Obama's Financial Proposal: Why It's Too Soon for Reforms 10 comments
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If you listen to the criticism from the right and from the left, from pro-regulation and anti-regulation pundits, you can understand the political constraints which produced the white paper which the President unveiled yesterday. Given those constraints, I consider the white paper a good effort.
My initial reaction, therefore, was largely positive. However, upon further reflection, it is clear this is a political document more than a regulatory one. The white paper is a govern by consensus product about which I have grave reservations. There is much to like about the white paper, but also much to question. As a result, I see no need to rush ahead and enact sweeping legislation and reform before the full measure of the financial crisis has been felt and the implications of regulatory lapses is known.
Propaganda campaign is coming
An orchestrated media blitz is now under way. We have Summers and Geithner’s Op-Ed in the Washington Post Monday. Christina Romer on Bloomberg today. The President giving his speech, Austan Goolsbee was on CNBC talking this thing up and Sheila Bair released a statement of support. Obama’s whole financial team is out making the rounds in support of this legislation.
How are people reacting to the plan? Banks seem happy. Arthur Levitt, a consultant to Carlyle and Goldman Sachs (GS), is happy. Ron Paul and most economists – not so much – but for very different reasons. This should tell you that the legislation is fairly bank-friendly. But the unhappy parties make clear that there are political constraints.
There is no need to rush
During the Great Depression, most of the important pieces of legislation were enacted after the economy had already bottomed. The economy started down in 1929, bottoming in 1933. The reforms were enacted starting in 1933. The Glass-Steagall Act of 1933 was the comprehensive piece of regulation reform. It also established the FDIC. The Securities Exchange Act establishing the SEC was enacted in 1934. Fannie Mae (FNM) was founded even later in 1938.
Today, the knock-on effects of the financial crisis are still being felt. Just yesterday, California was rejected in its request for a U.S. government bailout. Today, the large U.S. retailer Eddie Bauer (EBHI) was declared bankrupt. The market for municipal bonds is still impaired because of municipalities deteriorating financial condition. Credit Card delinquencies are hitting a record high. These are just a few of the many events which make clear that we are still in the midst of some horrific economic turmoil. Enacting sweeping legislation in that environment would be tragically premature.
Having said that upfront, I am going to run through some of the more important bits in the white paper with you.
What’s wrong with this proposal
1. Financial Services Oversight Council. This is the new day-to-day super-regulator. Really it is more of a gathering of regulators to hash out turf wars and coordinate policy. I am hearing that this structure was implemented because there was a lot of pushback from lawmakers about abolishing regulatory agencies and consolidating power in the hands of the Federal Reserve. The Treasury leads this council, putting an unelected official in the executive branch in control of the most powerful day-to-day regulatory structure. I do not like this at all. Better would be an oversight council headed by an official appointed by members of Congress so that more elected officials have a role in those decisions.
2. Tier 1 FHCs. (Tier 1 Financial Holding Companies) This is the designation used for too big to fail financial institutions like JPMorgan Chase (JPM) and Citigroup (C). Under the proposed regulations, there will be a penalty for being too big to fail: these organizations must have more capital and are subject to more oversight than other companies. This is great in theory. However, in practice, right now it will mean less lending – one reason there is no need to rush to institute reforms prematurely. In fact, just today a number of Tier 1 FHCs repaid $68 billion in TARP money, i.e. they reduced their capital base by $68 billion. Higher capital requirements/less capital equal less lending.
3. Systemic Risk Regulator. (SiRR) As expected, the Federal Reserve is going to be the SiRR. This is the same organization that brought us 1% rates in 2003 and 0% rates this year. The Federal Reserve is also the same institution which refused to crack down on loose lending standards during the height of the housing bubble. Under no circumstances should the Federal Reserve’s lapses be rewarded with the role as the SiRR.
4. Executive Compensation. As far as I am aware, there is nothing to restrict executive compensation in the financial services sector in this proposal. And if you haven’t heard already, mega-bonuses are already making a comeback. Clearly this is an area that must be addressed in any reform package. You cannot get the right behaviors if you do not align incentives to those behaviors.
