What Financial Reform Means to You

Consumer advocates and the media start criticizing the "Dodd-Frank Wall Street Reform and Consumer Protection Act"

Financial Regulation Makes a Mountain of Legislative Paper from a Molehill of Reform

By Robert Reich, Business Insider, 7/16/2010  
http://www.businessinsider.com/finreg-is-a-mountain-of-legislative-paper-a-molehill-of-reform-2010-7

Thursday the President pronounced that “because of this [financial reform] bill the American people will never again be asked to foot the bill for Wall Street’s mistakes.”

As if to prove him wrong, Goldman Sachs simultaneously announced it had struck a deal with federal prosecutors to pay $550 million to settle federal claims it misled investor — a sum representing a mere 15 days profit for the firm based on its 2009 earnings. Goldman’s share price immediately jumped 4.3 percent, and the Street proclaimed its chair and CEO, Lloyd (“Goldman is doing God’s work”) Blankfein, a winner. Financial analysts rushed to affirm a glowing outlook for Goldman stock.
[See link: Goldman Sachs settles Fraud suit with small SEC fine amounting to a few days' revenue.] 

Blankfein, you may recall, was at the meeting in late 2008 when Tim Geithner and Hank Paulson decided to bail out AIG, and thereby deliver through AIG a $13 billion no-strings-attached taxpayer windfall to Goldman. In a world where money is the measure of everything, Blankfein’s power and influence have grown. Presumably, Goldman can expect more windfalls in future years.

Although the financial reform bill may have clipped some of Goldman’s wings — its lucrative derivative business may require Goldman to jettison its status as a bank holding company, and the access to the Fed discount window that comes with it — the main point is that the Goldman settlement reveals everything that’s weakest about the financial reform bill.

The American people will continue to have to foot the bill for the mistakes of Wall Street’s biggest banks because the legislation does nothing to diminish the economic and political power of these giants. It does not cap their size. It does not resurrect the Glass-Steagall Act that once separated commercial (normal) banking from investment (casino) banking. It does not even link the pay of their traders and top executives to long-term performance. In other words, it does nothing to change their basic structure. And for this reason, it gives them an implicit federal insurance policy against failure unavailable to smaller banks — thereby adding to their economic and political power in the future. 

The bill contains hortatory language but is precariously weak in the details. The so-called Volcker Rule has been watered down and delayed. Blanche Lincoln’s important proposal that derivatives be traded in separate entities which aren’t subsidized by commercial deposits has been shrunk and compromised. Customized derivates can remain underground. The consumer protection agency has been lodged in the Fed, whose own consumer division failed miserably to protect consumers last time around.

On every important issue the legislation merely passes on to regulators decisions about how to oversee the big banks and treat them if they’re behaving badly. But if history proves one lesson it’s that regulators won’t and can’t. They don’t have the resources. They don’t have the knowledge. They are staffed by people in their 30s and 40s who are paid a small fraction of what the lawyers working for the banks are paid. Many want and expect better-paying jobs on Wall Street after they leave government, and so are shrink-wrapped in a basic conflict of interest. And the big banks’ lawyers and accountants can run circles around them by threatening protracted litigation.

Why do you think Goldman got off so easily from such serious charges of fraud?

Reliance on the discretion of regulators rather than structural changes in the banking system plays directly into the hands of the big banks and their executives and traders who contribute mightily to Democratic and Republican campaigns. The flow of money virtually guarantees that regulatory agencies won’t be adequately staffed to enforce the law, that penalties for violations won’t be overly onerous, and that all loopholes (what’s a “derivative”? what has to be listed on exchanges? exactly how much capital must be on hand for which transactions? How are the various forms of predatory lending to be defined?) will be easily stretched in future years. Wall Street lawyers will have a field day. The profit-for-nothing sector of the economy (law, accounting, finance) will continue to grow buoyantly. 

