Regulation vs. Retribution
The United States Congress, at the urging of our President, is in the midst of passing a “comprehensive” package of financial reforms in response to the recent financial crisis. Both the Executive Branch and Congressional Majority leaders have specifically stated that these tough regulations should be enacted, bipartisanship be damned. Democratic leaders sense a window of opportunity to play upon public anger and fear in order to roll back the clock on Wall Street and the financial innovations of the past 30 years. The problem is, however, that lost in the discussion is an honest accounting of who and what precipitated the financial crisis, the underlying motivations for the proposed regulations and a reasoned analysis of the structure of Wall Street by people who actually know what they are talking about. And because of this opacity and dishonesty, the desire to leverage populist rhetoric into votes and a fundamental lack of understanding of how Wall Street and capital formation works, we will likely get a package of regulations that will hurt the US and the global economy fall more than they will help. And this would be a shame, because it will reflect the loss of a golden opportunity to do something truly positive.
The financial crisis was merely the tail-end of a daisy-chain of events seeded by two policy disasters: (1) the Greenspan-led credit bubble; and (2) Congressional approval of a multi-trillion dollar expansion of Fannie Mae and Freddie Mac’s balance sheets (GSEs) and the resulting diminution of underwriting standards. This was neither caused by CDOs and other derivative securities nor the existence of Wall Street proprietary trading desks. As all manner of entities lined up to take advantage of the Federal Reserve’s and Congress’s largess - mortgage brokers, borrowers, banks, structured finance operations, derivatives desks and rating agencies - fraud, deceit and poor risk management emerged in its wake. A breakdown of conduct on this scale and associated conflicts-of-interest were enabled by poor rules and regulations as promulgated by the Financial Accounting Standard Board (FASB), the SEC and Congress. I would posit that this was due to a lack of understanding of the forces at work coupled with the influence of lobbyists, greed and self-interest. Nobody looks good coming out of the crisis and hundreds of billions of dollars were lost, so in our media and PR-driven society somebody has to pay - now. But the last thing Congress and the President should be doing is agitating for change without truly understanding its impacts, and focusing on payback instead of fundamentally reforming elements of the system that are truly broken. I am deeply concerned that this is exactly what they are doing.
Given the severe flaws in macroeconomic policy underpinning the crisis, the outcome was not surprising. But as we look at th subsequent chain of events what might have dampened the magnitude of the crisis? I see four core principles that, if they had been in place prior to the crisis, could have materially altered the outcome: (1) financial markets transparency; (2) enhanced accounting disclosures; (3) clear and punitive rules against conflicts-of-interest and (4) elimination of the US Government as a perceived back-stop for creditors.
Transparency should be the cornerstone of any discussion around legislation. Proposals agitating for banks to shut down or spin-off their swap operations are nonsensical and destructive. When used properly and with adequate collateral to handle changes in mark-to-market value, they are powerful tools for risk management and speculation to support efficient, two-sided markets. Moving the lion’s share of over-the-counter derivatives volume to exchanges will substantially enhance the transparency around market pricing, how derivatives desks make money and reduce risk of inadequate capital provision. Accounting disclosures have recently been tightened to better address off-balance sheet exposures, but still fall woefully short in areas such as fair value accounting. Conflicts-of-interest are still embedded in many aspects of our system; it is incomprehensible that rating agencies still retain their position considering their pivotal role in the credit markets crisis. Not smart enough to understand the possible impacts of highly structured instruments? Then they shouldn’t slap on a rating. The excuses provided for their miserable performance are divorced from reality: they were greedy, and they did what they had to in order to maximize short-term profits. Case closed. Open-sourcing credit ratings is likely the right avenue for dealing with this particular conflict, but many other conflicts remain. And until the US Government is no longer perceived as 100% certain to bail out the creditors of complex financial institutions, we will see a repeat of 2008 again and again. Could the answer be a tax based upon the complexity, scale and risk of a bank’s operations, rather than an open checkbook provided by the US taxpayer? Perhaps, provided that such rules were applied globally and in conjunction with regulators of the other major financial centers. This would also help address the “Too Big To Fail” issue, as super-sized institutions would pay out-sized taxes because of the risk they pose to the global financial system. But one thing is certain: without elimination of the implicit US Government guarantee, private and public/private (GSEs) institutions will revisit the sins of the past decade without adopting fundamental change.
I penned a little-read post back in November 2007 where I touched on certain of these issues; my fundamental views have not changed much over the past two and a half years. It is almost as if the aftermath of the crisis has turned into a soap opera; painfully slow-moving and not particularly entertaining. And the way things are looking, the outcome might be of similar quality to what is being served on daytime TV.