5. OTC Derivatives. Larry Summers was not a big fan of regulation on this score when he was in the Clinton Administration. This time, the proposal suggests ‘clearinghouses’ for these derivatives. What does ‘clearinghouse’ mean? To me, it doesn’t mean anything. George Soros wants to ban OTC derivatives outright like CDS contracts. At a minimum, we need to see these contracts traded on exchanges like the CME or CBOE in standardized forms with adequate collateral from counterparties. Forget about ‘clearinghouses.’
6. Office of National Insurance. While I like the fact that we are seeing a move to comprehensive regulation of insurance instead of the present state-by-state system, this proposal should be a non-starter because, yet again, the power lies at Treasury. Why is Treasury a good place for an Office of National Insurance other than the desire to increase power in the executive branch? Moreover, this does not remove the balkanized regulatory framework in insurance. I see this as an inadequate half-measure.
What’s 50-50
1. Determine Future role of Frannie Mac. This is a complete punt. There is no information here. It’s probably for the best as it is too early to make a call one way or another.
2. Enhance International Coordination. This is another punt. At least, we see an effort in the right direction. In my view, this will be an important area to flesh out with other regulators as the world of finance is global and global regulatory controls are needed.
3. Consumer Finance Protection Agency. The proof here is in the pudding. But, clearly abuses in the last decade were extreme. How this agency works in concert with other regulators is unclear. As they have zero authority as the bank regulator, I do not think putting them in a separate agency is going to work.
4. Credit Rating Agencies. There is a proposal to tighten oversight over the rating agencies in this white paper. This proposal has no meat on the bones so the devil will be in the details.
What’s right with this proposal
1. Hedge funds. Hedge funds and other large pools of capital must now be regulated under this proposal. In all likelihood, the proposed changes will end the shadow banking system as we know it, with hedge funds being completely outside the regulatory structure.
2. Money Market Funds. The SEC is going to strengthen the rules around MMFs in order to prevent runs and to mandate MMFs always have access to emergency liquidity facilities.
Conclusion
As you can see from the number of items in each category, there is probably more to dislike than to like. I do think this is a good effort but it is not nearly concrete enough to be the basis for legislation. Moreover, it is much to soon to start making comprehensive reforms. We are still in crisis mode. On the whole, it would be a deep disappointment to see any legislation resulting from this white paper, particularly now as we are in crisis. However, by this time next year, things should be clearer and having this white paper in hand will be to everyone’s benefit.
One last thought: Barack Obama does a very good job of striking the right tone and saying the right things, but I am suspicious about his commitment to true reform. This document is not the product of someone who wants reform, but of someone looking to strike a middle ground in a political game.
Below is the audio of comments I made regarding the ‘political nature’ of the agenda on BBC Radio Five Live. The clip also talks about how this is likely to affect Alistair Darling and Labour’s need to reform in the U.K.
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Our overpaid leaders think their mandate is more of the same. We need some serious game-changing elections if the middle class is to survive in America.
What’s odd about the white paper is the inference that all of the misbehavior took place in the private sector. No mention is made of government policies that contributed; too much weight is attached to populist objectives and too little attention is paid to, for example, HUD leaning on the GSE's to expand lending to lower income groups to broaden the base of home ownership.
Nor is space, much less sufficient, given to the failures of The Office of Federal Housing Enterprise Oversight which has responsibility for oversight of the GSE’s. In 2006 there were accounting scandals in both firms and at the root of both scandals were overstatement of earnings to permit large bonuses to be paid to executives. Subsequently the heads of both firms resigned and the firms paid large fines.
Nor was mention made of the inherent and egregious conflicts arising from campaign contributions made by Freddie to Barney Frank, who was having an affair with a Freddie executive and who chairs the House Banking Committee which shares oversight of the GSE’s with FHEO. How can responsible oversight be exercised in this climate and what will be done to address it?
Instead, the story is one of government that needed a better regulatory structure and more powers. The Fed, which already has considerable powers to reign in poor lending practices, failed previously and now to be vested with responsibility for oversight of systemic risk raises the obvious question why should it be better now than then?
Systemic risk just isn’t nearly as easy to spot as it sounds in these discussions of a systemic risk regulator. We’re now aware of the scale of CDS issues and systemic risk linkage but the problem with financial markets is that the pace of innovation always outstrips our ability to understand the consequences.