Make no mistake: As long as there’s no fundamental change in the structure of Wall Street — as long as the big banks stay as big and are allowed to grow bigger, and have every incentive to invent new financial gimmicks with which to bet other peoples’ money — they will remain too big to fail, and too politically powerful to control. 

Goldman’s share price, as well as those of JP Morgan Chase, Citicorps, Morgan Stanley, and Bank of America, will no doubt soar on the basis of the final bill because their future profits are almost guaranteed. The pay of their executives and traders, and of the managers of hedge funds and private-equity funds they deal with, will likewise accelerate. In the short term the economy will benefit, at least to the extent financial entrepreneurship is now the apex of American wealth and innovation. But over the longer term we will be much weaker for it. 

Congress has labored mightily to produce a mountain of legislation that can be called financial reform, but it has produced a molehill relative to the wreckage Wall Street wreaked upon the nation.

Five Problems Financial Reform Doesn’t Fix

The legislation focuses on helping regulators detect and defuse the next crisis. But it doesn't address many of the underlying conditions that can cause problems.

By Ezra Klein, Newsweek, 7/15/2010
http://www.newsweek.com/2010/07/15/five-problems-financial-reform-doesn-t-fix.html

“We would have loved to have something like this for Lehman Brothers," said Hank Paulson with a sigh, in a recent New York Times story. "There’s no doubt about it.” 

Paulson was talking about the financial-regulation bill that the Senate passed today. And he’s right: the next time there’s a financial crisis, regulators will say a quick prayer of thanks to Rep. Barney Frank for giving them the power and information to quickly figure out what’s happened and how to respond. The legislation ushers derivatives out of the darkness and onto exchanges and clearinghouses, gives regulators the power to oversee shadow banks and take failing firms apart, convenes a council of superregulators to watch the megafirms that pose a risk to the full financial system, and much else.

But the bill does more to help regulators detect and defuse the next financial crisis than to actually stop it from happening. In that way, it’s like the difference between improving public health and improving medicine: The bill focuses on helping the doctors who figure out when you’re sick and how to get you better rather than on the conditions (sewer systems and air quality and hygiene standards and so on) that contribute to whether you get sick in the first place.

That is to say, many of the weaknesses and imbalances that led to the financial crisis will survive our regulatory response, and it’s important to keep that in mind. So here are five we still have to watch out for:

1. The Global Glut of Savings: “One of the leading indicators of a financial crisis is when you have a sustained surge in money flowing into the country which makes borrowing cheaper and easier,” says Harvard economist Kenneth Rogoff. Our crisis was no different: Between 1987 and 1999, our current account deficit—the measure of how much money is coming in versus going out—fluctuated between 1 and 2 percent of gross domestic product. By 2006, it had hit 6 percent.

The sharp rise was driven by emerging economies with lots of growth and few investment opportunities—think China—funneling their money to developed economies with less growth and lots of investment opportunities. Think, well, us. Ben Bernanke—not a man known for his vivid turns of phrase—called the hundreds of billions of dollars that emerging economies were plowing into our financial system every year “the global glut of savings,” and said “it is impossible to understand this crisis” without talking about it.

But we’ve gotten out of the crisis without fixing it. China is still growing fast, exporting faster, and sending the money over to us. And we’re still happily taking it, because it allows us to spend without growing. After falling to 3 percent after the crisis, the current account deficit is back up to 4 percent and rising. Rogoff thinks that’s a problem. “One or 2 percent would be more sustainable,” he says.

2. Household Debt—And Why We Need It: The fact that money is available to borrow doesn’t explain why Americans borrowed so damn much of it. Household debt as a percentage of GDP went from a bit less than 60 percent at the beginning of the ‘90s to a bit less than 100 percent in 2006. “This is where I come to income inequality,” says Raghuram Rajan, an economist at the University of Chicago. “A large part of the population saw relatively stagnant incomes over the '80s and '90s. Credit was so welcome because it kept people who were falling behind reasonably happy. You were keeping up, even if your income wasn’t.” 

