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Fear and Loathing on Wall Street

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The Washington Witch Hunt hits home.

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Banks have long suffered from a perception problem but that has evolved into a populous uprising; people are pissed and in many cases, rightfully so.

The easy money unleashed to stem the financial crisis had the unintended consequence of ballooning profits at many of the companies central to the storm. As patience thins on Main Street and regulatory headwinds stiffen, the witch hunt is widening with each passing day.

We shouldn't be surprised by the posture in Washington; policymakers were toothless tigers before the crisis and pendulums tend to overshoot in the opposite direction. The fact that President Obama dropped his regulatory bomb the same day Goldman Sachs (GS) reported earnings wasn't a coincidence.

"The Volcker Rule," as it's being called, takes aim at proprietary trading, among other things. While the proposed concept certainly makes sense -- the mandate of a bank should be to protect the deposit base -- the devil resides, and may be unleashed, in the detail of execution.

Broker-dealers facilitate customer order flow and those positions are traded on behalf of the bank. Attempts to limit that functionality would let loose a fresh set of unintended consequences, including but not limited to market liquidity. If, on the other hand, the rule is aimed at pure prop desks, the net effect will be marginal, at best.

There is a high degree of probability this will serve as the first in a series of steps that will include credit default swap reform, off-balance sheet transparency, short-sale restrictions and perhaps transaction taxes. The trick to these trades will be the ability to introduce perceived solutions without inducing a state of systemic shock.

What is and What Will Be

Having worked in the financial field for almost twenty years, specializing in derivatives at Morgan Stanley (MS) and hedge funds thereafter, I have a unique lens into what happened and why. Many of the practices that laid the groundwork for the financial crisis weren't malfeasance in the traditional sense; they were universally accepted trading practices that fell pray to the demons of greed and the complexities of scale. See also Will The Banking Industry Survive?

It's a classic case of risk gone awry, coupled with the failure of regulators to conceptually understand the products they governed. Policymakers have since masked the symptoms rather than address the underlying disease; they've pushed risk along the time continuum with hopes that the true medicine -- debt destruction -- will be less painful if taken in doses.

I agree with the precept that an economic patient must be stabilized before he can recover. The fatal flaw of this approach is that the imbalances percolating under the seemingly calm financial surface are cumulative still. While credit markets suggest we have a window of opportunity to implement solutions, the bar tab, unpaid after many years of societal largess, looms large on the horizon.

With regard to our current course, this week may serve as a microcosm for what's to come. Earnings traditionally serve as the eye of the market storm but they've taken a back seat to the State of the Union, the FOMC meeting, and the Ben Bernanke confirmation process. When the eyes of Wall Street are fixated due south, it speaks volumes about the complexities of the political climate.

The Tightrope and the Tangled Web

While many believe financiers have abused their privilege and Uncle Sam should take their sugar-high away, we must remember banks were not the sole cause of this crisis. The spectrum of culpability extends from consumers who over-extended on credit to institutions responsible for financial engineering to policymakers complicit by acceptance to the CEO of the United States of America.

Adding spice to the mix is the "other side" of globalization; in a finance-based, derivative-laced global economy, deleveraging is a worldwide affair. We saw China address this dynamic last week with the implantation of lending curbs and Standard & Poor's raised the issue as it pondered a downgrade of Japan's sovereign debt rating on Tuesday.

Through these lenses, the bitter pill of medicine, as opposed to the faux fix of synthetic drugs, must be a collective and concerted global effort. This isn't about "Wall Street vs. Main Street," nor can we let protectionism and isolationism percolate. We're in for a prolonged period of price discovery and our actions will define our generation. The sooner we wrap our heads around the task at hand, the better prepared we'll be to deal with it.

The McKinsey Global Institute recently released a report that echoes this view, offering "deleveraging episodes are painful, lasting six or seven years on average and reducing the ratio of debt to GDP by 25%." See the McKinsey Report here.

As the crisis shifts from the financial to economic to social sphere, the emerging risk is our current societal progression. A tight correlation appears to be forming between the view of bankers as villains and strategic defaults, both from those underwater and by those who opt for default, according to Minyanville Professor Peter Atwater in his article Why Vilifying the Banks Matters.

What if mortgage defaults and credit card delinquencies emerge as weapons of mass defection?

What if, as posed by Minyanville professor Kevin Depew, folks stop caring about their FICO scores and remove themselves from the financial pecking order? Also read After the Comedown.

We, the people, must take a step back and a deep breath before we hand this toxic baton to our children. We must stop asking ourselves who's to blame and focus on positive change through lessons learned -- and do so without overcompensating on regulation or, for that matter, the blame game.

If society is truly a sum of the parts, those parts are us and the time is now.

R.P.

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