Hedge Fund Managers High Five Obama

high five bearObama recently announced that among other things, the US government was planning to prevent banks from engaging in any non-banking activities such as proprietary trading. Certainly this news is cause to make certain hedge fund managers to do a round of high fives on their trading desks. Banks are prodigious competitors for the available alpha that hedge fund managers seek to harvest. To have them summarily removed from the equation means that hedge fund industry has the prospect of improved returns, ceteribus paribus.(as we economists like to say). Investors should also be happy about this prospect.

It is not known how much capital banks have relatively employed on their prop desks, but my guess is that is at least 25-50% of what the industry itself invests. So a $2 trillion (2007) industry may actually have another $500 billion to $ 1 trillion running along side of it. What we can only guess at is the amount of leverage banks were utilizing in their prop desk activities, but when you have a direct pipeline to assets of the bank and you can earn more than the cost of capital, it has got be substantial.  And banks do not just have one prop desk-they have many- in fixed income, currencies, commodities, equities, convertibles and so on.

Proprietary trading can be an enormous profit centre for the banking industry, and there lies the rub. Remove this profit centre and what will likely happen?  Revenues will fall causing the banks to seek ways to make up the shortfall.  The favourite source of revenue when shortfalls occur is fees.  Next is the spread over the cost of funds. Do not be surprised to see rising fees and interest rates, if Obama’s initiative becomes law.

More troubling however is the basic premise of Obama’s action. It assumes the banking industry through proprietary trading, and with it the hedge fund industry, were somehow responsible for economic mess of the past two years.  There is not a shred of evidence to support this and indeed, it will be shown in the forthcoming research they were removing risk from the system, not adding to it.

Hopefully saner voices in the Obama administration will prevent implementation of this shortsighted initiative.