With respect to Tier 1 BHC's having to have more capital, I would argue the sooner the better. I do not believe the outcomes of the stress tests and believe these firms are saddled with more toxic assets than we are led to believe and, more seriously, will not produced anywhere near the earnings forecasted during the stress tests. I would opt to lower their lending than to place them in a position of having to return to the federal money trough after becoming insolvent.
There were some good points, particularly about too big to fail and over-the-counter derivatives trading. But most of the good ideas are presented vaguely, and are surrounded by bad ideas and huge omissions.
This was generally a pretty good article, but you're off on this one. The Exchanges (CME, CBOE, et al) would use clearinghouses to stand behind every CDS transaction. In order to do that the clearinghouse would oversee capital requirements and require standardized forms and daily mark-to-market. The clearinghouse ensures the proper conduct of delivery procedures and the adequate financing of the entire transaction. There has never been a failure of a financial clearhouse. If CDS transactions had been done through a clearinghouse, AIGs Financial Products Group would have made a lot less money during its salad years, but it would also have eliminated the AIG bailout fiasco.
"Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government."
Therefore, I suspect the word clearinghouse is used to connote a watered-down structure without all of the regulatory oversight and standardization mechanisms an exchange like the CME provides. I would prefer to see language that makes it explicit that we are talking about exchange-traded contracts for all CDS transactions. That's why I point out clearinghouse. If it was explicitly stated as a robust mechanism, I would be fine with the term clearinghouse but Geithner is on the recordas wanting exceptions.
On Jun 18 03:29 PM Kinabalu wrote:
> "What does ‘clearinghouse’ mean? To me, it doesn’t mean anything"
>
>
> This was generally a pretty good article, but you're off on this
> one. The Exchanges (CME, CBOE, et al) would use clearinghouses to
> stand behind every CDS transaction. In order to do that the clearinghouse
> would oversee capital requirements and require standardized forms
> and daily mark-to-market. The clearinghouse ensures the proper conduct
> of delivery procedures and the adequate financing of the entire transaction.
> There has never been a failure of a financial clearhouse. If CDS
> transactions had been done through a clearinghouse, AIGs Financial
> Products Group would have made a lot less money during its salad
> years, but it would also have eliminated the AIG bailout fiasco.
I personally will not invest as I did unless things change in Wall Street. We need more oversight and more accountability. Too much fraud. I am happy stashing my cash away, buying land and gold.
This is just the groundwork in the making. Next will be structures to be built into this foundation in the years and decades ahead. Since this is a discovery process, nothing is guaranteed, but at least there is hope of a better stock markets environment in the future.
Unlike in years leading to year 2000 of internet and technology bubble; investors had no guidelines when to sell and when to hold. They sold so the markets went down with no downside target until 9/11 happened and the US rose to the occasion thus the 2002 to 2007 rally was made possible.
That rally was short-lived, since smart investors did know that there were systemic risks to an economy based on profligate living while the baseline support of manufacturing and technology industries were being eroded and being handed to China, India and other developing countries. Thus when the profit taking took hold, there was no downside target and nothing to stop the panic selling until all sellers have exhausted themselves last March 2009 and we have this "healthy" bounce off the March low.
What I can digest out of this government effort is that they are now taking concrete and direct pro-active actions to prevent panics in the economy from setting in as what happened during the 2000 to 2002 and second time around on 2007 to 2009. The Fed had been pretty useless during those times with investors not heeding their advise that the economy was fine but were only suffering some "hiccups" and would need some "fine-tunings". Smart investors simply have to do what they have to do = protect their profits. So they took their money off the table and run until the dust settled.
In the future, with the government having a direct hand in managing the economy, albeit more on the psychological side rather than the day-to-day operations of the economic industries; investors will be looking more for government guidance rather than depending on their own analysis and instincs on when to buy and when to sell. The banks sector will become the government's lieutenants overlooking the other industries such as retail, insurance, computers, software, biotech, real estate, etc. Treasury and the Fed are the generals.
Thus, many investors who would not listen to the "new empowered" Fed and the Consumer Protection Team will find that their usual practice of taking profits while the going is good will miss out on a seemingly endless rallies with minor sell-offs or "fine-tunings" for decades to come assuming that this initiative works.
Since there is no bigger hand to guide the economy than the government, investors would be better off joining the "fun" rather than use their own judgement as in the past.
