Submitted by Edward Harrison of Credit Writedowns.
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, 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 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 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 co-ordinate 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 and Citigroup. 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.’ [Update: the reason I stress the term ‘clearinghouse has to do with Obama Administration opposition to making OTC derivatives exchange-traded. A clearinghouse is not enough. An exchange is more than a clearinghouse and involves standardization of contracts and regulation.]
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.
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You appropriately took the long view for the whole article, then at the end you seemed to feel the need to say, "This document is not the product of someone who wants reform, but of someone looking to strike a middle ground in a political game."
This is an inference that is psychological and unsupportable.
As you said previously, this is a long process, and this is a framework, not the finished product. It's a basis for future work. So how can it "not be the product" of a reformer?
Bennett,
Yes, I try to be objective here. But, I am really getting frustrated by Obama's need to seek the middle and build a consensus. More and more, it seems like a political tactic. Shrewd, but political, nonetheless.
Given the fact that he 'sold' himself as a reformer, I am beginning to doubt his reformer chops. I apologize if that last statement reflects this bias on my part.
Edward
If you read what I have to say in the following post, you'll see why no regulatory measures are likely to work: http://amoleintheground.blogspot.com/2009/05/stress-tests-regulatory-capture-and_12.html
Here's a sample: "When things reach a certain pass it's not so much a feeling of loyalty or obligation to the guys who write your checks, as a feeling of responsibility for the entire financial edifice, which could collapse to the ground if you said the wrong thing at the wrong time."
Regulation won't work for the same reason the recent stress tests were a sham. If things seem to be going well and there is some hope that they will continue to go well, NO ONE wants to be saddled with the responsibility for saying something that will destroy everyone's confidence and spoil the party. So long as the whistle blower can be accused of precipitating the disaster it was his responsibility to avert, no one will ever want to blow the whistle. We've seen this syndrome time and time again and it's really pathetic if Obama actually believes his "reforms" will make a meaningful difference.
I think Edward's conclusion is supported. What's been put out may serve as an appropriate starting point; but given the media blitz and the deep sense of urgency attached to it (sounds familiar), it's highly likely that this will be pushed, not as a starting point, but as a final product. That supports the point of this being a political middle ground–being seen as "doing something" in the short term–rather than a serious attempt at reform.
Also, I appreciate the point regarding "political restraints", but that's an excuse this administration has repeatedly fallen back on all too readily. Real reform means that somebody is going to be angry, and that's a fact this administration should face. Given their central role in the crisis, any real reform would tie the hands of the banks and the Federal Reserve; the fact that both are generally pleased with this proposal is very worrisome.
Obama has a neoliberal economics team so his starting point is not the middle but to the right of center. I agree though that this is more about giving the appearance of doing something than actually doing it. The bank bailouts have been unpopular with most ordinary Americans because they don't think that the bad actors in this should be rewarded but this has been what both the Bush and Obama Administrations have done.
Re the Tier 1 FHCs, the $68 billion paid back to the TARP was an attempt to duck regulation. These companies want us to ignore that they still have been and continue to be major beneficiaries of other government credit lines. I am concerned too that they sit on boards at the Fed, the enity which ostensibly is supposed to regulate them.
Along these lines, the ICE was chosen as the clearinghouse for derivatives. This represented a major victory for the banks since they control this exchange.
There are so many cases of what real reform would look like: Glass-Steagall, revamping the Fed, reforming ratings agencies (or making companies do their own ratings for themselves as a fiduciary responsibility), trading derivatives on a real exchanges, forcing CDSs to conform to insurance regulation and/or gaming laws, reducing or eliminating the role of non-commercial traders in futures markets (like oil), forcing the break up of companies large enough to pose a systemic risk, and placing limits on the out of control securitization schemes that caused the system to collapse.
Arthur Levitt, a consultant to Carlyle and Goldman Sachs, is happy
That's all I need to hear. FAIL.
