Although the Volcker Rule and other provisions of the recently passed Dodd-Frank Act limit the principal trading and investment activities of large financial institutions, they fail to address the cause of the current crisis, according to commentary today from Christopher Whalen of the Institutional Risk Analyst. By extension, the firms that are proactively implementing Dodd-Frank are actively structuring derivatives that could lead to the “next investment bubble on Wall Street,” Whalen wrote. Dodd-Frank does not address the creation and sale of fraudulent securities and structured assets based on residential mortgages — what Whalen called “toxic waste” sold on the over-the-counter (OTC) market as private placements often without Securities and Exchange Commission (SEC) registration. Financial firms are implementing Dodd-Frank with respect to limits on account trading, and spinning off private equity investments, but at the same time structuring assets based on corporate debt, Treasury bonds “or nothing at all — that is, pure derivatives,” Whalen wrote. Firms are selling these bonds to institutional and retail investors through derivative sales desks. Some bank holding companies (BHCs) sell five-year structured transactions to retail investors, promising double-digit yields. The yield may look attractive, but in fact, the securities are illiquid and lack extensive disclosures. In short, by allowing complex structured securities without SEC registration and failing to end abusive practices in the OTC structured assets and derivatives markets, Whalen wrote that, “Congress and the Fed are effectively even encouraging securities firms to act as de facto exchanges and thereby commit financial fraud.” But the firms originating these securities are the only ones that can provide an indicative valuation due to the opaque nature of the structures and models. “In fact, we already know of two hedge funds that are being established specifically to buy this crap from distressed retail investors as and when rates start to rise,” Whalen wrote. “The sponsors expect to make returns in high double digits by making a market for the clients of large BHCs who want to get out of these illiquid assets. But the one thing that you can be sure of is that nobody at the Fed or the other bank regulatory agencies knows anything about this new bubble.” Write to Diana Golobay.
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