why the current financial reform proposals are fundamentally flawed

Last night GOP senators blocked an attempt by the Democratic majority to bring Chris Dodd's (D-CT) financial reform bill the the floor of the Senate so that it could be debated and voted upon.   Majority Leader Harry Reid has already said that he would bring the bill back to the floor for another cloture vote this afternoon.  Democrats are attempting to characterize this GOP opposition as purely political: according to their storyline the Republicare in the bed with the likes of Goldman Sachs and are only attempting to block reform so that they can increase their campaign contributions.  This blatant partisan attack does little more that distract from the substance of the bill, and I have no doubt that the Democratic attacks are designed to do just that.  Anyone who has followed the housing and financial markets over the past decade understands that one of the major causes of the financial crisis were some of the policies enacted by Dodd's Banking Committee and his counterpart in the House, Barney Frank (D-MA).  Obviously neither man admits any of this, and their financial reform bill does nothing to stop many of the practices that led to the housing bubble.  So, in the interest of having a informed debate, rather than one of rhetoric, I will lay out may objections to the current financial reform proposal and explain how I would address the problem instead.

From what I can tell, Dodd's bill has three major sections: 1) The creation of a Consumer Financial Protection Agency that will regulate the so called "predatory lending practices" that dooped so many people into buying homes they couldn't afford and spending to much money on their credit cards; 2) Ends the over-the-counter treatment of most derivative investment contracts (CDOs, MBSs, etc.) by forcing them to be traded on an exchange; and 3) Creating a "Resolution Authority" within The FDIC that would be capable of dissolving banks, bank holding companies and other financial institutions deemed to be a systematic risk if they fail.  Man that is some exciting stuff.  Now you can see why it is so easy for the Democrats to claim that this is major reform because 98% of Americans have no idea what any of these things mean.

Starting with number one, my basic beef with the Consumer Financial Protection Agency is that it even if one was in place prior to the recession, it probably would have done very little to help stop the financial crisis.  We all now agree that many people were taking on more loans that in retrospect they could not afford.  This was based on the faulty presumption that the housing market would continue to climb in value, and that even if borrowers were paying very high interest rates after the teaser rate of a sub-prime or Alt-A loan expired, this imbalance would more than be made up for by the increase in equity owned by the homeowner based on the home's increased value.  Presumably he could use this increased equity to refinance if payments could not be met.  Well guess what?  The market fell out, and now many homeowners owe more than the total equity value of their house.  This makes defaulting a rational decision in many cases. 

So according to the Democratic pundits the Consumer Protection Agency would have stopped these bad loans from happening and all would be well.  BULLSHIT.  If there is one thing that is true about all governmental regulators it is that they are backward looking.  All regulators were created because of some event in the past that caused a large amount of financial hardship.  The regulators attempt to stop that specific type of situation from happening again.  The sub-prime crisis was a novel problem in the financial markets.  The very large majority of people, including many sophisticated investors who are much smarter and more savvy than any potential regulators, did not see it coming and lost A LOT of money.  When people lose that much money, then it is a sign that the downturn was very hard to foresee.  It is easy in hindsight to try and stop things that have happened in the past, but in reality it is impossible to predict the problems that will arise in the future.  The next "crisis" will probably have nothing to do with the mortgage market, and even if it did the CFPA would probably fail to stop it anyway.  This really is about a government power grab, so that the government can set all the applicable rates and provisions of almost any financial deal.  They will outlaw certain kinds of loans, favor others, and basically attempt to micromanage decisions that should be made of individual, case-by-case basis.  As is always the case, lobbyists will have a field day because their clients will want to get tight with the regulators so that their offerings will get preferred treatment over that of a competitor.  This will inevitably lead to crony capitalism at its worst.

