Felix Salmon

When JP Morgan’s London Whale blew up, one part of the collateral damage was the publication of a detailed Volcker Rule. The Whale was gambling JP Morgan’s money, and wasn’t doing so on behalf of clients — yet somehow his actions were Volcker-compliant. And when the blow-up revealed the absurdity of that particular loophole, the rule went back to the SEC for further refinement.

So we still don’t know exactly what will and what won’t be allowed under Volcker, if and when it ever comes into force. We do know, however, that Citigroup is selling off its internal hedge fund, Citi Capital Advisors. If by “selling off” you mean “giving away“: it’s spinning the fund out as an independent entity, to be owned 75% by its current employees. Citi will retain a Volcker-compliant 25% stake, and slowly reduce the $2.5 billion of its own money it has invested in the entity so that the managers can “diversify the client base away from Citi and to build a stand-alone firm”.

It’s incredibly difficult to value a hedge fund, especially a relatively small one without a long track record. The high-water point for such transactions was probably Citi’s acquisition of Vikram Pandit’s fund, Old Lane, in 2007. Old Lane managed $4.5 billion, and was sold for $800 million, but even then the markets appreciated that the buy was more of an “acqui-hire” of Pandit than a fair price for a young and volatile business.

A few years later, Citi was on the ropes and selling rather than buying; that’s when it unloaded its fund-of-funds, Citi Alternative Investments, to Skybridge Capital. Skybridge paid almost nothing up-front for the business, but agreed to remit a large chunk of the group’s management fees back to Citi for the first three years.

Bloomberg managed to find one consultant who valued Citi Capital Advisors, which manages about $3.4 billion, at $100 million. I, for one, wouldn’t buy in at that valuation: less than $1 billion of the assets under management constitute real money, as opposed to simply being a place where Citi parks a small chunk of its balance sheet. And as the Citi funds diminish, the chances of Citi Capital Advisors becoming a profitable standalone entity have to be pretty slim.

Which brings me to Multi-Strategy Investing, a small group of a dozen people within Goldman Sachs, who between them manage about $1 billion. As Max Abelson shows, MSI is unabashedly an internal hedge fund, concentrating on medium-term trades lasting a few months. (The idea is that if positions are held for longer than 60 days, that makes them Volcker-compliant.)

Abelson finds a lot of illustrious alumni of the MSI group; maybe the bank is keeping it on just for nostalgia’s sake. Because I can’t for the life of me see the point of it. Goldman Sachs has a trillion-dollar balance sheet; the $1 billion it has invested in MSI is basically a rounding error. And by the time you’ve shelled out annual bonuses to a dozen high-flying Goldman Sachs professionals, the contribution of MSI to Goldman’s annual profits has to be downright minuscule. (Let’s say the group generates alpha of 5%, or $50 million per year: that doesn’t go very far, split 12 ways at Goldman Sachs.)

Clearly, with a mere $1 billion under management, MSI doesn’t present Goldman with much in the way of tail risk. But by the same token, this really doesn’t seem like a particularly attractive business for Goldman to be in. As Abelson says, Goldman’s own CEO is adamant that the bank doesn’t make money trading for its own account: everything it does has to be for clients. Under that principle, MSI shouldn’t exist. And the profits from the group simply can’t be big enough to make it worth the regulatory and reputational bother.

Goldman should take a leaf out of Citi’s book, here, and spin MSI off as a standalone operation, if necessary retaining a 25% stake. If its principals can make a go of it, attracting real money from outside investors, great. If they can’t, no harm done. Alternatively, Goldman could just shut down MSI entirely, and put its valuable employees to work helping the bank’s clients, and making money that way. Either way, there doesn’t seem to be any point to keeping this small fund going as is.

The theme of the day, today, is nostalgia for the simple banking systems of yore, where the Bailey Building & Loan was run by simple, honorable men who had no problems complying with Basel I or its predecessors. If you have a large chunk of time today, you can start with the 9,500-word cover story in the Atlantic by Jesse Eisinger and Frank Partnoy, and then for dessert follow it up with Yalman Onaran’s 2,600-word explanation, for Bloomberg, that bank regulation these days is really complicated.

These are genuine problems. Once you’ve read the Atlantic article, which takes a deep dive into Wells Fargo’s 10-K and comes out convinced that it’s impossible to really know anything about the risks and assets in any big bank, you’ll understand why that’s a huge systemic problem:

As trust diminishes, the likelihood of another crisis grows larger. The next big storm might blow the weakened house down. Elite investors—those who move markets and control the flow of money—will flee, out of worry that the roof will collapse. The less they trust the banks, the faster and more decisively they will beat that path—disinvesting, freezing bank credit, and weakening the structure even more. In this way, fear becomes reality, and troubles that might once have been weathered become existential.

This paragraph is the heart and soul of the piece. (You’ve gotta love any article where the nut graf comes more than 2,000 words in.) We can’t trust the banks; but unless we can trust the banks, another major financial crisis is inevitable, since banks are built on trust, and without trust they are nothing.

This dynamic was central to what went wrong during the financial crisis, and a large part of the problem was the global system of bank regulation known as Basel II, which basically allowed the world’s biggest banks to simply make their own determination of what their risks were and how much capital it made sense to carry against those risks. Obviously, that didn’t work out very well. So, what can be done about this problem?

The answer of the global regulatory regime was something called Basel III. It was pushed through in something of a rush, and so it built on Basel II as a base: my metaphor is that it’s a bit like the way Windows was built on DOS. As a result, although it’s a clear improvement over Basel II, it is necessarily at least as complex as Basel II. And when complexity itself is part of the problem, extra layers of regulation are unlikely to constitute much of a solution.

That’s Onaran’s point, but I think he pushes it a bit too far. His headline is “Basel Becomes Babel as Conflicting Rules Undermine Safety”, and he talks at the very top about how “conflicting laws, divergent accounting standards and clashing rules” have “created new risks” in the banking system. But the shoe never drops: he doesn’t actually explain what these new risks are, or how Basel III undermines the safety of the baking system.

Partly, it’s a baseline game. Both the Atlantic and Bloomberg are essentially comparing Basel III to Basel I, and saying that everything is still far too complicated. By contrast, if you compare Basel III to Basel II, it’s a clear improvement. Onaran’s article is full of quotes from people saying that we should go back to a much simpler system. And the Atlantic actually lays out what such a system might look like:

Congress and regulators could have written a simple rule: “Banks are not permitted to engage in proprietary trading.” Period. Then, regulators, prosecutors, and the courts could have set about defining what proprietary trading meant. They could have established reasonable and limited exceptions in individual cases. Meanwhile, bankers considering engaging in practices that might be labeled proprietary trading would have been forced to consider the law in the sense Oliver Wendell Holmes Jr. advocated.

Legislators could adopt similarly broad disclosure rules, as Congress originally did in the Securities Exchange Act of 1934. The idea would be to require banks to disclose all material facts, without specifying how. Bankers would know that whatever they chose to put in their annual reports might be assessed at some future date by a judge who would ask one simple question: Was the report complete, clear, and accurate?

This is basically principles-based regulation, as opposed to rules-based regulation. Rather than forcing banks to comply with thousands of pages of abstruse regulation, keep things simple and deliberately vague: that’ll keep them on their toes, goes the argument, and force them to err on the side of caution.

