“Financial Reform, or, Rearranging Chairs on the Titanic”

By L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City and writes for New Deal 2.0

Congress is nearing completion of its financial reform bill HR 4173 (Wall Street Reform and Consumer Protection Act of 2009), which appears to amount to shifting chairs on the deck of the sinking Titanic. The monstrous legislation is too big and too complex to analyze in a short blog. Instead I will discuss three areas in which Congress is failing to address the real issues: dangers posed by derivatives, the folly of bailing-out troubled “systemically important” institutions, and reformation of credit ratings agencies.

Title III of the Act would attempt to get derivatives trade onto formal exchanges. However, as Mike Konczal demonstrates, there are enough loopholes in the draft to drive Goldman Sachs right through it. In truth, it won’t make that much difference whether derivatives are exposed to the standardization and daylight that exchanges could bring. Note that a large portion of commodities futures are run through formal exchanges without dampening the speculation that is driving yet another commodities boom that will go bust next year. Yes, there are loopholes that allow commodities traders sitting in front of computers in the US to escape exchange rules by pretending they are offshore, and it is likely that the majority of futures contracts trades go unreported. But it is virtually certain that the same will be true of derivatives markets even if HR 4173 passes. In short, the problem is not really opaque and unregulated derivatives trading, but rather the fact that we allow protected and regulated institutions to gamble with house money. They put down a dollar of their own funds and place bets of $30 or more that interest rates or prices will move in a favorable direction. Congress has proposed nothing that will change this — and putting derivatives onto exchanges will make little difference.

The House is also proposing to grant to the Fed the ability to create and spend money to rescue any financial institution it deems to be “too big to fail”, including investment houses, insurance companies, hedge funds and any other private pools money whose collapse might endanger the financial system. (See William Greider’s recent post). We all remember former Treasury Secretary Paulson’s gambit in which he held a gun to his head and demanded that Congress give him three-quarters of a trillion dollars to spend any which way he chose, with no oversight and no accountability. Congress wisely told him to go shoot himself. Now Congress is proposing to give such powers to Chairman Bernanke. Why? Has Gentle Ben exhibited any predilection to indicate that his instincts are better than St. Paulson’s? I don’t think so. This is just a proposal to institutionalize the favors that a Predator State (Jamie Galbraith’s felicitous term) can grant to cronies.

Finally, in spite of great hope that the ratings agencies that blessed all the toxic waste with triple A ratings might be subject to some sort of retribution, Congress proposes to let them continue as if nothing happened. To recap, the Big 3 ratings agencies — which have a virtual monopoly of the business — prostituted themselves in a “pay-to-play” scheme in which they would give to garbage securities any rating sellers desired, so long as the assessed fees were sufficiently high. At a very minimum one would have thought that reforms would align incentives, with buyers of rated securities paying for assessment of risk. But, no, Congress worries that such a massive change to the industry might reduce business for the monopolies. Hence, there will be no significant changes required of ratings agencies, who are encouraged to continue pimping their ratings.

Is there an alternative to the ineffective and wimpy Congressional “reforms”? Sure. Forget about reforming derivatives markets, ratings agency behavior, or too big to fail doctrine. Here are three easy steps to real reform.

1. Prohibit regulated and protected financial institutions from trading derivatives. All financial institutions with access to the Fed’s lending as well as any financial institution with Treasury guarantees on liabilities (such as FDIC insurance) would be prohibited from selling or buying any derivatives. All assets would be carried on bank books through maturity-with full exposure to interest rate, currency, and default risk. That provides the correct incentives to protected lending institutions. Underwriting would be assured-since institutions could not shed default risk through securitization. Any institution that was foolish enough to play across exchange rates (lending in one currency while borrowing in another) would bear the risks. And any that tried to play the maturity curve would be subject to rising short-term rates. Personally, I would put tight constraints on the Fed to avoid another Paul Volcker “experiment” (he killed the thrifts by pushing overnight rates above 20%), but that is a matter for another blog. So forget the attempts to regulate derivatives markets. All that is necessary is to prohibit regulated and protected institutions from playing with them.

2. Abandon “too big to fail” and “systemically important” doctrine in favor of a “too big to save” and “systemically dangerous” approach. It is likely that all the largest financial institutions are insolvent, in spite of their machinations to manufacture imaginary trading profits. So, close them down. It’s the law. Insolvent institutions are supposed to be resolved, at the least cost to the Treasury; all we need to add is a proviso that they must be resolved in manner that does not increase industry concentration. The top 4 banks (BofA, Citi, JPMorgan-Chase, and Wells Fargo) have about half of the industry, and there is little doubt that each is massively insolvent and systemically dangerous. Shut them down. If there is collateral damage, deal with it. Leaving them open not only encourages each to “bet the bank” through excessively risky trades, but also tells all other financial institutions that their only hope is to join the “too big to fail” club through unsustainable growth that requires they adopt the same failing strategies adopted by the behemoths.

3. Forget about regulating the top 3 ratings agencies — they are beyond hope. Instead, prohibit regulated and protected institutions from using any ratings obtained by sellers of securities. Instead, they should be required to purchase ratings services from arms-length professionals, with the top 3 monopolists specifically excluded because they have demonstrated their inability to provide unbiased ratings. Further, make ratings agencies liable for improper ratings, imposing a fiduciary responsibility to actually evaluate any instruments that are rated. The top 3 never actually looked at any of the mortgages that collateralized the securities they rated-it was all too pedestrian for them. As we now know from internal emails, they did not have the loan tapes (the data provided by borrowers), the experience (they had no expertise in rating mortgages-all of their experience was in rating corporate and government debt), nor the time to assess credit risk. And they have never understood how to rate sovereign government debt (on which there is no default risk-yet the ratings agencies provided higher ratings to NINJA loans than to riskless sovereign debt) If anyone wants to purchase debt rated by these nincompoops, I wish them luck. But we must prohibit banks and other protected institutions from purchasing the garbage.

So here is the main point. We do not need to regulate the “markets”. Personally, I do not care whether hedge funds and other pools of unregulated funds gamble in opaque derivatives rated by incompetent ratings agencies. But I do want them to fail when their bets go bad. Nor do I want them to be rescued in the event of a run to liquidity-if they leveraged and cannot come up with cash, they shoull fail. It will be painful for their creditors-so be it, the more pain, the better. That is the downside to private property. Greed is good, but must be balanced by the fear of failure. Without failure there is no fear.

On the other hand, I want to have a protected and closely regulated portion of the financial sector for those who do not want to take excessive risks. And any institution that bets with “house money”-that is, that has access to the Fed in the case of a liquidity problem and to the Treasury in the case of insolvency must be constrained. That is the direction that true reform ought to take.