Secondly, I really think that derivative contracts have gotten a bad name from all of this.  Yes, I ONE HUNDRED PERCENT AGREE that the proliferation of mortgage backed securities and credit default swaps (which were instruments that were intended to spread risk) led to a situation were counter parties were dependent on each others' solvency.  However, why, fundamentally, is this a bad thing?  Because it leads to "too big to fail" says Paulson/Bernacke/Geithner/Summers.  No it does not.  Period.  No one, and I mean no one, is too big to fail.  Let's look at what happened to Lehman Brothers.  They failed.  They went bankrupt.  Did it have an extremely negative impact of financial markets?  Of course.  Credit was extremely hard to find, people started calling debts and most firms had short term liquidity issues.  Did it lead to the end of the world?  No.  That is because we have a bankruptcy system in this country for a reason.  Just because Lehman was forced to take huge losses and dissolve does NOT mean that the good assets of the company went away.  Lehman provided many profitable services and products even up to and after its bankruptcy.  These sectors were sold off during their bankruptcy to help pay off creditors and finance losses in other business areas.  To this day I am not convinced that AIG/Goldman Sachs/CitiBank bankruptcies would have led to the end of the world.  Are you?  Would things have been bad for a while?  Yes, but they are also very bad right now.  But what happens when you allow of a market correction rather than a bailout is that you get the bad assets out of the system immediately.  Instead, we prolonged the problem and helped pass it on to our kids through ridiculous amounts of debt.  In a non-bailout world, the smart firms who could afford to buy up Goldman's bad assets in  bankruptcy would be the ones with market share today, and the moral hazard of bailouts would be eliminated.  Nothing sends a better signal to market actors to rethink their positions than the knowledge that they bare both the risk of failure and are entitled to the benefits of success.  Instead, we rewarded failed firms that that in retrospect misused many derivatives to the detriment of firms that did not.  No amount of regulation of derivatives would do more to temper there use than allowing firms that use them in ultimately unprofitable ways to fail, just like any other multiparty contracts. 

Additionally, derivatives serve many important roles in the financial system such as providing a hedge to risk.  A lot has been made about Goldman's supposed "fraud."  That type of "fraud" (selling a security to two sides: one side with a long position, one side with a short position) helps drive markets to their true value by increasing total information built into the product prices.  Even if people were using derivatives to bet against the housing market, that is a good thing.  It shows that people believe prices are overvalued, helping to deflate the bubble earlier than it would have been absent the derivative trades.  Rather than forcing all derivatives to be traded on exchanges, counter-party solvency and fear of default would provide enough incentive for firms to contract accordingly.  That is only true, however, if firm failure is an option.

Lastly, and in my mind most importantly, is the resolution authority granted to the FDIC.  First, you just read my take on too big to fail, but that doesn't mean that we currently have a perfect mechanism for dissolving failing financial firms.  We don't.  But the best place to do that is in a bankruptcy court, which can provide at least a little bit of insulation from political interests interfering with the process.  But anyway if all the bill did was to create this resolution authority for the purposes of liquidating of a firm entering resolution, that wouldn't be too bad.  However, the Dodd bill gives the FDIC clear authority to engage in loan guarantees during a crisis for any company deemed to be systemically important to the financial system.  This is a bailout authority for creditors in addition to the resolution authority!!!!!  The FDIC can accept any collateral it chooses to borrow up to 90% of the assets value to provide guarantees for for these companies creditors.  And nowhere in the bill does it say that these guaruntees must be made equally and fairly for all creditors.  WE ARE JUST ASKING FOR THE SAME KIND OF FAVORITISM SHOWN TO CREDITORS IN THE CHRYSLER/GM BAILOUTS.  This is simply unacceptable.  Obviously it makes legislators' jobs very easy to simply leave it to the FDIC to determine how and when to exercise this authority, but this puts the the U.S. taxpayer on the hook for the mistakes of political favorites.  For example, take CitiBank.  If the FDIC had used this authority to bailout Citi's creditors it could have borrowed up to $1 trillion. 