If there were a real chance of doing this, I’d be all in favor. Principles-based regulation doesn’t always work: just look at what happened to the City of London. Banks ran rampant, committed massive Libor fraud, and required enormous bailouts; London is also, not coincidentally, the home of JP Morgan’s Chief Investment Office. Eisinger and Partnoy rightly use banks’ price-to-book ratio as an indicator of the degree to which anybody in the market understands or trusts what they’re doing; what they don’t say is that it’s hard to find a lower price-to-book ratio than Royal Bank of Scotland, which was regulated in the UK rather than the US, and which is owned not by out-of-control risk-loving capitalists, but rather by the much safer and much more risk-averse UK government.

And what neither article really admits is that regulators are painfully aware of all the problems they lay out — and many more. That’s why the UK government spent so much effort trying to lure Mark Carney over from Canada to run the Bank of England: he was one of the few regulators who managed to ensure that his national banking system didn’t implode during the crisis, or require any kind of bailout.

But the fact is that all regulation is, by its nature, path-dependent. In 1932 it was easy to install a simple system of bank regulation, because there was no existing system of bank regulation to replace or build on. Since then, as Eisinger and Partnoy write, “accounting rules have proliferated as banks, and the assets and liabilities they contain, have become more complex. Yet the rules have not kept pace with changes in the financial system.” That’s just the nature of things: complexity breeds further complexity, and with it much higher levels of endemic systemic risk.

The genius of Canada, and other countries with safe banking systems like India, is that they never allowed their banks to become highly complex in the first place. There are financial capitals like London, New York, and Frankfurt; those countries will have lots of capital flows and complexity and systemic danger. And then there are second-tier places like Toronto and Delhi, where financing can be much simpler. The problem is that you can’t turn New York into Toronto, or London into Delhi. Nor would any of the politicians in the US or the UK particularly want to do so: they get too much precious tax revenue from being global financial centers.

And it’s equally hard to take a multi-layered rules-based system, complete with a large and powerful and entrenched regulatory infrastructure, and tear it down to build something smaller and simpler. Accounting rules proliferated even during the era of deregulatory zeal in the 1990s; accounting rules will always proliferate, and it’s pretty much impossible to find an example of a regulatory system which has ever managed to go in the other direction, losing complexity, gaining constructive ambiguity, and reducing systemic risk in the process.

So while Eisinger and Partnoy and Onaran are absolutely right when it comes to diagnosing the problem, I think they’re either naive or way too optimistic when it comes to suggesting that all we need to do in terms of a solution is press some magic button and find ourselves with the banking system of the 1950s. We can’t — which is exactly why complexity and systemic risk are here to stay.

Basel III isn’t perfect, but it’s as good as we’re going to get, and is actually significantly better than most people dared hope when it first started being negotiated. And the technocrats who put Basel III together are not some group of knaves, deluding themselves that they’ve magically fixed all the problems with the banking system. They’re smart and well-intentioned regulators, who know full well what the problems are, and who are implementing the best set of patches and solutions that can be implemented in reality. Or if not the very best, then something damn close. They too would love to tear everything up and start from scratch with a much simpler system featuring much smaller banks. But, unfortunately, they can’t.

Journalists are up in arms about the latest fine to hit Citigroup. In general, journalists tend to like it when banks get bashed for violating rules, but in this case the bashing hits home: Citi was fined $2 million, and two analysts were fired, because those analysts talked to the press — actually, emailed reporters — and got caught doing so. And reporters, of course, hate anything which makes it harder for them to talk to sources.

But there is something admirable about this fine: it’s a very rare case of Citi being dinged for violating its promises.

Reading the official consent order, it becomes clear that Massachusetts, here, is doing something which ought to be done far more often. Whenever a bank enters into a settlement, it makes an empty promise to behave itself in future. And with this case we finally see a regulator taking Citi to task for breaking one of those promises.

The actual violations, here, are pretty minor: they involve analysts talking to the press via Citi’s corporate email system. Oops. In doing so, those analysts were violating internal Citi disclosure policies — and Citi, in a 2003 consent agreement, had promised to get serious when it came to those policies. So Massachusetts found itself in possession of a rare smoking gun, and took full advantage of it. Other banks should be worried too: the state says that it’s investigating “all of them, Morgan Stanley, Goldman Sachs, JPMorgan” on similar grounds.

This is not, then, an attack on analysts talking to journalists: it’s an attack on banks breaking their promises, and not really caring what they agree to do in legal settlements.

But the settlement does make it very clear how silly SEC disclosure rules are. As I said in May, sell-side research isn’t inside information, even as settlements like this make it seem like it ought to be treated as incredibly confidential.

When analysts talk to journalists — especially very plugged-in journalists at places like TechCrunch — it’s basically a way for both sides to bounce ideas off each other. There’s nothing nefarious going on. But the SEC doesn’t like the idea of sell-side analysts bouncing ideas off people, especially if those ideas involve things like forecasts or upgrades or downgrades. The regulatory architecture here is based on the fiction that analysts come up with all of their ideas in a vacuum, and then write those ideas down in the form of a research note. Only once the research note is public can the analysts talk about its contents to anybody else — and even then they can only really parrot what’s in the note.

The real world, of course, doesn’t work like that. Wall Street ideas, like all other ideas, thrive on conversations and iterations between a large group of people: investor-relations types, analysts, investors, journalists, bloggers, you name it. I would love to see a world where such conversations took place largely in the open, rather than a world where the sell-side is constantly being harried by compliance people, and being told they can’t talk to anybody.

On the other hand, if a bank makes a series of promises in a series of settlements, it behooves regulators to get serious about holding the bank to those promises. Banks make far too many promises they don’t intend to keep. So even while today’s fine is likely to have a chilling effect on information flow in the markets, the silver lining here is that it might also provide an incentive for banks to take their promises seriously.

Is simplicity the new new thing? The front page of the new issue of Global Risk Regulator — the trade mag for central bankers around the world — features an excellent article by David Keefe about Sheila Bair, Andrew Haldane, and calls for a “return to simplicity”. Bair tells Keefe that “we’re drowning in complexity”:

“The public is tired of rules they don’t understand,” she said, adding: “We should be simplifying the rules, we should be simplifying the institutions for which the rules are made, but it’s going in the opposite direction.” …

Bair said she was in “wholehearted agreement” with Haldane’s attack on the complexity of regulation.

“Regulation”, in this context, means one very specific thing: Basel III, the new code governing the world’s banks. No one is advocating that it be abolished: it’s clearly much more robust than its predecessor, Basel II.

But if Basel II was horribly complicated, Basel III is much more complex still — and, as I and others have been saying for the past couple of years, that’s a real problem. Ken Rogoff puts it well:

As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.

More recently, bankers themselves have started saying the same thing: yesterday, for instance, Sallie Krawcheck said that the complexity of financial institutions “makes you weep blood out of your eyes”.

So perhaps there’s a consensus emerging that regulation needs to be simplified, trusting heuristics more while spending less time and effort complying with thousands of pages of highly-detailed rules. What matters is not whether financial institutions dot every i and cross every t, so much as whether they are behaving in a safe and sensible manner. After all, one of the main reasons that we haven’t seen any high-profile criminal convictions of bankers for their roles in the financial crisis is just that their compliance officers were generally very good at staying within the letter of the law. Which didn’t really help the system as a whole one bit.

