WHY IS THERE OPPOSITION TO FINANCIAL REGULATORY REFORM?

“Let me close with this thought. My father grew up in the Great Depression. Like so many of his generation, he was shaped by sacrifice – hardened by economic hardship and war – keenly aware of the financial recklessness that made his life so much harder than it needed to be. His generation learned the lessons of financial disaster so that the country could avoid it for decades. Let us learn the lessons of our time.  Let us be diligent and thoughtful today, so that our financial and economic system can rebound fully, and enrich and sustain the Americans of tomorrow.”

– Phil Angelides

I think we are all fairly well versed in the various causes of the financial crisis by now.  This was a widespread break-down of the entire financial system.  Consumers got greedy, the banks got greedy, the government stopped enforcing the rules (or dismantled them altogether) and monetary and fiscal policy broke down on several levels.  I’ve spent a great deal of time here talking about the consumer break-down and how Americans spend more than they make and are generally fiscally irresponsible.  Fortunately, the consumer is de-leveraging and continues to reshape and improve their balance sheet.  Hopefully, this is a continuing trend.  Corporations have also been very effective in reducing leverage and paying down debt.  One of the few bright spots in all of this is that U.S. corporations remain quite robust.  Unfortunately, the monetary and fiscal response has been similar to what caused this crisis, but that is a mess derived from years of misunderstood (in my opinion) and backwards thinking with regards to our monetary system.  That is something that can only be resolved with time and education.  What remains entirely unresolved, however, is financial regulatory reform.  It’s time that we update our antiquated regulatory system and install a system that ensures the Enron banking system is contained.

Since the early 1980’s we have been slowly breaking down the regulatory system that helped the United States avoid a major financial crisis for almost 60 years.  As banks have evolved and financial innovation has grown the regulators have failed to keep pace.  As big banks and corporations sought to maximize profits they have slowly chiseled away at any regulatory measure that stood in their way while also staying one step ahead of regulators who try to properly regulate the ever evolving Wall Street.  Lobbyists have come to rule Congress and the banks have subsequently put us all at risk.

If there’s one thing we’ve learned from all of this it is that markets do not regulate themselves.  Just like human beings cannot regulate themselves.  We are irrational and inefficient creatures.  Throw money, family and emotions into the mix and we become very inefficient and very irrational creatures.  This experiment with de-regulation has helped build a financial industry that not only cannot regulate itself but has nearly succeeded in destroying the entire U.S. economy.  What appeared like a garden variety recession was transformed into a near implosion of the economy when vital U.S. institutions were allowed to lever themselves up using opaque and unregulated instruments.  Yet some people don’t have any desire to pass a harsh regulatory reform bill.  They would rather protect Wall Street than Main Street.

I have been very disappointed by the Republican response to any reform bill.  I’m going to shoot straight here because I am in an unbiased political position.  Before the political rants begin I just want to remind readers that I have been very much against the majority of the Obama spending policies.  I have been very vocal about the passage of the healthcare bill and my opposition to it (9.7% unemployment is no time to pass an inefficient spending bill).  I have been very vocal about the inevitable tax hikes that the Obama administration’s inefficient spending will result in.  Not to mention, I am a registered Republican.  But I am deeply disappointed by the Republican party’s staunch opposition to this bill.  This has devolved into political sideshow as opposed to government working for the people.  The Republicans are doing little to help their cause in looking like the party of Main Street.

As of the end of last week, the major rally cry for the Republican party was that they could not stand behind a bill that put taxpayer dollars on the line again.  I couldn’t agree more.  The only problem with this argument against the financial reform bill is that the bill doesn’t put taxpayer dollars at risk.  According to TIME the bill uses bank funding for the bailout fund:

“Bailout fund: The biggest financial institutions pay into what is basically a bailout insurance fund, a $50 billion pool fed by a tax on the largest financial institutions that acts as a cushion between the cost of intervention and the taxpayer. (The fund is $150 billion in the Frank bill.) This money would be used to rescue or liquidate some firms in trouble, paying for taking bad assets off the books or the operational cost of busting down the company to spare parts. The FDIC can borrow more money from the Treasury to work with while it sells off assets, but only as much as they expect to be repaid in the end. If those funds get eaten through and the government lends institutions money out of its own pocket, the feds get to be first in line for repayment. Worth noting: Current estimates put total losses from TARP at a bit under $100 billion.”

