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Explainer: Paul Volcker's rule
Banks are bracing themselves. Next Tuesday we may finally witness the rollout of the completed Volcker Rule ... and so ...
Q. What’s the Volcker Rule, again?
Back in 2010, former Fed Chairman Paul Volcker proposed curbing excessive risk-taking by banks by banning proprietary trading. Nice and simple, he thought: A policy that should be about four-pages long.
Q. 2010? That’s nearly four years ago! Why hasn't it happened yet?
Today, the Volcker Rule looks a bit like a neutered dog: It has swollen to a tremendous size – nearly 1,000 pages covering 400 regulations – and it has lost almost all its aggression against the banks. Almost everyone complains that the rule doesn’t define two key terms: Hedging or market-making. This effectively means that there is a giant loophole in the law, through which any half-decent banking lawyer will be able to drive a battle tank.
Q. Hedging and market-making? What are they? And why are they so important?
Hedging and market-making are two key functions performed by banks of all sizes all over the world.
A hedge is essentially an insurance contract: In the same way that I make an investment (paid monthly to an insurance company) to protect myself if something goes wrong with my car (like if it gets stolen); so too do banks insure themselves by making investments (say, buying ...
Crocs and the PIPE
No, Crocs is not on crack: It needs money.
The PIPE is a way of raising cash, in what's called a private investment in public equity.
Q. Sounds complicated. What does it mean?
It means a private equity fund - Blackstone, in this case - buys shares in a public company - like Crocs.
Q. Where do those shares come from?
They're shares owned by the company. When a company "goes public" in an IPO, it doesn't put all its stock on the market. A big chunk of shares are held by the company's officers, and maybe by the company itself.
Q. So if the company needs money, why doesn't it sell its shares on the open market?
It could, but that would take a long time. If it dumped all the shares it wanted to sell on the market in one go, that could send the price sinking, which would kind-of defeat the point. It could also sell the block of shares in what’s called a secondary offering. But that takes a long time -- it’s a lot like an IPO, where you hire an investment bank, go on a roadshow and jump through all sorts of regulatory hoops.
Q. So a PIPE is quicker. But is it cheaper?
Probably not. In exchange for doing the deal quickly, the private equity company usually buys the shares at a discount to their trading price.
Q. But what about Crocs. I like my plastic shoes and know lots of folks do too. So why does Crocs need the money?
The company’s not saying, but word is they’re raising the cash to buy back a bunch of their own stock.
Q. Whoah, hold on! They’re selling stock to raise cash to buy stock? How does that make sense?
Companies buy back stock for a number of reasons. Sometimes it’s because they want more control of the company; sometimes it’s because they want to be sure the value of the shares remains high. In Crocs case, there’s talk of a restructuring, which Blackstone would help with. The company could be aiming at holding as many shares as it can afford to buy, to make that restructuring as smooth as possible.
Why 13 is a lucky number, economically-speaking
The Richmond Federal Reserve had some good news for us today: Its survey of industrial activity in November registered a 13. Now most folks might consider 13 to be an unlucky number, but in a month when most economists had expected the survey to score four, up from a score of one in October, 13 looks pretty good. So when you hear the news that the Richmond Federal Reserve rated the economy a 13, you probably have a couple of questions:
1. What? There’s a Federal Reserve bank in Richmond?
To most of us, the Federal Reserve is the nation’s central bank, and we really only pay attention to it when it’s pumping oodles of cash into our banking system, or fiddling with interest rates. But the Fed is more than just the house of Greenspan/Bernanke/Yellen. It's a network of 12 regional Federal Reserve Banks, located around the country, each of which has its own chair, its own area of responsibility, and tracks economic progress in its region. So while the quarterly announcements from the big ol' Fed give us a view on how the entire U.S. economy is doing, data from the regional Feds, of which Richmond is one, give us a much more focused view of how the economy is doing in certain areas.
2. So what does 13 mean?
Every month, the Richmond Fed surveys industry in Virginia, the Carolinas, Maryland, Washington, D.C. and West Virginia. It plugs all of that data into its abacus and comes up with an index. It’s a lot like the Dow Jones Industrial Average – a weighted average of data. So when you hear the Richmond Fed’s survey increased to 13, that’s a bit like hearing the Dow reached 16,000.
And given where we are in our economic recovery right now, 13 is a great number. So let’s consider ourselves lucky.
Lien times: The HELOC is back
If you've ever taken out a loan, whether to buy a car or a house or a new PlayStation, you've probably heard the term lien. "I'm putting a lien on your house," for instance.
That’s pretty standard: The bank who lends you the money puts a lien on your property. Fail to make those payments, and the bank gets the house or the car, or whatever.
But what about a second lien? It's pretty apparent, right? A second loan on the same property.
The rules for a second lien are similar to the first, and the net effect is the same: Fail to make a payment on the loan, and the lender can legally force the sale of the house, to get their money back. The only difference is that the second-lien lender has to wait in line: The main mortgage lender gets paid in full first, and only then will the second-lien lender get refunded.
