The Roadblocks to Financial Reform

Includes: BAC, BRK.A, BRK.B, C, GS, JPM, MCO, WFC
by: Zacks Investment Research

By Dirk van Dijk

It is now the end of April, 2010. That is more than two years after the collapse of Bear Stearns (which was eventually taken over by JPMorgan Chase (NYSE:JPM) with substantial assistance from the Fed) and more than a year and a half since the fall of the House of Lehman Brothers nearly sank the entire world economy. However, apparently, things are being “rushed” in forming a legislative response to make sure that we don’t have to go through this all over again.

Wall Street is spending more than $1 million a day to lobby Congress to make sure that whatever passes has no real teeth. Frankly, they like a system where in the good times, they win and win very big, and when it all blows up, the taxpayer picks up the tab. They know that they are about as popular right now as a piranha in a swimming pool. So their best bet is to delay, delay and then try to delay some more. They are betting on the short attention span and even shorter memories of the public.

Financial reform -- real reform -- took a significant hit last night when 41 Senators decided that the subject was not even worthy of bringing to the floor of the Senate for debate. Of particular significance is that Senator Ben Nelson (D-NE) voted to prevent debate, joining all members of the GOP. Majority leader Harry Reid (D-NV) switched his vote to nay at the last minute in a procedural move that will make it more easy for him to call for another vote later this week.

Flaws in the Proposed Bill

The Dodd bill is far from perfect. However, its flaws are not that it is too stringent on Wall Street but that it is not stringent enough. That is not the direction that the opposition is pushing.

One of the key flaws is that it does very little to constrain six of the biggest banks in the country. Collectively, the assets of the six major banks in the country amount to more than 60% of GDP, and banking assets are much more concentrated than before the crisis started. That is because during the worst of the crisis, the regulators had to turn to some of the stronger institutions to help save some of the ones that were in most trouble.

A crisis that caused Wall Street banks to be bailed out because they were "too big to fail" resulted in JPMorgan swallowing Bear Stearns -- along with the biggest savings and loan in the country, Washington Mutual. It also resulted in Bank of America (NYSE:BAC) owning Merrill Lynch and Wells Fargo (NYSE:WFC) owning Wachovia. Not exactly the best outcome, but in the heat of the moment, there was nowhere else to turn.

There is an amendment to the bill being proposed, the Kaufman Brown amendment, that would address this problem. However, the forces that are blocking the Dodd bill from even being debated and amended are even more opposed to the Kaufman Brown amendment than they are to the underlying Dodd bill.

The Way the Bill Would Work

If we want to end taxpayer bailouts of "too big to fail" banks (and just as importantly shadow banks), we need to make sure that conditions don’t arise in the future where they need to be bailed out, and that if they do, there is an orderly way to go about it. This sort of procedure already exists for smaller banks, and it works well. It is called the FDIC.

It is not bankruptcy, since bankruptcy procedures are far too slow to deal with institutions that need constant access to liquidity. However, the economic effect is generally similar to that of a bankruptcy: the shareholders get wiped out, and often unsecured creditors, at least those that do not fall under the FCIC insurance umbrella (depositors), generally have to take a haircut.

The Dodd bill proposes something similar for the biggest financial institutions. It proposes a $50 billion fund, raised from fees on the big banks themselves (just as the FDIC is funded from assessments on all banks) that would be available to provide the liquidity needed to wind down the mega institutions should the need arise.

I would argue that the size of the fund is way too small, and that the version in the bill the House passed last year, $150 billion is more like it. If the fund is depleted or the need for liquidity is greater than that, it can borrow from the Treasury. In the absence of the fund, the borrowing would be from the first dollar, not the $50,000,000,0001st dollar. I would hope that the ultimate size is closer to that of the House version than the Senate version. However, to suggest that the existence of a fund will make taxpayer bailouts more likely is at best disingenuous.

The Dodd bill will also force all standardized derivatives to be traded on exchanges, the way that equity options and futures, which are derivatives, are currently traded. This would greatly increase transparency, and would greatly reduce counterparty risk.

The problem is that the bill leaves open too many ways for Wall Street to get around this by making the derivatives customized. Trading in customized derivatives is far more profitable for the Street (and much less profitable for the customers) than is trading in standardized derivatives.

Before the vote yesterday, one of the more egregious carve-outs -- one which would grandfather existing derivatives from trading on exchanges, or the institutions holding them having to post collateral -- was eliminated. In other words, there was some (but not quite enough) progress in the right direction in the derivatives portion of the bill. Not so coincidentally, the biggest winner if that carve-out were allowed to become law would have been Berkshire Hathaway (NYSE:BRK.A), which, incidentally, is by far the largest firm headquartered in Senator Nelson’s state.

There are some other areas that the Dodd bill is weak on. It does little to change the structure of the bond ratings agencies, or their incentives. The current system is that the issuer of the bond pays the rating agency, and also gets to pick which agency rates the bond. This creates a huge incentive on the part of the ratings agency like Moody’s (NYSE:MCO) to give favorable ratings to bonds from issuers which are likely to have lots of bonds to rate in the future. Surprise surprise, then, that S&P and Moody’s handed out AAA ratings as freely as people pass out candy on Halloween.

The bill should be amended to fix this problem, or it should be addressed in separate legislation in the near future. However, to prevent the bill from even coming to the floor so it can't be debated and amended is not serving the interests of the country, it is simply serving the interests of the largest players on Wall Street. Delay will only result in the bill being watered down, not strengthened, and that could be worse than even having no financial reform at all since it could lead to a false sense of security.

However, if no reform is passed, we WILL have another financial meltdown, not this month or even this year, but most likely within the decade. I’m sure it will be met with pleas that no one could have seen it coming, just like the crisis we just went through had been.