The Volcker Rule Surprises Wall Street – Thanks to JPMorgan

Federal regulators will vote tomorrow (Tuesday) on the Volcker Rule, and this latest draft includes stricter language than Wall Street had expected...

The Volcker Rule, proposed by former U.S. Federal Reserve Chair Paul Volcker, is a central provision of the 2010 Dodd-Frank Act reform law. It would stop banks that receive federally insured deposits from engaging in risky trading practices and force Wall Street banks to end or spin off proprietary trading operations. The goal is to prevent future taxpayer bailouts.

Many pundits expected regulators to finalize a relatively toothless rule, full of vague terminology like "hedging" and "risk" and perverse loopholes that could enable another "London Whale" trade in the future (the famous trade in which JPMorgan lost $6 billion in 2012 on a very risky hedge.)

In fact, the original draft planned to leave a huge loophole that allowed banks to engage in a process called portfolio hedging. This allows banks to enter trades designed to protect against losses held in a broad portfolio of assets.

But on Thursday, The Wall Street Journal reported that a stricter version of the Volcker Rule would prevent portfolio hedging.

It's an important distinction - and one that few saw coming, even the banks who lobbied extensively to prevent a rule against portfolio hedging.

Now Wall Street is upset.

And it's pointing the finger at one firm for undercutting big banks' profits...

You see, for a long time, regulators couldn't distinguish the difference between prop trading and more important healthy practices like market making. This made the terminology in the original Volcker Rule vague when regulators attempted to define "hedging."

And someone on Wall Street took hedging strategies too far: JPMorgan Chase & Co. (NYSE: JPM).

Federal Reserve Governor Dan Tarullo said last month that the London Whale provided a wakeup call to regulators and placed a bull's eye on portfolio hedging practices. 

Even though JPMorgan played far less of a role in the mortgage-backed securities meltdown during the 2008-2009 crisis, the company's high-risk proprietary trades would have been banned by the Volcker Rule under the ordinary guise of hedging.

This new ban came as a sharp surprise to Wall Street's leading firms. They have relied on this practice as a loophole in taking significant derivative positions in recent years in the name of "protection."

Now Wall Street firms and their supporters believe the Volcker Rule could have a profound impact on profitability. About $44 billion is earned each year with the help of these trading practices.

It's unclear how much of the $44 billion per year prop trading would hinder. Multiple reports indicate that pretax profits at the eight largest U.S. banks could get hit by up to $2 billion to $10 billion a year, total.

In order, the four banks that will likely feel the greatest impact are Goldman Sachs Group Inc. (NYSE: GS), JPMorgan, Bank of America Corp. (NYSE: BAC), and Citigroup Inc. (NYSE: C). For the most part, Goldman has been very quiet about this announcement.

Banning prop trading and portfolio hedging will certainly affect the global derivatives markets. No longer will banks be able to defend their loan portfolios by purchasing billions, if not trillions, in credit default swaps for the purposes of hedging, even if the positions bet heavily against their own customers.

There are some who argue this could lead to a significant breakup of the banks - but what's more likely is banks will seek new ways to work around the law.

In the financial legal system, where the regulators become the bankers, and the bankers become regulators through the revolving Wall Street-Washington door, Wall Street's top firms will find ways to come out on top, despite the short-term cuts to their profits.

One option is the offshoring of proprietary trading to Hong Kong, Singapore, or other financial locations - but it could possibly lead to greater action by international financial organizations to clamp down on risky trading practices.

The more likely solution for banks is to spin off trading desks, create joint ventures, or establish entirely new organizational legal structures that would take years for regulators to monitor.

Even with the Volcker Rule, regulators still face a steep uphill climb.

The two primary challenges for regulators on the Volcker Rule are still the two biggest challenges for all regulation in the post-crisis era.

First, regulators need to actually enforce capital requirements and trading oversight on the banks. This requires manpower and relies on chief regulators to stay in their respective oversight roles and not accept seven- or eight-figure offers from the very banks they are in charge of monitoring.

The second challenge is to find ways to wind down failing banks without requiring additional taxpayer funds. U.S. Secretary of the Treasury Jack Lew stated U.S. President Barack Obama's intent on continuing this reform in a prepared statement to Congress on Thursday.

"While the process of putting these reforms in place has taken longer than we hoped, much has been done, and much is being completed," Lew said. "As I have said before, this is not about writing a set of rules, and then walking off the field," he added. "This will require ongoing attention - ongoing fact-finding, review, analysis, and action."

The big question for the top four banks is whether the impact of the Volcker Rule has already been priced into their stocks or if shareholders are going to be hit. How much the street blames JPMorgan in the event of a scalping remains to be seen.

When thousands of home equity loans made during the housing bubble turn 10 years old, borrowers, banks, and the overall housing market will face big trouble. It's starting NOW, and it will get worse before it gets better.