But there are lots of very good reasons why even if we are reaching a consensus on this, that doesn’t mean there’s much if any chance of some new simple system ever actually coming into place.

For one thing, the window of opportunity has closed. In the immediate wake of the financial crisis, regulators found agreement that they should get tough: that had never happened before, and it’s likely that it will never happen again. Even in the Basel III negotiation process, national regulators tended to push hardest for regulations which would be felt the most by banks in other countries, rather than their own. But at least everybody was in the vague vicinity of the same page. Without another major crisis, no one feels any real urgency to implement yet another round of major regulatory change, especially before Basel III has even been implemented. And without that sense of urgency, nothing is going to happen.

And more generally, there’s a ratchet system at play here. It’s easy to make a simple system complex; it’s pretty much impossible to make a complex system simple. All of us live in a world of contracts and lawyers — and the financial system much more than most. Financial regulation will become simpler the day that contracts become shorter and easier to understand, which is to say, never.

How has the financial-services sector managed to make an ever-greater proportion of total profits over time? By extracting rents from complexity. As a result, any attempt to radically simplify anything in the sector is going to run straight into unified and vehement opposition from pretty much every bank and financial-services company in the world. (Note that Sallie Krawcheck, like Sandy Weill, only started criticizing bank complexity after she left the industry.)

So while banks opposed Basel III, at least they got increased complexity out of it, which means that the barriers to entry in the industry were raised. Which is good for them, and bad for the rest of us. Why did Simple, for instance, take so long to launch? Because it’s very, very difficult to create anything simple in today’s banking system. Complexity is here to stay, whether the likes of Bair and Haldane and Krawcheck like it or not. And with complexity comes hidden risks. Which means we’ll never be as safe as any of these people would like.

Jesse Eisinger, today, joins Matt Levine in worrying about the effects of allowing hedge funds to advertise. The all-but-certain consequence is that while the handful of excellent hedge funds will remain highly secretive, a bunch of much less savory characters will start hitting the airwaves with gusto. As Jesse says, “Jacoby & Meyers advertises on television; Sullivan & Cromwell does not.”

You get no prizes for guessing who counts as the Jacoby & Meyers of the hedge-fund world:

“I am hellbent on creating a global brand and the only way to do that is through advertising,” said Anthony Scaramucci of fund of hedge funds SkyBridge Capital, which manages $3 billion in assets and hosts a star-studded industry conference in Las Vegas.

Earlier this year, Mr. Scaramucci had lunch with a midsize New York ad firm he says he could hire if the ban is lifted, adding he was waiting to learn what rules the SEC would issue and for his lawyers to approve any plans he might hatch.

The big problem here is that we seem to be going from one extreme to the other: while the restrictions on what hedge funds can say in public have historically been too strict, they’re now going to be far too loose. As Levine notes, hedge funds will be able to basically say anything they like about their funds, while omitting anything they want to omit at the same time.

It’s very hard to see how any good can come of this. Picking a hedge fund (or, in Scaramucci’s case, a fund-of-funds) is hard — much harder, actually, than picking a mutual fund, and that’s difficult enough. It’s almost impossible that advertising from individual funds will be helpful rather than unhelpful in this respect.

That said, the SEC is dragging its feet here — the new rules were meant to be in place in June — and it’s really not the main culprit: Congress has mandated that these changes be made, and the SEC can’t just ignore one of the few bills to pass with genuine bipartisan support.

It could, however, put in place a series of hoops that any hedge fund would have to jump through before being allowed to advertise. It could require that all ads be run by the SEC first, for instance, and it might also restrict the kind of places that hedge funds can advertise. It could even, if it wanted, force all advertisements to be in print form, with lengthy disclosures a bit like the ones you see in pharmaceutical ads.

But the SEC didn’t do any of that: it’s basically washing its hands of the whole issue, and saying that if Congress wants hedge-fund ads, then Congress is going to get hedge-fund ads. It’s quite a passive-aggressive stance, actually.

As Eisinger says, “the best-case scenario from the agency’s move is a bunch of Paulsons”, with investors buying in at the top and selling at the bottom, “while the worst-case is a bunch of Madoffs.”

That said, I can see one upside. Once the new rule is passed, a lot of hedge fund managers are going to be much happier starting their own blogs and Twitter accounts. They’ve been muffled until now: while reporters have always been able to call them up and have off-the-record phone calls, hedgies have found it much more difficult to get their compliance officers to sign off on public communication. If that kind of thing is now allowed without constraint, we could see an influx of very smart people into the Twittersphere. A blogger can hope, anyway.

The NYT has two excellent articles about the Standard Chartered affair today. Read this one first, about the law which may or may not have been broken; and then move on to this one, about the reaction to the case in London.

Up until 2008, the US law governing banking transactions with Iran fell short, shall we say, from what you might expect from a perfect model piece of legislation. Banks in New York couldn’t do such business — unless the money just came in to the US and then immediately left again — but even then there were lots of rules surrounding disclosures and the like which tended to slow such business down. The big argument in this case is not whether the transactions took place, but rather whether Standard Chartered illegally circumvented the disclosure rules, by stripping lots of information from the transactions before they reached New York.

In other words, this whole thing is a fight over the size of a loophole. Standard Chartered defends its actions on the grounds, in the NYT’s words, that they “fell squarely within that loophole” — while Benjamin Lawsky sees the loophole as being much smaller, and the StanChart transactions as falling outside it.

Viewed from across the pond, all of this seems a little bit silly. London has always been a more freewheeling and international banking center than New York; moving money around the world is what London banks do. And so the English are seeing a war on London here:

John Mann, perhaps the most strident critic of Britain’s banking culture in Parliament, said in an interview on Wednesday that the Standard Chartered allegations reflected an anti-Britain bias by American regulators, who he said were trying to bolster Wall Street at the expense of the City of London.

This is silly; I’m quite sure that Lawksy doesn’t have some kind of hidden agenda to boost the fortunes of Goldman Sachs or BofA. But the US rules are definitely written in a world where the US can and will advance its own geopolitical agenda by imposing regulations on domestic institutions, as well as foreign institutions with a US presence. And since it’s impossible to be an international bank without having a US presence, the US geopolitical agenda ends up being imposed on every major bank in the world.

The London view of things is different: it sees itself more a global financial center, rather than a UK city, and historically has tried to be as welcoming as it can be to foreign institutions and capital flows. Hence the now-famous quote from an English StanChart executive, complaining about where the “fucking Americans” get off telling the rest of world what they can and can’t do when it comes to Iran.

What’s more, while London regulation is principles-based, US regulations are rules-based — which means that if Standard Chartered could find a way of moving money around the world while remaining within the four corners of the law, it would happily do so. There’s very little doubt that StanChart’s actions violated the spirit of the law; Lawsky’s assertion is that they violated the letter of the law, as well. But that remains to be seen. In London, and in general, StanChart would generally avoid taking refuge in loopholes like this. But New York is different, and in New York, StanChart played by different rules.