Incomes, of course, are even more stagnant now that unemployment is at 9 percent. And that pain isn’t being shared equally: inequality has actually risen since before the recession, as joblessness is proving sticky among the poor, but recovery has been swift for the rich. Household borrowing is still more than 90 percent of GDP, and the conditions that drove it up there are, if anything, worse.

[HOT agrees: Despite the economic crisis, the list of billionaires has grown by more than 200 and their aggregate capital has expanded by 50%.

In 1950 the ratio of the average executive's paycheck to the average worker's was about 30 to 1. Since 2000 that average has ranged from 300 to 500 to one.

Since 1980, the richest Americans have seen their incomes quadruple, while for the "lowest" 90% of us, incomes fell. The average wage today is lower than it was in the 1970s, while productivity has risen almost 50%.

According to Federal Reserve figures, real weekly wages in the U.S. rose until 1973, and have been declining since. From 1977 - 1989, the wealthiest 660,000 families gained 75% of "average pretax income" increases, while most middle income families saw only a 4% increase -- and those in the bottom 40% of income had real declines. In 1990, the median income was $29,934; in 1973, it was $30,943 (constant dollars). Women in the workforce and an increased reliance on credit helped forestall lifestyle crashes, but that also got us into our current economic bind.

The average annual earnings of the top group increased from $315,000 to $560,000 in twelve years. An estimated 28% of the total net wealth is now held by the richest 2% of families in the U.S. The top 10% holds 57% of the net wealth. If homes and other real estate are excluded, the concentration of ownership of financial wealth is even more glaring. In 1983, 54% of the total net financial assets were held by 2% of all families, those whose annual income is over $125,000. Eighty-six percent of these assets were held by the top 10% of all families.]

3. The “Shadow Banking” Market: The Great Depression was visually arresting: Long line of frantic families lining up outside their bank to pull every cent out before the bank collapsed. The financial crisis started out similarly severe, but aside from some despondent-looking traders, there was nothing to look at. That’s because it wasn’t, at first, a crisis of consumers. It was a crisis of banks.

It never became a crisis of consumers because consumer deposits are insured. But large investors—pension funds, banks, corporations, and others—aren’t insured. They use the “repo market,” a short-term lending market in which they park their money with other big institutions in exchange for collateral—collateral like mortgage-backed securities. But when they hear that their collateral is dropping in value, they demand their money bank. And when everyone does that at once, it’s like an old-fashioned bank run: The banks can’t pay everyone off at once, so they unload all their assets to get capital, the assets become worthless because everyone is trying to unload them, and the banks collapse.

“This is an inherent problem of privately created money,” says Gary Gorton, an economist at Princeton University. “It is vulnerable to these kinds of runs. It took us from 1857, which was the first panic really about deposits, to 1934, to come up with deposit insurance.” This year, we’re bringing this shadow banking system under the control of regulators and giving them all sorts of information on it and power over it, but we’re not doing anything like deposit insurance, where we simply make the deposits safe so runs become an anachronism.

[HOT sees another “Shadow Banking” example that’s been totally ignored: vertically-integrated homebuilders with their own mortgage, title and insurance companies. By not restoring the Glass-Steagall Act of 1933, the bill provides no regulation of builder-owned finance companies that have more incentive to sell homes than ensure loan repayment. These builders, in our view, taught the banks and mortgage companies the art of predatory lending. See “Texas Homebuilding and the Global Collapse.”]

4. Rich Banks: In the 1980s, the financial sector’s share of total corporate profits ranged from about 10 to 20 percent. By 2004, it was about 35 percent. Simon Johnson, an economist at MIT, recalls a conversation he had with a hedge-fund manager. “The guy said to me, ‘Simon, it’s so little money! you can sway senators for $10 million!?’ ” Johnson laughs ruefully. “These guys [big investors] don’t even think in millions. They think in billions.” 