In the U.S., second-lien loans on homes usually come in the form of a home equity line of credit, or HELOCs. If you recall, the HELOC was a key player in the financial crisis.
As home prices kept increasing, many Americans borrowed against their homes. But when the value of the property fell, they found themselves underwater on their mortgages: Owing more than the house was worth.
Small wonder that HELOCs fell out of favor over the last five years: Homeowners were scared of them, and lenders didn’t like that they risked not getting the full amount of their loans back as property values fell.
But now, it seems, the HELOC is back. Bloomberg News reports that HELOC originations could rise 16 percent this year and reach another five-year high in 2014.
Home prices are rising, and real estate watchers like Zillow reckon the number of underwater homeowners is falling sharply. Americans are once again taking advantage of rising real estate prices to pull money out of their homes.
We can hope that this time they’re doing it to renovate (as opposed to buying a jet ski), but the risks remain the same.
That HELOC may not seem like a lot of money compared the main mortgage, but fall behind on payments, and you’re in danger of losing the whole enchilada.
Today’s monetary forecast: Low rates through the summer
Three numbers out today are fodder for fiscal doves to argue that the economy is giving a green light to the Fed to keep buying bonds and pumping money into the economy:
Retail sales: Rose more than forecast in October. Translation: Low borrowing costs and rising home and stock values are juicing the economy. Keep pumping!
Existing home sales: Fell in October to the lowest level in four months as rising interest rates and limited supply crimped the market. Translation: The Fed needs to keep hammering at interest rates, to keep them low so that Americans can afford to buy homes. Keep pumping!
And the kicker, inflation: The Consumer Price Index fell for the first time in six months. Translation: The cost of living is falling, and inflation is still barely moving the needle. Keep pumping!
Add that to Ben Bernanke’s statement last night that the Fed will likely hold down its target interest rate after it stops its quantitative easing program, and possibly after unemployment falls below 6.5 percent, and you have a low interest rate environment that could last until next summer, at least.
Fiduciary duty, new rules for advisers and an explainer
You see those beads of sweat on the brow of your financial adviser? She’s rushing to get you to sign on the dotted line before the SEC creates a uniform fiduciary rule for brokers and advisers.
This could be a very big deal for the personal finance industry, but when I mentioned it to Kai Ryssdal, he said, “Sorry man, you lost me at uniform fiduciary rule.”
So if you’re confused about anything involving the word fiduciary consider yourself in good company. And consider yourself in need of this here explainer video:
So why is it a big deal? Because if the rule is written right, brokers and financial advisers will have to act as a fiduciary, which means they’ll have to act in the client’s best interest. That’s your best interest, not theirs. That means they won’t be allowed to sell you some dodgy mutual fund or insurance product that pays them a fat commission.
Hats off to the Consumer Federation of America, which drafted the proposal. The SEC’s Investor Advisory Committee is expected to vote on it Friday.
Here’s the nub, according to the subcommittee: That any fiduciary duty imposed by the SEC should provide "an enforceable, principles-based obligation to act in the best interest of the customer.”
Fed to banks: Get a bigger rainy-day fund
The Federal Reserve said today that it wants to “strengthen the liquidity positions of large financial institutions.” In everyday language, the Fed wants banks to have a lot more cash on hand than they do right now, in case of an emergency. Like an emergency fund. Or the air bag in a car.
Banks don’t usually have much cash lying around in their vaults, since they prefer to lend it out to people and earn interest on it. The only thing that cash in a vault accumulates is dust. But just like any other business, banks need cash to run their businesses. They need to make payroll, make bond payments, settle lawsuits.
But rather than have cash on hand to do those things, banks prefer to borrow the money … from other banks.
In order for one bank to lend to another, the lending bank has to trust that the borrower bank will be able to pay it back. And if the lender doesn’t trust the borrower, he won’t lend. And that leaves the wanna-be borrower with a liquidity crisis.
Trust can break down between banks for any number of reasons. Maybe the lender bank’s been tipped off that the wannabe borrower has bought too many toxic assets. Or maybe there’s a rumor that a big fund owned by the wannabe borrower is about to go bust.
There may be some truth to this ... or there may be none. But all it takes is the whiff of a problem for the money to dry up. And without money coming in the door, a bank can’t send money out the door. And if it doesn’t send money out the door, the bank goes bust.
The Fed doesn’t want banks to go bust.
So it’s come up with an idea.
Banks will have to estimate how much cash is going to go out the door during a short-term period of stress, and based on that, it will have to hold a certain amount of cash on hand. That will essentially allow a bank to operate on its own, without borrowing from other banks, for a certain period of time.
Does this mean that bank robbers are now feverishly working out plans to tunnel into the Bank of New York from the crypt of Trinity Church? Hardly. By cash, the Fed doesn’t mean bank notes necessarily, it means stuff that can be converted into cash very easily and quickly. Like Treasury debt, commercial paper, shares of blue chip companies and the like.