So while Lawsky’s suit isn’t a matter of bolstering Wall Street at the expense of the City, it is a matter of trying to impose the US (and, indeed, NY) vision of finance on every global financial institution. When it comes to things like capital adequacy, regulators around the world have interminable meetings in boring cities to try and build a global framework they can all agree on. When it comes to things like money transfers, however, every country has different rules, and the US has no compunction in declaring that, say, all flows in and out of Iran are money laundering and/or terrorist finance unless proven otherwise.

Up until now, US bank regulators have taken a relatively sanguine view of such matters. They understand that New York is an international financial center, and so long as banks are making a good-faith effort to stay within the letter of the law, they’re often given the benefit of the doubt. Some might call that regulatory capture; others might simply see New York regulators triangulating towards international norms.

Lawsky, on the other hand, clearly doesn’t care a whit for international norms or the global nature of finance. He sees behavior which on its face involves trading with Iranians and making hundreds of millions of dollars in profit from activities no US bank would want to touch. He has every right to go after StanChart, which has a major New York presence. And he also — crucially — has the right to take away StanChart’s banking license here, which would basically kill the bank entirely. What he sees as the moral high ground looks to Londoners very much like judicial bullying.

The US tightened up its loophole in 2008, and when it did so, StanChart’s U-turns came to an end: they thought they were within the loophole, and when that loophole went away, they stopped what they were doing. In other words, we’ve already had the US action which put an end to StanChart’s behavior: in fact, we had it four years ago. What extra purpose is served in going so aggressively after StanChart now? That’s the question that London is asking; I’d be interested to hear Lawsky’s answer.

One of the problems with financial journalism is its rather kludgy attempts to appeal to a general audience. If something bad happens, for instance, it has to be presented as being bad for the little guy. This was a huge problem with the Libor scandal, since anybody with a mortgage or other loan tied to Libor ended up saving money as a result of it being marked too low.

But don’t underestimate the imagination of the financial press. For instance, what if there was a New York county which put on Libor-linked interest rate swaps to hedge its bond issuance? In that case, if Libor was understated, then the hedges would have paid out less money than they should have done — and presto, the Libor scandal is directly responsible for municipal layoffs and cuts in “programs for some of the needy”.

This is all a bit silly. The Libor understatements actually brought it closer to prevailing interest rates; the fudging basically just served to minimize the degree to which the unsecured credit risk of international banks was embedded in the rate. And in any case, the whole point of a hedge is that it offsets risks elsewhere: it’s intellectually dishonest to talk about losses on the hedge without talking about the lower rates that the municipality was paying on its debt program as a whole.

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

The markets version of the Confidence Fairy certainly gets invoked: Arthur Levitt, for instance, said that recent events “have scared the hell out of investors”. And Dennis Kelleher of Better Markets goes even further: I was on a TV show with him last night, where he tried to make a distinction between “high-frequency trading” and “high-speed trading”, and said that shops like Knight rip off small investors. He’s wrong about that: they absolutely do not. Yes, Knight and its ilk pay good money for the opportunity to take the other side of the trade from small investors. But those investors always get filled at NBBO — the best possible price in the market — and they do so immediately. Small retail investors literally get the best execution in the markets right now, thanks to Knight and other HFTs. And those investors want companies like Knight to compete with each other to fill their trades as quickly and cheaply as possible. If Knight loses money while doing so, that’s no skin off their nose.

So Andrew Ross Sorkin is right to treat such pronouncements with skepticism. The argument that “investors are worried about high-frequency trading, therefore they’re leaving the market, therefore stocks are lower than they would otherwise be, therefore we all have less wealth than we should have” just doesn’t hold water at all. Sorkin has his own theories for why the stock market doesn’t seem to be particularly popular these days, which are better ones, but the fact is — he doesn’t mention this — that the market is approaching new post-crash highs, and that if investors follow standard personal-finance advice and rebalance their portfolios every so often, they should probably be rotating out of stocks right now, just to keep their equity holdings at the desired percentage of their total holdings.

The calls for more regulation are a bit silly, too. Bloomberg View says that “if any good comes out of the Knight episode, it will be a commitment by Wall Street’s trading firms to help regulators design systems that can track lightning-speed transactions” — but regulators will always be one step behind state-of-the-art traders, and shouldn’t try to get into some kind of arms race with them. More regulation of HFT is not going to do any good, especially since no one can agree on the goals the increased regulation would be trying to achieve. If what we want is less HFT, then a financial-transactions tax, rather than a regulatory response, is the way to go.

I do think that the amount of HFT we’re seeing today is excessive, and I do think that we’ve created a large-scale, highly-complex system which is out of anybody’s control and therefore extremely dangerous. Making it simpler and dumber would be a good thing. But you can’t do that with regulation. And let’s not kid ourselves that up until now, small investors have been damaged by HFT. They haven’t. The reasons to rein it in are systemic; they’re nothing to do with individuals being ripped off. Sad as that might be for the financial press.

Jim Surowiecki and John Kay both have columns today looking at the way in which regulatory structure failed to stop abuses in the financial-services industry, and wondering how we might be able to do better in future.

Surowiecki says that we trusted the banks when we shouldn’t have: their incentive to preserve their reputation was not nearly big enough to override their incentive to make money. He’s right about that. But his proposed solution is vague: first, he says, prosecutors should “admit that fraud is a crime and throw some people in jail”, and secondly regulators should “be aggressive not just in punishing malfeasance but in preventing it from happening”. Well, yes. This is the rhetorical equivalent of throwing your hands up in the air: if you end up proposing something which absolutely everybody will agree with, then there’s almost certainly no substance there.

Kay, by contrast, has been looking at UK equity markets in detail, and has determined that the problem lies more with market structure than with anything within the realistic control of prosecutors or regulators. Surowiecki’s proposal basically boils down to “all you prosecutors and regulators are weak, weak people, you should man up and go to war”. I don’t know how many prosecutors and regulators he’s talked to, but this does them a disservice: there are serious institutional and legal constraints here. And what’s more, we can’t try to reform financial-services regulation by assuming that we can easily find a whole new breed of regulators: we can’t.

One reason why we can’t is laid out clearly by Kay:

Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.

But this is in turn only a symptom of a broader problem, which is the way in which the consolidation and ever-increasing complexity of the financial-services industry has reduced the ability of firms to police each other and to earn each others’ trust, while at the same time increasing incentives to fraudulently game the system. Barclays’ Libor lies, for instance, started life as a way for its derivatives traders to make money: something which could never have happened when the banks reporting into the Libor system didn’t have derivatives desks.

A large part of the problem is the way in which financial tools which had a utilitarian purpose when initially designed have become primarily vehicles for financial speculation. Libor, for instance, was a way for banks to peg loan rates to their own funding costs, and thereby minimize their own risks while at the same time minimizing the amount that borrowers had to pay. Today, banks don’t fund on the interbank market any more, and Libor has become something else entirely: a number to be speculated on in the derivatives market, and, in times of crisis, an indication of how creditworthy banks are perceived to be.

Similarly, equities used to serve a capital-allocation purpose, and there was, as Kay says, a chain of trust running from investor to board to management. “Most asset managers want to do a good job – earning returns for their clients through strong, constructive relationships with the companies in which they invest,” he writes. “Most corporate executives also want to do a good job, leaving the companies they manage in a stronger competitive position.”

