Tax Wall Street trades

July 16, 2009

Reports of the death of the investment bank have been greatly exaggerated, as Mark Twain might have put it.

It was just 10 months ago, after Goldman Sachs and Morgan Stanley
quickly converted themselves into bank holding companies, that nearly everyone had written off investment banking. All those predictions about Wall Street firms becoming less profitable and boring places to work seem laughable in light of Goldman’s blowout second-quarter profits and JPMorgan Chase’s equally impressive earnings.

Now all the chatter is about how little things have changed on Wall Street, with trading revenues and fees from underwriting stock deals padding the bottom lines of both banks. Back in September, The New York Times ran a lengthy article headlined “Wall Street, R.I.P.: The End of an Era.”

But this week the paper of record is writing about the return of the gilded pay package at Goldman.

Of course, things are different on Wall Street. Two big investment banking competitors are gone, leaving more opportunities for the remaining players. Banks like Goldman and Morgan Stanley owe a large debt of gratitude — and maybe their very existence — to the federal government.

In particular, Goldman, Morgan Stanley and JPMorgan collectively sold more than $80 billion in government-guaranteed debt. The government-backed bond sales enabled the banks to raise desperately needed capital at a time when investor confidence was at an all-time low.

It’s amazing what a big bank can do when it’s all but got the full faith and credit of the U.S. government behind it.

The big trading gains at Goldman and JPMorgan also should put to rest the notion that banks can’t generate hefty trading revenues, if forced to operate with lower levels of leverage. The gross leverage ratio — a measure of a bank’s debt to assets — dropped to 14.2 at Goldman, nearly half of what it was at the start of the financial crisis.

Leverage becomes less critical when there are fewer competitors around and a bank’s cost of borrowing money is negligible. Even so, Goldman is operating with a higher degree of leverage than most hedge funds.

So what’s to be done?

Investors and Wall Street critics could simply accept the revival at the nation’s big banks as a sign that the financial crisis is abating. One can rightly argue the speedy return of outsized profits on Wall Street is simply the price to be paid for restoring the natural order of the financial system.

But Wall Street shouldn’t be able to get off that easy. It could be months, even years, before the Obama administration’s proposed regulatory overhaul of the financial system takes effect. And even then, it’s not clear that the Obama plan is the right preventive for avoiding financial calamity in the future.

Here’s one thing the Obama administration and legislators on Capitol Hill can do right away to rein in some of the excess that has begun to reappear on Wall Street: Impose a new proprietary trading tax on big banks.

This would be a tax aimed specifically at the profits a bank generates from prop trading, which is trading stocks, bonds, currencies and commodities for a bank’s own account. In essence, this new tax would be a penalty imposed on banks for excessive risk taking.

The chairwoman of the Federal Deposit Insurance Corp, Sheila Bair, recently endorsed a similar proprietary trading tax scheme in an interview with Bloomberg News. Bair would impose a special fee on any too-big-to-fail bank that engages in proprietary trading or non-traditional lending activity.

Bair’s plan is a good idea. But a prop trading tax has the added benefit of forcing Goldman, JPMorgan and other firms to separate profits for prop trading from profits arising from customer trades.

Banks currently lump all trading revenue together — making it impossible for investors to understand how these giant financial institutions tick. A prop trading tax would allow investors to get a picture of the risks embedded in a bank’s trading operation.

But whether it is a tax or a fee, the key is for the nation’s elected leaders to do something. To simply stand back and marvel at Wall Street’s ability to reinvent itself is only setting the stage for more trouble ahead. (Editing by Martin Langfield)

UPDATE: Here is my colleague Felix Salmon’s take on Bair’s proposal.

UPDATE 2.0: Great post by John Carney at Clusterstock on Goldman’s defacto government-guarantee to print money.


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