What you get for that money is favors. The last financial crisis fades from memory and the public begins to focus on other things. Then the finance guys begin nudging. They hold some fundraisers for politicians, make some friends, explain how the regulations they’re under are onerous and unfair. And slowly, surely, those regulations come undone. This financial crisis will stick in our minds for awhile, but not forever. And after briefly dropping to less than 15 percent of corporate profits, the financial sector has rebounded to more than 30 percent. They’ll have plenty of money with which to help their friends forget this whole nasty affair.

5. Lax Regulators: The most troubling prospect is the chance that this bill, if we’d passed it in 2000, wouldn’t even have prevented this financial crisis. That’s not to undersell it: It would’ve given regulators more information with which to predict the crisis. But they had enough information, and they ignored it. They get caught up in boom times just like everyone else. A bubble, almost by definition, affects the regulators with the power to pop it.

In 2005, with housing prices running far, far ahead of the historical trend, Bernanke said a housing bubble was “a pretty unlikely possibility.” In 2007, he said Fed officials “do not expect significant spillovers from the subprime market to the rest of the economy.” Alan Greenspan, looking back at the financial crisis, admitted in April that regulators “have had a woeful record of chronic failure. History tells us they cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be." 

But this bill leans heavily on regulators: they watch the firms, set capital requirements, have to reach consensus before taking down a failing institution, and, well, everything else. Greenspan, in that same speech, expressed a preference for rules that “kick in automatically, without relying on the ability of a fallible human regulator to predict a coming crisis.” The bill contains precious few of them. 

“In history,” says Gorton, “it always takes us a long time to get financial regulation right, and I expect it will this time, too. Maybe we’re done for this year, or the next couple. But we can’t possibly be done.”

SELECTED READER COMMENTS:

EarthOrbitsTheSun:

Five Problems Financial Reform Doesn't Fix - The Short List! 

1. Liberals 

2. Congress 

3. Rampant bribes (Lobbyist Monies) 

4. Rampant political party donations (bribes) 

5. The Federal Government in general!!!

SactoGuy018:

I'm surprised they didn't just re-impose the 1933 Glass-Steagall Act. That would have brought a lot of stability back to the economy because it would protected bank assets from the ups and downs of the stock market.

GregCovert:

The only three that 'made out like a bandit' is Fannie, Freddie, and Barney Frank.

Mindless partisanship mars passage of banking reform

Editorial, USA TODAY, 7/16/2010
http://www.usatoday.com/news/opinion/editorials/2010-07-16-editorial16_ST_N.htm

The most amazing thing about the financial overhaul that won final congressional approval on Thursday might be that it took long and proved so contentious.

Immediately after the worst financial meltdown since the Depression, it appeared as though the national priority of fixing a broken banking system would ensure that the response would be swift and far-reaching. Lawmakers of good faith would work together. Chastened banks would accept change.

But that's not quite how things worked out. After a few weeks of remorse, Wall Street got its swagger back and fought like mad to preserve its profits. And Republicans, once seemingly inclined to work constructively, reverted to "just say no" partisanship. Only three GOP senators — Scott Brown of Massachusetts and Olympia Snowe and Susan Collins, both of Maine— voted for the bill on Thursday. The same number of Republicans voted for an identical measure a couple of weeks ago in the House.

In some ways, this says as much about the pathetic state of contemporary American politics as it does about the troubling nature of Wall Street finance.

To hear those on the right, the measure is an attack on business and a vast overreach. House Minority Leader John Boehner, R-Ohio, compared it to "killing an ant with a nuclear weapon." To some on the left, it is a feeble gesture because it does not carve up big banks like Christmas hams and feed them to the poor.

Hard as it may be to believe, not long ago it was possible for Congress to pass significant measures on a more-or-less bipartisan basis. The 2001 Bush tax cuts garnered 12 Democratic votes in the Senate. The Iraq invasion authorization got 29. The No Child Left Behind law got 42. The new Medicare drug benefit got 11. And the bank bailout, known as TARP, got 39. 