But that’s not the equity market we see today: “It is hard to see how trust can be sustained in an environment characterised by increasingly hyperactive trading, and it has not been.”

Kay’s conclusion is sobering spot-on: the entire financial-services industry, he says, needs to be restructured so as to create the kind of institutions which thrive on increased trust, rather than on maximized arbitrage of anything from news to interest rates to regulations.

In order for that to happen, we’re going to need to see today’s financial behemoths broken up into many small pieces — because at that point each small piece is going to have to earn the trust of the other small pieces which rely on it.

Of course, that’s not going to happen. And as a result, financial-industry scandals will continue to arrive on a semi-regular basis. When they do, they will always be accompanied by calls for stronger regulation: rules-based, or principles-based, or some combination of the two. But the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution. The real problem is deeply baked into the architecture of too-big-to-fail banks. And frankly I don’t see any realistic way of unbaking that particular loaf.

Brad Miller, arguably the most sophisticated and well-informed member of the House when it comes to housing finance issues, has an op-ed in American Banker today about the eminent-domain plan being mooted in San Bernadino (which just voted to file for bankruptcy, by the way). Miller’s excited about the plan, because he thinks that it will force banks to take losses on all-but-worthless second liens. But, sadly, he’s wrong about that.

Miller actually makes two mistakes in his piece. The first comes when he explains how the price of the mortgages would be determined:

Deciding a fair price would not be hard. There are frequent auctions of mortgages with a sufficient number of informed, sophisticated buyers. The auctions are an almost perfect pricing mechanism. There would be comparable sales to determine almost any mortgage’s fair market value.

Miller’s right that mortgages do get auctioned relatively frequently, if not frequently enough that the market can even be considered highly liquid, let alone “an almost perfect pricing mechanism”. But here’s the thing: the private-label mortgages which tend to get sold off are precisely the mortgages that Mortgage Resolution Partners does not want to buy — the ones in default. Banks which own performing mortgages have almost no incentive to ever auction them off. And MRP has said that performing mortgages are the only mortgages it’s interested in.

What’s more, when performing underwater mortgages are traded, they’re often sold above par, since the homeowner is locked in to higher-than-prevailing mortgage rates. MRP, by contrast, is determined that it will only buy mortgages well below par: indeed, they’re saying that they’ll demand a discount not only to the face value of the mortgage, but even to the market value of the property. As a result, deciding a fair price might well be completely impossible: the owners of the mortgage would value it as a performing loan at a high rate of interest, while MRP would essentially ignore the fact that it’s performing, and value it on the basis that it cannot be worth more than the value of the collateral.

A free market copes quite easily with huge valuation discrepancies like that: there’s simply no trade, and the owner of the mortgage holds onto it, while companies like MRP find themselves unable to offer a price at which anybody is willing to sell. That’s why MRP’s whole idea is contingent on doing an end-run around the free market, and forcing the owners of the mortgage to sell. The point here is that if there really was a low market-determined fair price for the mortgages, then MRP wouldn’t need eminent domain at all: it could simply buy up those mortgages on the free market, directly from banks. Maybe, eventually, once it ran out of free-market mortgages to buy, MRP could try to use the eminent-domain method to buy mortgages from CDOs and MBSs. But at that point they’d have real-world market-based proof of how much such mortgages were worth.

MRP isn’t going down that road, however, because it knows that no one will voluntarily sell them mortgages at the kind of discounts it’s looking for. Which is prima facie evidence that the amount it’s willing to pay is not a fair price after all.

Miller then moves on to the thorny issue of second liens. While first liens are often owned by special-purpose investment vehicles, second liens are generally owned by banks. Miller writes:

So the real losers from the program would be the biggest banks, the holders of second liens, not investors in first mortgages. And even for the biggest banks, eminent domain would not cause losses but reveal losses.

But this isn’t true. If anything, the holders of the second liens would make money from this scheme, rather than losing money. Remember that MRP is not planning to buy houses using eminent domain, which would make much more sense. Instead, it’s only planning to buy mortgages — and it’s refusing to buy any mortgages held directly by banks. Instead, it’s only buying mortgages held by special-purpose investment vehicles, which tend not to have expensive lawyers willing and able to contest any and every valuation.

“Involuntary sales of seconds at fair market value would end fictitious valuations and require an immediate accounting loss,” writes Miller — and he’s right about that. Sadly, there’s nothing in the MRP plan which suggests that MRP has any interest at all in buying up second liens from banks. If MRP were buying houses rather than mortgages, then the banks holding the second liens would be forced to take an immediate loss. But it’s not. Instead, it’s just buying up performing first liens, and leaving everything else intact, including all second liens. At the margin, then, by reducing the amount of money that homeowners owe on their first liens, the MRP plan will increase, rather than decrease, the value of the second liens.

Why won’t MRP buy up second liens at what it considers to be a fair market value? For the same reason that it won’t buy up first liens directly from banks, either — the two sides will never be able to agree on a price. By MRP’s calculation, if the first lien is worth much less than par, then the second lien has to be worth something very close to zero. By the bank’s calculation, on the other hand, a performing second lien is a valuable revenue stream, worth a significant amount of money. And because MRP will be willing to pay very, very little for that second lien, it will not be willing to spend a substantial amount of money defending that near-zero valuation in court: its legal fees would almost certainly be greater than the amount it was willing to pay for the second lien in the first place.

If Brad Miller can point me to a plan where eminent domain is used to buy underwater houses rather than underwater mortgages, or if he can point me to a plan where eminent domain is used to by delinquent mortgages rather than performing ones, including seconds — then he’ll have me persuaded. But sadly the plan on the table is not the plan that Miller thinks it is. Which is why it’s a bad plan.

Back on June 21, I looked at the plan from Mortgage Resolution Partners to use eminent domain to buy up underwater mortgages. I wasn’t very impressed, and now that the dust has settled a bit, it increasingly looks as though the scheme — at least as currently designed — is going to end up going nowhere.

San Bernadino, which seemed to be very interested in the idea originally, is now backpedalling:

“We see it as intriguing, but it’s definitely not something we’ve decided to do,” says San Bernardino spokesman David Wert. “We just wanted to get all the information and see if it might actually work.”

And most importantly, a grand coalition of powerful interest groups has released a strong broadside saying that MRP’s plan is a really bad one. Check out some of the names here: The American Bankers Association, the American Securitization Forum, the Association of Mortgage Investors, the California Bankers Association, the Community Mortgage Banking Project, the Mortgage Bankers Association, Sifma, the Financial Services Roundtable — it’s an impressive list, and at this point it’s pretty much impossible to find any institution which supports the idea, other than those directly involved.

The letter from the various interest groups does not, in truth, make particularly compelling arguments. For instance:

If eminent domain were used to seize loans, investors in these loans through mortgage-backed securities or their investment portfolio would suffer immediate losses and likely be reluctant to provide future funding to borrowers in these areas.

This is pretty silly stuff: the fact is that nearly all new mortgages in San Bernadino and across the country are being financed by the government, and insofar as there is a little bit of private-sector financing, it’s probably not coming from people who bought subprime CDOs at the height of the bubble.

