VIX Flies As Obama's "Prop Chop" / China Weigh In

A: The volatility index surged about 56% in the past 3 days from 17.58 to 27.31 as markets reacted to what a future world of regulation and lending curbs may look like. As discussed three days ago in "Stimulus Withdrawal: Ain't It A Bitch!", China was a glimpse on Wednesday into how our markets would ultimately react when the 'juice' is talked about being taken away and the first forms of regulation are discussed. As usual, we got way too addicted to a world of free money, accounting gimmickry, liquidity facilities and stimulus packages. With selling volume surging, the dollar rally gathering steam and the VIX rising, I wonder if these are the beginning indicators of a dollar carry trade unwind?

Here is a quick look at the VIX over the past 6 months, focusing on the last 3 days with a spike of about 56% from mid-week; via Bloomberg:

The crazy thing is that people forget about the insane amount of stimulatory policies and programs that were taken to stem this severe episode of debt deflation. They just want their home prices to stabilize or rise, stocks to rise, and things to get better at any cost. The short term fix is what is wanted, without consideration for longer term consequences of such actions. That is what I want people to understand when they look at the equity markets these past few days.

As Jeff alluded to on Thursday, Obama's limits on prop trading in my opinion was the biggest driver, coupled with China's bank lending curbs, to drive the recent equity selloff. The Wall Street Journal reports, "Goldman Seen Hardest Hit By Prop-Trading Limit":

Goldman Sachs Group Inc. (GS) would be the hardest hit if White House proposals to limit so-called proprietary trading become law, analysts said Thursday.

Morgan Stanley (MS), J.P. Morgan Chase & Co. (JPM), Bank of America Corp. (BAC) and Citigroup Inc. (C) also would be affected, the analysts added.

On a day when Goldman reported a full-year profit of more than $13 billion, President Barack Obama proposed that banks and financial institutions that contain banks should be banned from running proprietary trading operations unrelated to serving customers.

Obama also proposed that banks should not be able to own, invest in or sponsor hedge funds and private-equity funds. The announcement shocked some banking analysts, making them more concerned about regulatory risk in the industry. The proposal to ban the practice, known in the industry as prop trading, comes roughly a week after Obama unveiled plans to levee at least $90 billion in fees on the largest financial institutions. In the U.K., large bank bonuses are being taxed at 50%.

According to Reuters:

Prop trading accounts for 4.9 percent of revenue at Credit Suisse, 4.3 percent at Deutsche Bank, 4.2 percent at Barclays, 3.1 percent at Societe Generale and 1.4 percent at BNP Paribas, UBS analysts estimated.

For Goldman, that percentage is significantly higher; a reported $4.5Bln of revenue was from prop trading in 2009, 10% of their total reported $45Bln in net revnue for the year. The WSJ article mentions that "prop trading could account for up to 20% of Goldman's revenue during a particularly successful quarter...". Ouch, that would hurt and the stock would have to re-adjust to that new reality if the proposal becomes law.

With the equity markets being the discounting mechanism that they are, this is the new world we have to get used to as stocks start to discount future realities. This includes higher rates, higher taxes, more regulation, expiration of liquidity programs, expiration of the fed's debt monetization experiment, and tougher capital constraints to curb lending and make sure this credit boom and bust doesn't happen again; at least for a while. Wall street will have to wait to see how this all plays out before inventing new and improved ways to work and play around the new regulation; something the street is very good at doing.

For now, expect continued volatility especially if the dollar does something nobody expects it to do: continue rising! Quietly, the greenback is at a 5-month high against the Euro and I wonder if this is the beginning of the carry trade unwind, as traders close out short term debt positions funded with cheap dollars? When a positive carry turns to a negative carry, crazy things can happen!

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