The financial reform measure, though far from perfect, is clearly a step toward making the system safer. It restricts risky trading, requires banks to maintain stronger balance sheets and sets up an orderly process for liquidating those that fail.

[One can argue that it does the opposite. It gives big banks an incentive to continue risky business practices where the risk is on taxpayers and not them.]

It won't necessarily change the culture on Wall Street, where banks have abandoned long-term relationships with clients for schemes to make a quick buck. But perhaps Goldman Sachs' $550 million settlement of a civil lawsuit brought by the Securities and Exchange Commission, announced Thursday, will make the big banks think twice about treating some of their customers as suckers to be fleeced.

[Big bankers think in Billions, not millions, and $550 million is just a few day’s revenue for Goldman – just an acceptable “cost of doing business”.]

President Obama's signature will hardly be the last word on financial reform. Many decisions — and much out-of-the-spotlight lobbying — will simply be transferred to regulatory agencies, which will implement the legislation.

Nor does the measure address the conflicts of interest inherent when rating agencies pass judgment on securities issued by the very banks that pay them. And it does not begin the process of dealing with troubled mortgage giants Fannie Mae and Freddie Mac.

All in all, however, financial reform is a victory for consumers and economic soundness, even if overheated rhetoric and senseless partisanship nearly kept it from happening.

Financial Reform, R.I.P.

By James S. Henry and Laurence J. Kotlikoff, Forbes, 7/15/2010
http://www.forbes.com/2010/07/15/dodd-frank-failure-regulation-opinions-contributors-james-henry-laurence-kotlikoff-wall-street.html 

So long Glass-Steagall. Hello Dodd-Frank -- the most comprehensive rewrite of financial rules since 1933. This 2,319-page colossus -- 10 times the length of Glass-Steagall--took 1.5 years to produce and will cost $30 billion and many more years to implement. Will all this time and treasure make Wall Street safe for Main Street?

No.

Dodd-Frank is a full-employment act for regulators that addresses everything but the root causes of the financial collapse. It serves up a dog's breakfast covering proprietary trading, consumer financial protection, derivatives trading, executive pay, credit card fees, whistle-blowers, minority inclusion and Congolese minerals. Dodd-Frank also mandates 68 new studies of carbon markets, Chinese drywalls, [HOT needs to dig into that one.] and person-to-person lending, and many other irrelevancies.

Root Causes

None of this deals with the central problem--Wall Street's ability to hide behind claims of proprietary information to facilitate the production and sale of trillions of dollars in securities whose true values are almost impossible for outsiders to determine.

This policy of "systematic non-disclosure"--the absence of complete transparency about what financial firms really owe and are owed--left only its CEOs and their top consiglieres in a position to know what their companies really owned and owed. Consequently, the valuation of Wall Street firms came down to trusting the bank's senior executives--those who often had the greatest stakes in the non-disclosure system.

As news of all this widespread Wall Street chicanery spread, investors eventually realized that the "grownups"--rating companies, boards of directors, regulators, and politicians--had been well-paid to look the other way. So public trust took a holiday. Wall Street's house of cards collapsed, taking Main Street down in the process.

All this malfeasance was no organized conspiracy, but a self-organizing, automatically expanding gravy train. Its participants included many of the world's largest and most prestigious banks, insurance companies, hedge funds, credit raters, law firms and accounting firms.

What share of financial institutions' assets and liabilities were fundamentally toxic may never be known. But that is beside the point. With no way to independently verify, in real time, the precise nature of financial firms' assets and liabilities, they are all vulnerable to panics by investors, counterparties, and depositors, based on rumors and speculation as well as fact.

The resulting serial collapse of Wall Street behemoths, in turn, led Uncle Sam to step in and issue his own brand of increasingly hard-to-value securities--some $24 trillion (according to Neal Barofsky, Congress' TARP watchdog) in contingent guarantees to all manner of financial companies.