The severe panic selling of 2000 to 2002 and 2007 to 2009 have given the government experts the necessary insight into how the government actions during and after the Great Depression failed to provide a long-lasting or rather a sustainable economic progression without the destructive process of bursting the inevitable bubbles that an economic progress do entail. Bursting of the bubble(s) in one or several sectors lead to almost total collapse of the whole system instead of just restricting the fall-out damage to those sectors that had been responsible for the bubble.
As far as the stock markets are concerned; it was a Wild West out there in the past 200 years or so.
With government "firmer" guidance, it may be possible to restrict the damage to the economy to those sectors that have gone "bubbly" rather than taking the whole economy down.
Meanwhile, while this government initiative is not yet in place and still untested, the stock market may still try to do the final cleansing process in the next 6 to 9 months.
I am hedging my investments at these SNP levels just in case the final cleansing process do happen. If it does not, there will be lots of opportunities in the years and decades ahead to add more positions into this "21st century" investment opportunity. We may call the 21st century the "Global Stock Markets" era if the government succeeds in reigning in the wild west of the past.
There is nothing like buying at the lows albeit the inherent risks involved. I am glad this "wild west" of a global stock market phenomena of the 20th century has the potential to come into an end with a regulated stock markets. A sheriff is now being appointed to do the initial tasks. Free market proponents will not be happy with this but a more or less predictable market is better than a completely unpredictable market.
You don't want to go shopping in supermarket hoping that there is no time bomb that might explode any time you are inside the market, do you? That was/is the stock markets of the past and of the present. Investors never had a peace of mind that their hard earned cash will be more or less safe with the stock markets. Everybody will have to watch out for themselves since the next guy might just drop a bomb that will evaporate most if not all of his/her investments.
Watch out for other countries to follow the US lead specially Europe, Japan and China. If they follow, the US initiative will have a better chance of becoming highly successful in it’s early stage.
On Jun 18 12:33 PM CautiousInvestor wrote:
> The author does a nice job of communicating his first impressions
> of this lengthly white paper to reform our financial industry. I
> am still digesting the document but find it, intellectually, a very
> disappointing piece of work. But given political considerations,
> I cannot say that I am surprised.
>
> What’s odd about the white paper is the inference that all of the
> misbehavior took place in the private sector. No mention is made
> of government policies that contributed; too much weight is attached
> to populist objectives and too little attention is paid to, for example,
> HUD leaning on the GSE's to expand lending to lower income groups
> to broaden the base of home ownership.
>
> Nor is space, much less sufficient, given to the failures of The
> Office of Federal Housing Enterprise Oversight which has responsibility
> for oversight of the GSE’s. In 2006 there were accounting scandals
> in both firms and at the root of both scandals were overstatement
> of earnings to permit large bonuses to be paid to executives. Subsequently
> the heads of both firms resigned and the firms paid large fines.
>
>
> Nor was mention made of the inherent and egregious conflicts arising
> from campaign contributions made by Freddie to Barney Frank, who
> was having an affair with a Freddie executive and who chairs the
> House Banking Committee which shares oversight of the GSE’s with
> FHEO. How can responsible oversight be exercised in this climate
> and what will be done to address it?
>
> Instead, the story is one of government that needed a better regulatory
> structure and more powers. The Fed, which already has considerable
> powers to reign in poor lending practices, failed previously and
> now to be vested with responsibility for oversight of systemic risk
> raises the obvious question why should it be better now than then?
>
>
> Systemic risk just isn’t nearly as easy to spot as it sounds in these
> discussions of a systemic risk regulator. We’re now aware of the
> scale of CDS issues and systemic risk linkage but the problem with
> financial markets is that the pace of innovation always outstrips
> our ability to understand the consequences.
>
> With respect to Tier 1 BHC's having to have more capital, I would
> argue the sooner the better. I do not believe the outcomes of the
> stress tests and believe these firms are saddled with more toxic
> assets than we are led to believe and, more seriously, will not produced
> anywhere near the earnings forecasted during the stress tests. I
> would opt to lower their lending than to place them in a position
> of having to return to the federal money trough after becoming insolvent.
>
>
> There were some good points, particularly about too big to fail and
> over-the-counter derivatives trading. But most of the good ideas
> are presented vaguely, and are surrounded by bad ideas and huge omissions.