"Forget about clearing houses…"
Is a misunderstanding of how the CME and other exchanges work.
Electronic, on-exchange trading RELIES upon having a clearing house (or central counter party [CCP]) to mutualise, absorb and manage the resulting risks between the trading parties.
What you've just said is equivalent to "use a car but forget about the noisy engine".
Happy to provide more information, but you need to correct your article.
Bill
A nitpick:
The 68 billion repaid are only a loss to lending IF they would otherwise have been lent out.
The current financial climate does not make it certain, or even probable, that the money would have been lent out (other than to the Fed).
Bill H,
Obama is talking about clearinghouses because his people do not want a fully-exchange traded vehicle akin to the CME. This is what the reference is. An exchange is more than a clearinghouse – it involves standardization and a higher level of regulation.
Anders,
Given the amount of excess reserves, the banks can repay the money without it having an effect on loans. However, it does reduce their capital and going forward having less capital will make them less likely to increase lending.
What would be problematic is if any of the banks exiting TARP found themselves undercapitalized in the future as a result of future losses.
Edward…you are quoted on huffington post as one of the people who is 'positive' on the 'plan'…just btw.
still..nothing about too big to fail…seems to be continued to be assumed they exist and might be better regulated.
increased role of the FED..the FED is a private corporation, privatizing more regulations is more of the same.
as long as 2 or 3 bank/brokerages can jack the markets up and down as is happening now, for example, you KNOW that BIG is NOT BETTER for us…for mainstreet.
still plan is totally wall st. centric, not main st centric…no emphasis on supporting community banks, credit unions..the institutions that can really form the basis of a real economy.
Edward…if your concern of the plan is LENDING then it will remain short term vision..and contradicted by your call to wait..back up and create a plan that actually addresses the systemic issues at hand.
we need a Glass-Stegal act of some sort…can't everyone see the collusion between the banks, brokerages, ratings??
when a bank/brokerage can move the market with a rating change while dealing stocks up and down within the same market what good can come of that??
these are not right and left issues, they are practical issues that affect our health and well being for decades to come.
screw political constraint. propose real change that serve the people. and IF the banks revolt and VOTE by jacking the markets down day after day..then everyone will/can see the power that still remains invested in them and not us.
Ed, here's your addition:
[Update: the reason I stress the term 'clearinghouse has to do with Obama Administration opposition to making OTC derivatives exchange-traded. A clearinghouse is not enough. An exchange is more than a clearinghouse and involves standardization of contracts and regulation.]
All 'exchanges' come with bundled clearing houses or CCPs. CME, LIFFE, NASDAQ, NYSE, LSE are all examples.
The history of the exchange dates back to early last century where physical commodities were traded.
'clearing' or a CCP was introduced to decouple the risk of trading with the risk of settlement – how can you trust the person you trade with? The CCP introduces a risk based environment which using various methods tries to eliminate credit risk (amongst others).
Since 2005 the DTCC has developed with the OTC industry the Trade Information Warehouse, which now captures 96% of OTC credit contracts (such as CDS) in a STANDARDISED form. The other 4% are 'non standard'.
Recent progress with ICE in the US has brought central clearing to these contracts, giving the exact benefits you suggest above without the need for a centralised electronic market place, or 'exchange'.
Likewise in the Rates and Equities space, the contracts are also rapidly being brought onto fully electronic platforms for confirmation and also clearing. SwapClear from LCH.Clearnet is another example of a CCP for STANDARDISED interest rate swaps.
Your assertion that an 'exchange' is the solution doesn't ring true, as practically the goal of standard contracts and risk reduction via a CCP have already been demonstrated in the market.
Standard regulation is something also delivered by the CCPs, as they are based on US or UK law for all the members of each – a level playing field.
I refute your logic that an exchange is the answer, and suggest that the rapid improvements in the OTC processing space and the expansion of clearing will deliver what you suggest, without a centralised trading platform.