This is a colossal liability, almost twice U.S. gross domestic product. If another massive bank run hit Wall Street--say, next week--Uncle Sam would be forced to print trillions to cover these guarantees. The prospect of getting paid back in watered-down dollars might then lead people to run even faster to the banks, to get their money and buy something tangible before prices skyrocket. Ultimately, Uncle Sam's guarantees are only worth what they are written on--paper.

So Uncle Sam didn't lead us out of the woods; he led us deeper into the woods. While he (temporarily) saved Wall Street, he may have gravely endangered Main Street. 

Meanwhile, many major players on Wall Street have been laughing all the way from their banks. One top banker after another has been able to leave office with their generous golden parachutes, starter castles and yachts intact.

In contrast, during the 1930s, Citibank's CEO and the head of the New York Stock Exchange did serious jail time for financial peccadilloes; in the late 1980s, the S&L crisis led to more than 1,000 felony convictions. This time around, aside from blatant thieves like Bernie Madoff and "Sir" Alan Stanford, we've been more forgiving. Of course Dodd-Frank does instruct the U.S. Sentencing Commission to re-examine its guidelines for financial fraudsters, but sentencing presumes conviction.

Yet the real criminal that needs to stand trial is this: our phony system of systematic non-disclosure about what financial firms are really worth.

Pictures of Food

Dodd-Frank no doubt contains some useful provisions--inevitably, in a 2,319-page bill. Overall, however, this law is like being invited to dinner and served pictures of food.

Far from streamlining regulations, mandating greater transparency, and reducing uncertainty, Dodd-Frank provides government bureaucrats with unrestricted hunting licenses. Only one of the roughly 115 federal and state agencies currently involved in financial regulation has been consolidated. At the same time, the new law creates 12 new regulatory bodies and gives them vast amounts of rule-making discretion. In the next two years these and other financial regulators will hold an estimated 243 new rule-making procedures.

The new law still provides no single regulator for deposit-taking institutions. The SEC and the CFTC continue to share authority over derivatives. A toothless National Insurance Office will "gather information" from 50 state regulators; the Fed's new Bureau of Consumer Financial Protection will have to tip toe around the SEC, the FTC, and the Federal housing agencies; a new SEC Credit Rating Agency Board will try to rate credit raters; the Fed also gets unfettered discretion to delay implementation of the Volcker Rule until 2023, and ... you don't want to know.

Dodd-Frank is not just a prescription for regulatory sclerosis. It is a bonanza for Wall Street lobbyists and lawyers, who will help determine what this law's 283,985 words actually mean.

In 1990-2009 Wall Street and its friends in the insurance and real estate industries spent an average of $2,973 (in 2010 dollars) per congressman and senator per day on campaign contributions and lobbying. All this spending kept full financial disclosure off the table and helped today's top 10 financial giants to dominate the industry.

Paths Not Taken

In 1982 seven people died in Chicago from consuming Tylenol tainted with cyanide by some criminal who is yet to be caught. Overnight, Johnson & Johnson found no market for its global 30 million bottles of Tylenol. Talk about a toxic asset!

J&J recalled all 30 million bottles, threw them away, and replaced them with safety-sealed bottles. In so doing, it disclosed the contents to be Tylenol not cyanide. Its toxic asset problem was solved for good.

Dodd-Frank's approach is different. This law is akin to J&J restocking the shelves with the same unsealed bottles, hiring thousands of people to randomly inspect drug store aisles in the hope of catching the miscreant, and contracting with funeral companies to quickly pick up the dead. Indeed, a major part of Dodd-Frank focuses on arranging speedier funerals for failing financial institutions rather than preventing such funerals in the first place.

Dodd-Frank also relies heavily on the failed "good bank"-"bad bank" model of regulation. In this model, "bad banks" that take extra risks will be allowed to fail, while "good banks" are protected.

Earth to Congress! We tried this in September 2008. "Bad bank" Lehman was allowed to fail, which blew up in Uncle Sam's face. Citigroup, a "good" bank, would have failed but for a bailout; Goldman Sachs, a "bad bank," might have failed had Uncle Sam not intervened indirectly. AIG wasn't even a bank. But it was bad, and it was saved. When push comes to shove, this regulatory ring-fence never works.

