dugan told CNBC last week . In the fourth quarter of 2007, Citigroup posted negative revenues of $16.9 billion in its Fixed Income Markets division, according to its quarterly earnings release. In a footnote, Citigroup stated "lower revenues due to writedowns on non sub-prime securitized products and in fixed income proprietary trading." In an article I wrote in January, that quarterly loss by Citigroup stood out as the most glaring example of several I found showing that proprietary trading losses by Citigroup, Morgan Stanley ( MS) and other big banks were not as minor as opponents of the proposed proprietary trading ban said they were. It is very hard, if not impossible, to know what goes on at giant banks from reading their financial statements, but here they were admitting that proprietary trading was an important factor in several big losses. Now that markets have rebounded, however, and the idea of banning proprietary trading is on the table, some might be forgiven for thinking the banks and their regulator want to rewrite history. If it wasn't proprietary trading that caused the losses, why did Citigroup say it was?
|John Dugan, comptroller of the currency.|
A Citigroup spokesman declined to comment for this article. OCC spokesman Kevin Mukri said in an email that the OCC publishes a quarterly report on banks' derivatives activities in which "we frequently remind readers that line items on financial statements require consolidation of information, and due to various accounting and regulatory reporting rules, the trading revenue numbers in particular can include data from a wide range of business activities -- regardless of what the line item might be labeled." So even though Citigroup said proprietary trading was a factor in that $16.9 billion loss, it wasn't the main issue, Mukri writes. Instead, it was the other part, the "writedowns on non subprime securitized products," that accounted for the bulk of the losses in that quarter and others during the crisis, according to Mukri. These "non subprime securitized products," according to Mukri, "were structured for customers who wished to assume the exposure of subprime mortgage assets and a number of banks held on to the super senior pieces because they were believed to be of low risk." So Citigroup created billions of dollars worth of mortgage securities, sold off the parts considered to be the riskiest, and held on to the parts it thought were the safest. These are the "customer-driven activities," Mukri refers to that caused most of the losses at Citigroup. These risks should not be thought of as proprietary trading, according to Dugan, and characterizing them as such "gets at customer accounts," and goes to "the core of what money center banks do." Really? "The core of what money center banks do," is creating highly complex securities they don't understand, selling off the parts they think are risky and holding the parts they think are safe? Citigroup doesn't appear to have been very good at this. I thought banks lent money to people who wanted to buy homes or start businesses. You could say that's what they were doing here, but the distance between the original borrowers and the ultimate lenders became so great that the risk was not fully understood by banks like Citigroup or their regulators.
Citigroup was taking on a lot of risk. Too much risk. What does Dugan propose doing to prevent it from happening again? "The super senior risk issue is being addressed by the supervisory community's adoption of better tools for stress testing and regulatory capital requirements that better reflect the risks associated with structured transactions," Mukri wrote in his email to me. The key word here is "better." If the "tools for stress testing" really are better and the regulatory capital requirements really are better, we will be in good shape. Banks looking to load up on risk and juice their returns will no longer be able to do so by holding complex mortgage securities. But, if Dugan and the big banks get their way, they will be able to do more proprietary trading. Apparently it didn't cause the last crisis, so it couldn't possibly cause the next one...right? -- Written by Dan Freed in New York.