Happy to discuss ;-) http://www.linkedin.com/billhodgson
Bill.
Hugh,
Your comment is dead on. My thoughts exactly.
Obama gave the best, most pitch-perfect speech about financial reform at Cooper-Union NYC during his campaign. Obama spoke eloquently and with ease about the need to reinstate a new 21st century Glass-Stegall and how Wall Street was not the friend of Main Street, how Mom and Pop must be protected from powerful unregulated hedge funds and the vicious short-selling traders who only profit through speculation and manipulation. It sounded so good. On stage with Obama that day was an impressive cast of economic talent/clout. Highly respected anti-neolibs like Volcker and I think Stiglitz were present but then paradoxically, so was the free-market/neo-liberal crowd like Larry Summers and Robert Rubin, the very man who was almost solely responsible for killing Glass-Stegall in the first place. ( I think we all know the rest of the story) So I wondered which economists on stage that day were the real Obama economists and which ones were the campaign props?
I got my answer sooner than I expected. If anyone thinks the current Obam economic crew is interested in real change I'm just wondering what information you're basing that on? Rubin protogeges and quant fund Neo-liberal Larry who helped create our current mess by dreaming up our de-industrialized, financialized hedge-fund economy do not have the vision, the moral authority, the inclination or the motivation to get us out of this mess. For all of his talk about change and despite being handed a golden opportunity to deliever change due to the financial crisis, Obama has hitched his cart to the old Clintonista bankster cabal which seeks to maintain the status quo at any cost. Just as there could be no honest revaluation of Iraq policy with Rumsfeld at Defense there will be no change in US economic/financial policy as long as Geithner and Summers are at the wheel. When is the next election?
Next election [?] Hell Iranian's and the French have a "bigger set" than Americans, you may not agree with their govements, but they act and not just moan about it.
Word verification is "ges/aus" lol with Yves in Germany.
Wie rechnet man I "ges aus"?
Ich habe mal eine Frage: Wie rechnet man I ges für einen Stromkreis, der Parallel-und Reihenschaltungen enthält aus?
Ich konnte leider kein Bild hochladen, aber ich versuchs mal so:
___________R6 ___________
I I
= ___R2______ I
I___R1 ___I__R4______I_____I
I__R5__R3__I
Die I-Striche sind noch Kabel! Und wie man sieht gibt es 6 Wiederstände.
Falls die Zeichnung doch nichts wird erklär ich es nochmal:
Nach R1 kommt ein Knotenpunkt mit einer Parallelschaltung von R2 , R4 und (R5 + R3) , (die wiederum in Reihenschaltung in der Parallelschaltung sind) danach folgt ein weiterer Knotenpunkt und es kommt nur noch R6. (ich hoffe man kann das so verstehn?!)
Ich vermute, dass sich das irgendwie mit der Kirchhoffschen Regel lösen lässt, aber ich bin mir nicht ganz sicher wie die dann aussehen soll, weil hier ja alles verschachtelt ist!
Ich hoffe, dass mir jemand weiterhelfen kann!!!
It's really about inefficient debt pricing. CDS is just a free ride on that inefficiency. For example, money market fund investors holding securitized products believed that credit risk was priced into structured products but discovered it had been siphoned off in CDS transactions (or alternatively that the anticipated due diligence had not been performed but "hedged" in a unmargined forward). Investors then abandoned MMF in droves resulting in the 3.2T government guarantee.
Investors are not now risk adverse; but rather understand CDS have distorted the risk pricing in bond products and so they've abandoned impacted instruments and fled to the most creditworthy debt instruments unimpaired by CDS activity.
Once the MMF guarantees are gone it's game over and the remaining investors will flee to insured deposits and "riskless" government debt. And what's Treasury's solution? To turn money markets into mutual funds and create a CDS CCP? Exactly how will that convince money market fund investors that their money is safe or fund managers that securitized products are low risk liquid investments?