The Right Financial Fix

Were we really serious about fixing our financial system, there's a very simple alternative--Limited Purpose Banking. LPB would transform all financial intermediaries with limited liability into mutual fund companies. Under LPB a single regulatory agency--the "Federal Financial Authority"--would organize the independent rating, verification, custody and full disclosure of all securities held by the mutual funds.

Voilà, by dint of competition and transparency, "liar loans," off-balance sheet gimmickry, and toxic assets would all disappear. LPB would let the financial sector do only what Main Street needs it to do--connect lenders to borrowers and savers to investors. 

The financial sector's job is not to take taxpayers to the casino and collect the winnings. This kind of "cowboy capitalism" is far too dangerous to maintain. But Dodd-Frank does precisely this, albeit with many more regulatory cops on the beat.

In contrast, LPB would put an end to Wall Street's gambling with taxpayer chips. Since mutual funds are, in effect, small banks with 100% capital requirements in all circumstances, they can never fail. Neither can their holding companies. Under LPB, financial crises and the massive damage they inflict on the entire (global) economy would become a thing of the past.

Of course, there would be losers. Some Wall Street executives might have to find employment in Las Vegas or offshore banks. Some lobbyists, lawyers, credit analysts and accountants might need to find higher callings. Some politicians might even have to solicit more support from Main Street.

Alas, Dodd-Frank bears no resemblance to Limited Purpose Banking. But bad laws don't always last, and this one may eventually lead us to LPB by showing us precisely what not to do--if we ever get another chance.

James S. Henry is an economist, lawyer, and investigative journalist and former chief economist for McKinsey & Co. He is the author of Banqueros y Lavadolares (1996), The Blood Bankers (2005), and Pirate Bankers (forthcoming). Laurence J. Kotlikoff is a professor of economics at Boston University and author of Jimmy Stewart Is Dead--Ending the World's Financial Plague with Limited Purpose Banking.

Wall Street Outsmarts Congress

By Randall Lane, The Beast, 7/15/2010
http://www.thedailybeast.com/blogs-and-stories/2010-07-15/financial-reform-how-wall-street-will-outsmart-congress/full/

By a vote of 60 to 39, the Senate passed an overhaul of financial regulations. President Obama is expected to sign it within days.

At a recent lunch with a former financial regulator who now has a big job at a big bank, the topic turned to the financial reform bill Congress seems poised to pass Thursday. “The market,” this human Washington-Wall Street nexus told me with a sly smile, “is always four years ahead of the regulators.” 

And that calendar, like the stock options of too many corporate scoundrels, apparently gets back-dated. Calling around Wall Street this week, I got the sense that the powers that be—and their accountants and lawyers—had been hard at work trying to end-run Wall Street reform before it even passed.

“It’s not going to affect us at all. We’ll move some stuff out, have some partial investments.”

Since none of the dozen or so people I spoke with—and virtually no one else in America—has read all 2,000-plus pages of the windily named Dodd-Frank Wall Street Reform and Consumer Protection Act, let’s consider this soon-to-be law in three mental buckets.

First, there’s a big bundle of consumer protections. An independent Federal Reserve offshoot will make sure big banks don’t gouge via credit cards, debit card fees, mortgages, and student and auto loans (though auto dealers somehow get an exemption, courtesy of their powerful lobby). These are good, smart policies that immediately feel as American as fried chicken and driving 80 miles an hour—and other than preventing some types of predatory mortgage practices, they have precisely nothing to do with the last meltdown or the next one.

The second part deals with many of the systemic problems that nearly brought the economy down but that Congress proved too gun-shy—or dysfunctional—to address directly right now, instead kicking decisions to nebulous regulators for determination down the road.

