Regulatory Reform: The Political Calculus

Sep.17.09 | About: SPDR S&P (SPY)

Obama's address to Wall Street was poorly received – a smattering of applause for the announcement of the CFPA, but otherwise a deafening silence, followed afterward by commentary that sees little probability of meaningful reform of financial regulation. Most denizens of Wall Street have missed the point. It is useful to go back over the speech, reading between the lines, and drawing information as to the solutions that will be legislated from the analysis presented as to the fundamental causes of the turmoil.

What Wall Street fails to comprehend is the anger of those who are impoverished by the ongoing transfer of wealth created by our political and financial system. When this anger is directed at President Obama because of his advocacy of health care reform, which seems to inevitably result in a transfer of wealth, they easily grasp that reform as the President envisions it is not politically feasible. From that they erroneously conclude that the he is politically powerless.

However, that same anger is likewise directed at those on Wall Street who have received massive taxpayer subsidies to prevent their fraudulent and abusive practices from destroying the economy in a financial crisis of unparalleled severity. They find it too easy to view the middle class as peasants with pitchforks, Luddites with hammers, populists, unsophisticated folk with a limited grasp of economic reality.

The economic reality is not that difficult to grasp: a government that is faced with the collapse of its major financial institutions has no recourse but to guarantee their obligations and to sustain those guarantees until the currency collapses. Because the US dollar is the world's reserve currency, it is unlikely to collapse. But China and others have broached the possibility of an alternative.

When the President said: “...hear my words: we will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis..,” he was simply relying on the political power created by the anger of those impoverished by Wall Street malfeasance. This has the same authority as the elder Bush's comment, “read my lips, no new taxes.” Bush was empowered by the citizens' unwillingness to pay new taxes. Obama is similarly empowered by the unwillingness of the victims to further subsidize Wall Street's excesses. There is a large group in Manhattan who just don't understand the politics of rage: they do not grasp the emotional states of those whose lifetime savings have been savaged by their wrongdoing, nor do they grasp the possibility of retribution, or of reparations.

From these considerations grows the statement: “The reforms I've laid out will pass and these changes will become law.” This has the ring of what my business colleagues in the insurance industry used to call a “facts of life discussion,” where those who don't understand the balance of power in a situation are disabused of their misconceptions.

Now it is not necessary to read between the lines to learn that there are those on Wall Street who have resisted reform, at their peril. But we can deduce how this has developed, and from there conjecture how it will play out. Obama's style is consultative, and in point of fact regulation in the financial industry has always proceeded by means of consultations, as if regulation required the consent of the regulated.

Tim Geithner, who has provided terrific leadership, who is a native of the environment, talks the talk and walks the walk, was sent to seek input and ideas from industry leaders, and received information that the present system was not broke and there was no need to fix it. There were those who elected to misinterpret forms of politeness as a sign of weakness, to confuse an order, or an offer too good to resist, with a request that could be safely disregarded, fluffed off with specious arguments about innovation.

I am one of Tim Geithner's supporters, rightly looking past the “deer in the headlights, no details” presentation to see that his plan to restore confidence in the banking system would work, and conducting my investments accordingly. But I suspect that he will be replaced with someone more forceful and less sympathetic to Wall Street views.

One of the trump cards of the excessive risk takers has been global regulatory arbitrage – the threat of taking their innovative practices elsewhere where they would be more welcome, taking advantage of the race to the bottom. Obama, in addition to denying them further choice of regulators domestically, is going to be pushing for stronger regulation globally. It is entirely possible that the leaders of other countries are aware of the role that lax regulation played in creating the crisis. Certainly they are aware of the US problems of that nature. Their financial systems are loaded with our toxic assets.

The solution to many problems is inherent in the causes and explanations for the problem that are presented by those responsible for corrective action.

Among the causes of the meltdown, according to Obama: “We've seen the development of financial instruments, like derivatives and credit default swaps, without anyone examining the risks or regulating all of the players.” Presented that way, the solution is pretty easy, someone will examine the risks of financial instruments as they are developed and someone will regulate all the players. Since CDS were developed without anyone examining the risks, corrective action is, someone is going to examine those risks soon.

I don't think it was a coincidence that Blankfein felt a need to discuss the idea that not all of Wall Street's innovations have any social utility. Goldman Sachs, perhaps by reason of anti-semitism, or perhaps by being the main winner of the meltdown, has become a target for the anger of those who have suffered economic losses in the course of the debacle. Aware of his firm's unpopularity and consequent vulnerability, he is positioning himself ahead of the solution, which is that financial products will need to have social utility. They have to be good for those who work, save and invest.

Another problem: “Those who refuse to game the system are at a disadvantage.” The President of the United States journeys to Wall Street to inform them what they already knew, they have been gaming the system to where anyone who plays by the rules can't turn a profit. Again, the problem defines the solution, those who game the system are going to find themselves at a disadvantage, spending time in the penalty box, suspended for a few games, or banned for life.

Finally the solution is accountability and responsibility. No one has accepted or claimed any responsibility for the whole chain of wretched excess that started with those who borrowed what they could not repay, with no intention of paying, and extending on up the feeding chain until the buck stopped with the US government, who passed it on down to the taxpayer.

Ultimately, the riches of our country and our society are perceived as existing independent of the thrift, industry and entrepreneurship that created them. They are a bountiful resource, free for all to game the system and take as much as they can while contributing as little as they can. The welfare cheat and the investment banker are alike in that both game the system. An entire society will have to relearn responsibility and accountability.

And those who can't learn these values will be given dunce's caps and training wheels, as much regulation as it takes to solve their problems. From there it will progress to perp walks and hard time. We don't really have a choice. The Chinese and the Europeans can establish a reserve currency that is not the US dollar.

Once that happens, if the US has too much debt, whether it is on household, corporate, or government balance sheets, they can call in our debt, denominated in the new reserve currency, and the US can either repay or suffer the collapse of the currency, the economy, and the demise of our mighty masters of finance.

Must the US persist in being a nation of fools, who borrow and cannot repay? There is a better way – stop gaming the system, make the financial system serve the real economy, and require all our citizens to take responsibility for their actions.

Investment Implications

Wall Street will become quite a bit safer for the retail investor than it has been for the past 20 years. Financial instruments will serve the interests of society, to a greater extent than they do now. Once this becomes clear, confidence will be restored, resulting in a market that will more fully reflect the earnings potential of the nation's businesses. S&P 1,200.

Disclosure: Citizen of USA