But really the point of the letter isn’t to make an argument: it’s to make a point. Two points, really. Firstly, there’s the word “unconstitutional”, which appears very high up. That’s code for “we’re going to appeal this thing all the way to the Supreme Court, so you’d better be willing and able to spend an enormous amount on legal fees.”

And secondly, the letter sends a very clear message that CDO investors are not on board with this scheme. And that’s the thing which ultimately will result in its death.

In principle, a plan like this could be put together in a way that investors could get behind. But it wasn’t, and MRP got greedy, and as a result it’s not gaining traction: just this morning, for instance, the LA Times came out against it.

The problem, at heart, is that MRP is looking to buy up only seasoned, performing mortgages: precisely the ones which are worth the most money, and which don’t present much of a systemic danger to the San Bernadino housing market. We’re talking here about loans which were made during the height of the bubble, on homes which have since plunged in value — and yet the homeowners have diligently made all of their payments on time. If I’m a mortgage investor holding a portfolio of mortgage loans, these are the ones I love — they’re the ones which help to offset the fact that so many of my other loans are in default. Yes, it’s true that I will have written down the value of my holdings on the grounds that my mortgages aren’t worth as much, in aggregate, as they were during the bubble. But that doesn’t mean that I’m valuing the performing loans at deeply-discounted rates. Quite the opposite, in fact: many of them are worth more than par, trading at about 106 cents on the dollar, just because the interest rates are high and the underwater status of the loan means that it can’t be refinanced.

MRP, by contrast, wants to pay vastly less than par for these loans. To use Kathleen Pender’s example, where a homeowner owes $300,000 on a house now worth $200,000, MRP might pay $170,000 for the loan. Which works out at just 57 cents on the dollar. That’s a highly-distressed price for a performing asset, and I can definitely see that MRP would have a huge amount of difficulty persuading the court that it was a fair price. After all, the only way you get to such a price is by assuming that there’s an extremely high probability of future default — despite the fact that the homeowner has remained current through the largest financial and housing crisis in living memory.

There’s a very big collective action problem in the distressed-mortgage world, and in principle the use of eminent domain is just what the doctor ordered to sort it all out. But I fear that MRP has done everybody a disservice here by putting forward the worst possible use of eminent domain: basically buying up precisely the mortgages which no one is particularly worried about. What’s desperately needed here is a plan which CDO investors can get behind. Right now, they own many mortgages they’d love to get out of, but instead they’re holding on to them because the way that the CDOs are structured, they basically can’t be sold and have to be serviced instead, at significant expense, even when they’re deeply in default.

So let’s see an eminent-domain plan which is designed to buy up defaulted properties, rather than ones which are current on their mortgages. Let’s see a plan which buys properties themselves, rather than just the liens on those properties. And most importantly, let’s see a plan which is constructed by the owners of CDOs, rather than by a bunch of outside financiers looking for a huge profit opportunity. In principle, there’s a way to do this right. It just isn’t the MRP way.

Barclays is to Liebor as Goldman is to structuring dodgy synthetic CDOs: not the worst offender, necessarily, but the first to hit the headlines.

The Economist has a good overview:

Almost all the banks in the LIBOR panels were submitting rates that may have been 30-40 basis points too low on average…

Among banks regularly submitting much lower borrowing costs than Barclays were banks that subsequently lost the confidence of markets and had to be bailed out. In Britain these included Royal Bank of Scotland (RBS) and HBOS.

Regulators around the world have woken up, however belatedly, to the possibility that these vital markets may have been rigged by a large number of banks. The list of institutions that have said they are either co-operating with investigations or being questioned includes many of the world’s biggest banks. Among those that have disclosed their involvement are Citigroup, Deutsche Bank, HSBC, JPMorgan Chase, RBS and UBS.

Court documents filed by Canada’s Competition Bureau have also aired allegations by traders at one unnamed bank, which has applied for immunity, that it had tried to influence some LIBOR rates in co-operation with some employees of Citigroup, Deutsche Bank, HSBC, ICAP, JPMorgan Chase and RBS.

And here’s Jonathan Weil:

What’s truly depressing is the thought that Barclays is only the first bank to settle with regulators over the Libor affair. Eventually, when others reach their own accords, similar inquiries will be made of their top officers.

David Merkel has a fascinating analysis of what the various different banks did, and he reckons there was a “tug of war” between two groups of banks. One group, including Barclays along with BTMU, Credit Suisse, HBOS, Norinchuckin, and RBS, was putting in high bids to raise Libor; another group, which included Citi, HSBC, JP Morgan, Lloyds, and Rabobank, was putting in low bids to bring Libor down. But of course given the almost complete absence of interbank lending during the crisis, it’s not entirely obvious whether there was even a “real” interbank offered rate at all.

In any case, when the other shoe drops, the headlines are going to be smaller: this kind of activity is never as shocking the second time around. Look at what happened to Citigroup, which was actually more evil than Goldman when it put together the Class V Funding III CDO. (The profits from Goldman’s Abacus deal went mostly to John Paulson; the profits from the Citi deal went straight to Citi.) Citi settled the case for $285 million — less than Goldman paid — and suffered almost none of the PR backlash that was inflicted on Goldman.

The truth is that Barclays is being hammered here, and its CEO has lost his job, not because Barclays was worse than anybody else, but rather because its employees were stupid enough to leave a written record, in emails, of exactly what they were doing. Similarly with Goldman: it was those emails from “Fab” Fabrice Tourre that really did for the bank. And so it goes, back through Henry Blodget and further. It’s not the act which matters, it’s the contemporaneous documentation thereof.

There will be many very large settlements to come, of course, both directly with regulators and also with clients who can claim to have lost money as a result of the manipulation. But banks can afford large settlements. What they hate is bad PR, and plunging share prices. And every single bank which isn’t Barclays is breathing a massive sigh of relief right now, and thinking “there but for the grace of god”.

It’s easy to be rude about banks’ boards, and how they tend to be filled with tick-the-boxes types: the management consultant, the retired general, the business-school professor, and a bunch of “private investors” (or “people who inherited their money”, as they’re also known). And given its manifest incompetence over the past week, I clicked over to the list of Barclays board members fully expecting to see the same usual suspects — especially since the chairman, Marcus Agius, sounds like he really ought to have been born about 2,000 years ago.

But the fact is that the Barclays board is actually not bad, on its face. Yes, 10 of the 12 members are white men in their 50s or 60s. But if you were looking for a board which clearly understands issues in both finance and governance, I’d say that this lot was pretty good, compared to any US bank I can think of. Which makes it all the weirder how they managed to get such a spectacular amount of egg on their collective faces this week.

It was always a bit peculiar that Barclays’ chairman would resign while the CEO remained in place. “As chairman, I am the ultimate guardian of the bank’s reputation,” he said yesterday. “Accordingly, the buck stops with me and I must acknowledge responsibility by standing aside.” This of course begged the obvious question: was Bob Diamond, the CEO, somehow not a guardian of the bank’s reputation? And given that Agius’s main failures were in the way that he managed Diamond (or, more to the point, didn’t manage Diamond), how would Agius’s resignation with Diamond still in place help anything?