For instance, when banks grow “too big to fail,” a 10-person “council of regulators,” with the Treasury secretary at the helm, can opt to crack down on them if they’re healthy, or liquidate them if they’re not. For pay packages that encourage executives to take risks with other people’s money, the Fed will issue broad guidelines, rather than specific rules, and then try to block plans that run afoul of these nebulous standards. Credit rating agencies that slap high grades on lousy loans made by the banks who pay their bills will face more liability for such actions, which is good—but regulators will also take two years to “study” further the inherent conflict of interest, which is like taking another two years to study further whether cigarettes cause lung cancer.

Realistically, though, the only part of financial reform that Wall Street was paying real attention to was the third area, which pertains to their ability to continue acting less like real banks—making loans and helping companies raise money and other traditional services that prove the lifeblood of capitalism—and more like the casinos they became over the past decade.

The big fight centered around the Volcker Rule, named for Obama’s lanky Wall Street adviser, former Fed Chairman Paul Volcker, who pushed for a complete ban on proprietary, or “prop,” trading. This is the money a bank gambles for its own gain, often using customers’ deposits as the seed bet, borrowing wantonly above that to keep things extra interesting. The basic math encourages crazy risk: Hit it big, and bankers get a monster bonus; crap out, and the taxpayers sit on the hook for a bailout. 

A strict Volcker Rule would have fixed that, and Wall Street shuddered accordingly. But after new Republican Senator Scott Brown extracted a watered-down version—banks will be allowed to risk 3 percent of their capital via prop trading and own up to 3 percent of hedge funds and private equity funds—Wall Street did what it’s best at: creating complicated solutions to exploit loopholes.

First, most banks are already content to bet tens of billions, given the leverage available, while sitting under the 3 percent threshold. For them, it’s business as usual. And rather than tamp down its prop operations, Wall Street’s most aggressive firm, Goldman Sachs, is already talking about semantics: Renounce its standing as a bank holding company, so that it would no longer need to comply.

Similarly, even once banks rub up against the 3 percent, they’ve already concocted another evasive maneuver: Keep the game, change the name. Specifically, Dodd-Frank allows banks to take the other side of a bet that a customer wants to make. “You could say, ‘Hey, I’m doing this for my clients,’” one sales trader explained to me. Voila! Prop trading, under a new guise. The SEC’s recent lawsuit against Goldman, involving hedge fund billionaire John Paulson and a bunch of dubious subprime holdings called Abacus, details exactly how this shell game can work.

And that game continues with the hedge fund ownership limitation. Yes, banks instinctively would prefer to own more. But over the past few weeks, a new calculus has cropped up: rather than own hedge funds, the new law gives Wall Street cover instead to push in its customers (hey, we’re committed the full 3 percent the law allows!) and take a hefty, risk-free management fee: Dodd-Frank as marketing coup.

Finally, the reform package addresses derivatives, the dangerous multitrillion-dollar market of swaps and other Frankenstein-like Wall Street creations. The rules here will be exceedingly complicated. Banks will be allowed to play in some of these markets and will be banned from others. But on Wall Street, it’s fairly simple: What’s still OK will be done in the U.S. And what isn’t, as one Wall Street partner told me, can just be pushed to overseas divisions.

“It’s not going to affect us at all,” the partner shrugged, referring to Dodd-Frank. “We’ll move some stuff out, have some partial investments.” 

But don’t take this guy’s word for it. The Wall Street shell game can be viewed another way—through those literal markets that always stay ahead of the regulators. Financial shares soared as the final deal clarified, partly because it removed uncertainty, which traders hate more than anything, but mostly because they realized that these rules allow them to continue pretty much business as usual. Wall Street is happy today. Historically, that’s not a bad thing—a robust financial industry generally produced wealth for all—but in these times, it sure seems to be.

Randall Lane is editor at large at The Daily Beast. The former editor in chief of Trader Monthly, Dealmaker and P.O.V. magazines, and the former Washington bureau chief of Forbes, he is the author of The Zeroes: My Misadventures in the Decade Wall Street Went Insane.