Senate Floor Statement on Introduction of Protect our Recovery Through Oversight of Proprietary Trading Act

Wednesday, March 10, 2010

Id like to relay a story that says a great deal about how the worst financial crisis since the Great Depression came to be.

In 2006, a bond trader at Lehman Brothers struck up a conversation with one of the firms college interns. When the trader asked this intern, who had not yet begun his senior year, what he was doing on his winter vacation, the young man replied that he would be trading derivatives for Lehman. That was a surprise, but the shock came when the intern said the firm had given him $150 million of its own money for this college student to bet on risky derivatives.

Now, one college junior and his $150 million trading account did not bring the entire financial system close to collapse. But it is just this brand of recklessness that led to the need for multi-billion dollar bailouts and to the worst recession in decades, one that has left millions of Americans without a job.

The losses that Lehman and other large financial firms racked up, trading on their own account and not on the behalf of investors, helped build the bonfire that nearly engulfed our entire financial system.

That is why I have joined Senators Merkley, Kaufman, Sherrod Brown, and Shaheen to introduce the Protect our Recovery Through Oversight of Proprietary Trading Act (or PROP Trading Act). With this legislation, we attempt to rein in some of the reckless practices that led to economic catastrophe, the proprietary trading and hedge- fund operations that lost billions of dollars, caused the collapse of some of our biggest financial institutions, and pushed other major financial firms to the brink of collapse.

This legislation would accomplish several important goals to ensure that the abuses of recent years dont lead to another crisis. It would ban taxpayer-insured banks, and their affiliates and subsidiaries, from engaging in proprietary trading that is, trading on their own behalf and not that of their customers. It would ban taxpayer-insured banks from investing in or sponsoring hedge funds or private equity funds. Nonbank institutions that are critically important to the systemic health of the financial system, i.e., those that have been deemed too big to fail, would be subject to new capital requirements and limits on their ability to trade on their own behalf or invest in hedge funds or private equity funds. Federal regulators would set those requirements and limits. And our legislation would prohibit underwriters of asset-backed securities from engaging in transactions that create a conflict of interest with respect to the securities they package and sell.

The reaction of Wall Street has been swift. Proprietary trading, they tell us, was not a large factor in creating the financial crisis. And restrictions on proprietary trading would have no effect in preventing the next crisis.

On both points, they are wrong. Here is why.

While Wall Street claims that proprietary trading was a tiny part of its operations before the crisis, their financial reports during the boom years tell a different story. Firms such as Goldman Sachs and Lehman Brothers earned as much as half their revenue on proprietary trades when markets were booming. Bank of America reported in a 2008 regulatory filing that losses in large proprietary trading and investment positions had a direct and large negative impact on our earnings. JP Morgan Chase warned in its 10K filing for 2008 that it held large positions in securities in markets that lack pricing transparency or liquidity (presumably proprietary positions). Likewise, Goldman Sachs told regulators that the collapse of proprietary asset values have had a direct and large negative impact on its earnings.

What these firms are saying in the dry, lawyerly language of SEC filings is that they had been betting big, and losing big, and those failed bets had done them serious harm.

How much harm? By August of 2008, according to one estimate, the nations largest financial firms had suffered $230 billion in losses from proprietary trading. Only a Wall Street trader could dismiss such losses as immaterial; in fact, that total is about one-third the size of the Wall Street rescue package we were forced to approve. Nearly every major financial institution suffered major losses in proprietary trades. Lehman Brothers, whose bankruptcy was a major contributor to the financial crisis, in 2006 derived more than half its revenue from proprietary trades. By 2007, its proprietary holdings totaled $313 billion. But the firm lost $32 billion on such trades in 2007 and 2008, nearly double the value of the firms common equity. Bear Stearns collapsed and was bought by JP Morgan Chase with federal aid in large part because of the collapse of its hedge funds. Morgan Stanley, JP Morgan Chase, Merrill Lynch, Goldman Sachs, each suffered major losses as a result of the risky bets they placed on securities that plummeted in value.

There also is a need to prevent financial institutions that create asset-backed securities from engaging in transactions connected to those securities that present a conflict of interest. As has been widely reported, some institutions at the height of the boom in asset-backed securities were creating these securities, selling them to investors, and then placing bets that their product would fail. Phil Angelides, the chairman of the Financial Crisis Inquiry Commission, has likened this practice to selling customers a car with faulty brakes, and then buying life insurance on the driver. It is an abusive practice, it should stop, and our legislation would stop it.

It would be irresponsible of us to allow such risk and abuse to remain present in our financial system, lying dormant until the day we are once again on the brink of financial catastrophe, and once again the need to rescue financial firms who refuse to prudently manage their risks. This legislation is urgently important, and I urge my colleagues to carefully consider the consequences of failing to act.