Today, it looks as though the board was attempting to sacrifice Agius — who had already said he was retiring next year in any case — in a doomed attempt to placate the UK’s parliament and media. Obviously, it didn’t work, and now we see an ignominious switcheroo: Diamond is out, along with COO Jerry del Missier, and Agius is back atop the board, looking for a successor.

“To state the obvious,” as Robert Peston says, “the impression has been created that this hugely important institution is not in charge of the basics of its destiny.”

Indeed, Peston reports that the decision to defenestrate Diamond was taken not by the newly-leaderless board at all, but rather by Mervyn King’s eyebrows. It’s surely right that when a board finds itself with a complete absence of testicular fortitude, top regulators have to step in to force the issue. But there’s something fishy here, too: Clive Horwood reports that at his scheduled testimony to Parliament tomorrow, Diamond was planning on blaming not himself for the Libor-fixing scandal, and certainly not Agius but rather — wait for it — the Bank of England. Which turns out to be the very institution which kicked him out, the day before he was due to testify.

The whole thing is incredibly messy and opaque, and will only serve to further damage Barclays’ reputation. Can that reputation be salvaged? I’m not sure it can: institutions the size of Barclays are hard to change, especially when a large cohort of their highest-paid employees used to work at Lehman Brothers. I very much doubt that any internal candidate could turn this ship around, and even a high-profile outsider — Bill Winters, perhaps — would find it incredibly difficult to take this peculiar beast and turn it into something comprehensible and manageable. Especially if he would be expected to raise the share price while doing so.

In the meantime, it seems that the newly-unemployed Diamond will still testify tomorrow; his departure today is unlikely to soften the blows from Britain’s parliamentarians. And given that Diamond’s resignation was clearly involuntary (Diamond pulled out of a Romney fundraiser yesterday “to focus all his attention on Barclays”), if anything he’s going to be more likely to veer off-message and start railing against those he blames for his own downfall. Who surely include Mervyn King. This is not likely to be an edifying spectacle, although it might be compelling in a car-crash kind of way.

I suspect the best bet for Barclays’ board and its new CEO, whoever that turns out to be, will be to get out in front of Vickers, and make a virtue out of necessity. Ringfence all the UK retail-banking operations and turn them into a boring utility. Then take everything else, including the whiz-bang traders and investment bankers, and list them as a separate company, most likely in the US, which can take on as much risk as its regulators allow it to. I believe the LEH ticker is still available.

Is 12,500 words on the demise of MF Global, courtesy of Fortune, not enough for you? How about 275 pages on the subject from James Giddens, the official trustee? They’re both tl;dnr as far as I’m concerned, so many thanks to Dealbook for picking up on one particularly salient theme of the trustee report: an MF Global subsidiary called MF Global Finance USA Inc, or FinCo.

The main thing you need to know about FinCo is that it was completely unregulated — it was basically an off-balance-sheet vehicle where Jon Corzine could park risk outside the purview of regulators. So when regulators started asking him to raise more capital against his risky European bond positions, he just moved a chunk of those positions out of MF Global proper and into FinCo:

While MF Global did move some cash around to protect against losses, the firm also transferred its roughly $3 billion in holdings of Italian bonds from the brokerage arm of the company to the “FinCo,” according to the report. By doing so, the firm met its requirements without having to raise money… The Italian bonds represented about half the firm’s risky European position.

Now I have to admit that I’ve been scouring the report this morning, searching on terms like FinCo and “net capital” and “Italian”, and I can’t work out what bit of the report Dealbook is talking about here: it would be great if they could use their DocumentCloud technology to show us rather than just tell us exactly what Giddens is saying. But assuming that the report says what Dealbook says it says, this seems incredibly damaging to Corzine.

The start of the financial crisis, remember, was in large part brought on when big banks like Citigroup started seeing enormous losses in their off-balance-sheet vehicles, and then were forced to recognize those losses by bringing them on balance sheet. Corzine, here, seems to have taken the decision that moving risk off his balance sheet was a great idea — even after having seen how dangerous it could be.

Meanwhile, that other rockstar banking CEO, Jamie Dimon, is testifying to Congress next week, and Andrew Ross Sorkin has a list of very good questions that he should be asked. To that list I would add one more: why was most of the Chief Investment Office’s activity based in London? The CIO’s investments were very much on JP Morgan’s balance sheet, of course, not off it. But they were pretty much out-of-sight, out-of-mind as far as regulators were concerned: the US regulators didn’t see them, and the UK regulators didn’t care about them.

The fact is that the CIO did most of its risk-taking in London for much the same reason that AIG Financial Products was based in London: regulatory arbitrage. Which is a problem regulators are always going to face, when dealing with big international banks. What MF Global did was far, far worse than what JP Morgan did. But the motivations were similar. And right now, regulators are simply not equipped to deal with such shenanigans.

There are a few different ways to look at the seemingly-unstoppable rise of the amount of “excess deposits” that JP Morgan ended up handing to its Chief Investment Office, rather than lending out to individuals and businesses needing loans. Maybe big corporations are flocking to deposit their billions at Chase because they know it’s too big to fail. Maybe Chase just can’t find anybody who both wants to borrow money and is likely to pay it back. Maybe — and more likely — Jamie Dimon funneled increasing sums to the CIO just because the CIO could generate a higher internal rate of return than his plain-vanilla lenders could.

But as Roger Lowenstein explains today, a large part of what we’re seeing here is the way in which lending has morphed into investing. All of us intuitively understand that there’s a difference between lending someone money, on the one hand, and buying a bond, on the other. The former is a bilateral contractual relationship which lasts until the loan is repaid; the latter is an anonymous purchase of securities which can be flipped for a profit (or sold at a loss) after weeks or days or even minutes.

The CIO, playing in the bond and derivatives markets, is very much in the latter camp rather than the former, as you can guess by looking at its name. It makes investments, rather than disbursing loans. But the danger here is not just that $400 billion of JP Morgan’s assets are being put to work gambling in the markets rather than extending loans to clients. The danger is that as the CIO gets bigger, it effectively turns the JP Morgan Chase loan portfolio into an investment, too.

It’s worth quoting Lowenstein at some length, here:

The new Jamie, and the people working for him, don’t have to worry quite so much. They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market…

When JPMorgan hedges, it doesn’t get rid of the risk. That only happens when the customer repays the loan or, say, improves its balance sheet. JPMorgan’s hedges didn’t make the risk disappear; they merely transferred it to someone else.

Jamie had an escape hatch, but hedging doesn’t offer an escape for markets as a whole…

JPMorgan still issues loans but with half an eye on their “hedging” potential, that is, on the willingness of traders who may be halfway around the globe to assume the risk. These traders are less well-placed to evaluate the risk. They don’t know the customer and, of course, they haven’t the faintest concern for character. By habit and preference, their involvement is apt to be brief.

They assume risk by writing a swap contract in the full knowledge that they can unwind it via another swap days or even hours later. Someone may get stuck with the bad coin but, each trader is certain, it won’t be him or her. So the approach of these traders is inherently short-term — too short to invest the time and effort to evaluate the risk. Too short, we might say, to really care.

The plasticity of modern finance — the ease with which institutions can transfer risk — is a major cause of the heightened frequency of meltdowns and increased volatility.