Over the weekend, the Obama administration was willing to compromise.  They have agreed to strike this portion of the bill despite the attempt by Republicans to twist its actual meaning.   Over the weekend Mitch McConnell ignored the Democratic concession and changed his story.  Now the Republicans don’t support the bill because derivatives reform is unjust.  Now this is where things get really interesting (and sad) because Mr. McConnell’s true colors begin to shine.  Mitch McConnell’s largest campaign contributors are the securities and investment firms so it’s not difficult to understand why Mr. McConnell is spending so much time standing up for the banks:

This is an important issue for the banks because they stand to lose billions in profits if the current structure of the derivatives markets are changed.  Jamie Dimon recently said that derivatives reform alone could cost the bank $500-$750MM in annual profits.  Personally, I’m fine shaving a few billion dollars off of total annual S&P 500 profits if it gets us closer to a system that won’t implode under poor risk management and excessive leverage.  McConnell should be too.  On the back of the financial crisis and the contagion that derivatives caused this should be the biggest no-brainer portion of the bill.  This is where the harshest regulatory changes should reside, but for some reason the Republicans stand in the way.  This is just another case of Congress looking out for Wall Street and not Main Street.

What is not mentioned in the Republican argument is many of the arguments that John Mauldin made over the weekend in his piece “First let’s kill the Angels”.  Mr. Mauldin makes some excellent points about changes in Angel investing and potential roadblocks for small businesses.  These are legitimate arguments, but even Mr. Mauldin, who is a Republican, has acknowledges the need to regulate the derivatives markets and end TBTF.

I still believe the blueprint for derivatives reform comes from Kyle Bass who made billions when he foresaw the crisis in these opaque markets.  In his brilliant FCIC testimony, Mr. Bass simply laid out the problems in the derivatives markets and the ways that banks are able to leverage themselves up and put the system at risk:

“The OTC Derivatives marketplace, with  the nearly  infinite  leverage  it afforded and continues  to afford the dealer community, must be changed.  AIG, Bear Stearns and Lehman would not have been able to take on as much leverage as they did, had they been required to post initial collateral on day one for the risk positions they assumed.”

Mr. Bass laid out simple reforms that would help mitigate the potential of another crisis driven by financial innovation:

“1.Homogenous minimum collateral requirements – all participants in the Derivatives marketplace should be required to post capital based upon a formulaic determination of risk by the appropriate regulatory body. This would prevent firms from establishing systemically risky derivatives positions by attaching a marginal cost to the establishment of each new position, thus preventing the recurrence of an AIG‐type scenario where hundreds of billions of dollars in risk is assumed with no cost. To put the current situation into context, in 2000, the FDIC Banking
Review  (Volum13, No. 2) estimated the entire cost of the Savings & Loan Crisis to the US
taxpayer to be $124 billion.  By comparison, AIG alone has been given $183 billion in taxpayer
funds.

2.  Centralized clearing and mandatory price reporting of all standardized (non‐bespoke) CDS, FX,
and interest rate derivatives (according to DTCC, roughly 90% of all CDS contracts are
standardized and could easily be cleared in this manner).

3.  Centralized Data Repository for all cleared and non‐cleared derivatives trades, allowing the
appropriate regulator to monitor exposures by dealer and counterparty to monitor systemic
risk.”

Mr. Bass only briefly mentions TBTF, but his points are poignant nonetheless.  I don’t necessarily believe TBTF is the problem.  Instead, I believe we need to rein in risk taking.  1,000 small Enrons or one huge Enron – it all adds up to the same amount of corruption.