To put this another way: liquidity is dangerous, because it breeds complacency. All you need to do is set a stop-loss, and you’ve protected yourself from large losses. Until, of course, the markets seize up and bids simply disappear from the market altogether. Or until your elaborate and complex hedging operations turn out to have been badly constructed, and you wake up in the morning with a loss pegged at $2 billion and growing.

Alan Greenspan famously said in 2003 that “what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” In practice, if you look at the actions of the CIO, derivatives were used to transfer risk from those who should have been taking it — big lenders — to hedge funds who make money only when JP Morgan turns out to have fundamentally miscalculated its risk basis.

Entities who want to really take on credit risk are called banks, and they do so by lending. People who sell credit protection in the markets, by contrast, are traders and speculators who trust in the liquidity of the CDS market and who are sure that they will be able to get out quickly if things turn against them. And thus is the CDS market used shunt risks off, unseen, into the tails.

Liquidity isn’t just dangerous in the loan market. Look at houses, which used to be highly-illiquid investments characterized by a long-term relationship between a homeowner and a lender. When did things fall apart? When that relationship was replaced by a frenzy of securitization and refinancings, with even 30-year mortgages lasting for just a year or two before they were paid off by someone flipping their house or deciding they needed a cash-out refinance. The more liquid housing became — the closer it came to being piggy bank, to be tapped for cash at any time — the more dangerous it became, as well.

Lowenstein’s proposed solution — banning credit default swaps entirely — is not going to happen. But it’s a useful lens through which regulators should be looking at the banks they regulate.

Activity in the CDS market, on this view, is a sign of weakness, not strength: it’s a sign that the bank doesn’t have much faith in its own relationships and underwriting standards, and is reduced to having to buy protection from speculators in order to feel comfortable with the risks that it’s taking. Since those speculators, by definition, don’t have remotely as much information about the bank’s borrowers as the bank does, and since they certainly can’t put covenants into loans protecting them from profligacy at the borrower, such trades make very little economic sense in theory.

Regulators should remember this the next time a bank starts boasting about its sophisticated, state-of-the-art risk management systems. Most of the time, those systems involve complex bets in a zero-sum-game derivatives market, where the bank’s counterparties charge a premium for the fact that they’re on the wrong side of an information asymmetry. At best, in such cases, the bank is merely abdicating responsibility for its risks, rather than properly managing them. And at worst, it thinks that it has gotten the credit risk off its books, when in fact it’s just pushed that risk into the tails, where it’s bigger than ever.

Either way, regulators should have precious little time for such antics. They should force banks to go back to basics, instead, and manage their risks the old-fashioned way, by building strong relationships with their borrowers. Lending those borrowers money right now, when such lending is sorely needed, would be a good start.

There are two stories often told of hedge fund managers, and they’re pretty much diametrically opposed. In the popular imagination, such managers are risk junkies, putting on massive bets in the hope that they’ll have huge payoffs, making a fortune for their investors and even more so for themselves. But that’s not the story told to — and bought by — big institutional pension funds and insurance companies and endowments, who lap up stories of state-of-the-art risk management, carefully-calibrated hedges, aggressively maximized Sharpe ratios, and returns which not only beat the stock market but do so with significantly lower volatility along the way.

So which is true? Read Lawrence Delevingne’s account of how Michael Geismar gambled away his time at the SALT conference in Las Vegas, and it’s pretty clear that the hedge fund manager of popular imagination is a very real creature indeed. He throws $1,000 tips around like confetti, he books a $20,000 private jet home on a whim, he wins and then he loses $70,000 and then he just keeps on playing, and ends the conference up $710,000 or so.

“He was jumping into the pit screaming ‘we’re going to need more chips over here!’” O’Leary recalls, laughing. “It was insane.”

The young dealer was visibly sweating with tens of thousands of dollars now being bet on every round of cards. A small crowd had formed around the table. At one point a casino pit boss came over, worrying that the players Geismar was backing up weren’t actually betting their own money. The table quickly convinced the man they were, and play resumed. The pit boss conferred with a superior, who O’Leary recalls saying “We’re never going to win our money back, but screw it, let’s let it roll.”

Well, yes. This is why SALT will always be in Vegas, and why Vegas will always welcome SALT with open arms. I’m sure the casinos made very good money on SALT even after accounting for Geismar’s winnings, and they’ll probably make money from Geismar too, on net, over time. If nobody ever won big money, no one would gamble at all. But in the end, the house always wins — and all of these hedge-fund managers are smart enough to know that. And still, left to their own devices, what they do is gamble, and they even layer on silly “risk management” techniques which don’t reduce risk at all — in this case, after a losing hand, Geismar would bet a little less, reckoning that somehow “laws of averages” would help him as a result.

Delevingne’s story makes for great reading, but it’s also pretty much impossible to imagine why anybody would invest in hedge funds in general, or Geismar’s hedge fund in particular, after reading it. SALT is the brainchild of our old friend Anthony Scaramucci, of course — and while I’ve definitely met people who like Scaramucci, or are charmed by him, I haven’t met anybody who thinks that Scaramucci’s fund-of-funds is near the top of any list of the best places to invest money. Whatever you think of gladhanding and gambling, they’re not really the kind of behaviors you’re primarily looking for in a fiduciary.

All of which brings me, inevitably, to JP Morgan’s Chief Investment Office, which, the WSJ reports, has been making all manner of highly-risky bets, including bets on LightSquared. There’s lots of hair-splitting in the story about whether or not the bets are funded with excess deposits, but ultimately money is fungible, and in any case the reason that JP Morgan can fund this Special Investments Group so cheaply is just that it’s a big commercial bank which is too big to fail. And if it’s entirely right and proper to look askew at hedge funds exhibiting symptoms of gambling addiction, we certainly shouldn’t stand for JP Morgan Chase to be engaging in anything like that behavior.

This is a Volcker Rule question, of course, but it’s not only a Volcker Rule question. There’s a much deeper issue here as well — which is whether big commercial banks should have hotshot trading desks staffed by the likes of Achilles Macris and Bruno Iksil at all. Both Peter Eavis and Jonathan Weil have new columns decrying the opacity of JP Morgan’s public disclosures: the bank seems to make it as difficult as possible for its owners to find out just how much risk it’s taking and where. And not just its owners, either: the owners’ representatives on the board, JP Morgan’s risk committee, is deliberately staffed by muppets.

There’s a good reason for that, of course: hedge funds need to operate in secrecy, because if the market can work out what their positions are, it will move sharply against them. JP Morgan’s CIO is a hedge fund in all respects except the fees it charges, and clearly the CIO (and the CEO) want its activities to be effectively unsupervised. That’s almost certainly the reason that the CIO is effectively based in London: it’s largely outside the scope of US regulators, there, while UK regulators tend not to care too much about the actions of foreign banks, when those actions don’t present a big risk to the UK economy.

So here’s another principle, which might be helpful alongside the Volcker Rule, in any principles-based regulatory regime: if you’re a too-big-to-fail commercial bank, you shouldn’t have any desk which needs to operate in secrecy in order to do its job effectively. In practice, as Sheila Bair says, that means that JP Morgan should be broken up. If hedge funds want to gamble, fine, let them do that. But not when they have an implicit US government guarantee.