The most obvious point which Congress is still ignoring is with regards to the Volcker Rule.  Mr. Bass believes the risk taking entity of the bank should be separate from the deposit-taking portion of the bank:

“Deposit‐taking institutions should not be able to leverage and bet in the derivatives marketplace.”

I couldn’t agree more.  Deposit taking institutions play a vital role in the economy.  Commingling this portion of the business with the risk-taking portion of the business only increases the potential contagion caused by any financial crisis.  Bank runs don’t just become banks runs when leveraged derivatives balance sheets are involved.  They become systemic problems that spread like a virus and potentially destroy the entire economy.  This was evident in 2008 and should never be allowed to occur again.  And let’s not kid ourselves, firms like Goldman Sachs and many of the other large banks are nothing more than hedge funds or pseudo hedge funds.  Why many of these firms are even publicly traded is beyond me.  Why they are allowed to accept customer deposits is even more confounding.

The only way to prevent the kind of contagion that occurred in 2008 is to separate these entities.  I don’t care if JP Morgan wants to spin-off their hedge funds and prop trading desks into another business.  Just don’t risk the failure of the deposit taking side of your business because someone on your prop trading desk made a few bad decisions.  This should be a no-brainer as well, but remains a point of contention for obvious reasons – profits.  Mr. Bass elaborates:

“If we must accept that there are institutions that are TBTF then the moral hazard must be addressed
through regulation. The systemically important part of the institution should be separated or firewalled
from the part that engages in excessive risk taking. I have mentioned earlier that new leverage ratios
and standards should be applied to the banking system. These limits should be ironclad, universal and
completely transparent (that means no SIVs or other off balance sheet vehicles) for institutions touching
the retail consumer. The cost of being a systemically important depositary institution is to have
profitability regulated and limited to balance the benefit of an implicit guarantee.”

Mr. Bass even briefly touches on the flaws in our fractional reserve banking system and the inherent need for confidence in these deposit taking institutions:

“Fractional lending operates on confidence that any one institution will be able to satisfy any creditors
from day‐to‐day even though there is an acceptance that all possible creditors could not be satisfied at
any given time (the proverbial “run on the bank”). This gives depositary institutions a special role in
maintaining confidence in the financial system. If one fails, it may have a contagion effect on others,
which is why we have the FDIC and an insurance mechanism for deposits to ameliorate this risk. This
special role only enhances the reasons for tighter regulation of the operations and behavior of these firms. Retail banking has essentially become a public utility, and should be regulated as one – with the
limits as well as the associated guarantees.”

Like myself, Mr. Bass has no desire to destroy or ruin these banks. He simply believes the risk taking entity should be separated from the deposit taking entity:

“I do, however, believe that there is a role for leverage and for aggressive risk taking in the economy, but
that role should be played by firms that are open and susceptible to the risk of insolvency and failure.
Capitalism requires failure and bankruptcy as a consequence in order to guide behavior. As the old
adage goes – “Capitalism without bankruptcy is like Christianity without hell”. If we cannot allow a firm
to go bankrupt, then we should regulate its activities so that it cannot engage in the sort of risky
transactions that put it at risk of bankruptcy. To be clear, we should not prevent all firms from taking on
leverage or engaging in risky behavior; we must ensure that they are not allowed to become TBTF.”

Of course, there are much bigger issues at hand including the role of the ratings agencies, various accounting shenanigans, executive compensation, etc, but it’s important that we put aside our politics for once and do what’s right for Main Street.

My goal here is not to put some political twist on things.  My only goal is to try to provide some perspective with regards to what we have done to get ourselves into this mess and what we should be doing to dig ourselves out of it and ensure that this never happens to ourselves or our children.  In the end, we all just want the economy to serve the public in a way that does not continue this endless rollercoaster we appear to have jumped on over the last 25 years.  Harsh financial regulatory reform is a good first step.  I could care less about the fact that this bill might help one party more than another. What I care about is promoting an economy that is more stabilized and helps each and every American achieve their goals. It’s time to ignore the politics here and begin focusing on the best way to help Main Street – even if it hurts Wall Street.