Finally, it is absolutely ridiculous that the role of Fannie Mae and Freddie Mac played in the financial crisis is completely ignored in the bill.  Together the two firms have already borrowed $125 billion from the feds and the Congressional Budget Office predicts they ultimately will drain $380 billion.  This is far more than any of the TARP expenses for all the financial firms and auto makers combined.  And we probably have no chance of ever being repaid.  Almost of these losses were realized because of a misplaced government mandate that Fannie and Freddie provide loan guarantees to spur home ownership among low income individuals.  These companies were a moral hazard in the housing market.  They were implicitly backed by the government and were more than willing to back some of the riskiest loans in the housing market.  But alas, they are ignored in the legislation..  Hopefully, the CFPA will crack down on Fannie and Freddie's predatory lending practices.

iran again, and obama's reqorking of the financial regulation system

Well since my last post, things in Iran seem to be getting worse. At this point the government has begun cracking down on protesters and several innocent people have been killed while trying to assemble peacefully and voice their outrage over this sham election. Earlier today President Obama made a statement condemning the "unjust actions" being taken by the Iranian government. Many Republicans have criticized the the president for not being more forceful with his condemnation. Although I had been critical of President Obama for not speaking out more clearly, I think he took a step in the right direction today. I think the President is right not to issue a harshly worded statement condemning the Iranian government in general. Although that is how every American feels, doing so would simply give fuel to the regime to spew anti-American propaganda and use it as an excuse to crack down on the dissenters. This type of harsh crackdown could end the protests altogether, along with any chance of seeing real change in Iran anytime soon.


The President should denounce the violence against the protesters. The U.S. stands for the principles of freedom of speech and assembly, and we should tell the world that any regime that does not respect those rights is no friend of ours. However, attacking the regime directly and threatening direct military action will probably do little more than given the Ayatollah an excuse to quash the protests even further. Things are currently moving in the right direction without the help of the U.S. and we should let the people of Iran continue their push for basic human rights. I'm not saying that we should never get involved, but until the regime starts using even more brutal tactics and killing its own citizens on a wider scale, we should let the Iranian people do the heavy lifting. The U.S. should allow the Iranians to contest the issue of whether the election was free and fair, and then focus the government's efforts on standing behind the rights of Iranians to peacefully protest election results that they believe have been manipulated.


But just because we won't intervene militarily, or threaten to do so, does not mean we should do nothing. First we should impose an oil embargo on Iran. Unfortunately, doing this through the U.N. will prove ineffective. The U.S. should come out and say that any country that buys or sells oil from Iran will no longer be a favored trading partner. This must include China. The consequence of doing business in Iran should be a large tariff place on any good imported from that country to the United States. If we make the penalty strong and stick to it, not even China will be able to skirt around it. They are much to dependent on U.S. imports.

On a very different note, I just want to say a few words regarding Obama's recently passed retool of the financial regulation system imposed by the federal government. The premise behind the whole bill was that although their were several agencies overseeing individual players and institutions in the financial markets, there was no single entity on the lookout for problems that posed a "systematic risk" to the system as a whole. According to Obama's flawed rhetoric, Wall Street bankers gamed the system and took tremendous long term risks in order to make large short term profits. According to the administration, the bankers deliberately packaged volatile investments such as mortgage banked securities so that they could hide risk and sell them to banks and other financial institutions for short term profits. How could anyone believe such a statement? Most Wall Street bankers are extremely intelligent people who were simply using the information available to them at the time to try and make profits for the investors they represent.

Investment bankers are logical decision makers like anyone else, and they make decisions based on two factors: potential returns and associated risks. The real cause of the crisis was not greedy bankers trying to make a quick buck, but the distortion of actual risk in the marketplace. And who caused that distortion of risk? I'm my opinion there were three principle causes: the federal government's implicit backing of Fannie May and Freddie Mac, failure of the ratings agencies and the federal reserve's easy money policy of the first half of this decade.

The first I think is quite obvious. Fannie and Freddie have always been semi-public entities, and the federal government has pressured them to finance mortgages for lower income people, even if those borrowers would not have received the loans absent the government pressure. By giving these loans to people who would not otherwise be deserving, at rates that do not reflect this risk of default, the government created bubble whereby they were almost statistically guaranteeing that default rates would be higher than would have otherwise have been expected. Additionally, by not adjusting the interest rates of these mortgages to reflect these higher probabilities of default, they did not hedge the risk of default with a higher rate of return. However, since the mortgages were backed by Fannie and Freddie, investors assumed they adequately reflected market conditions and even if they weren't that the federal government would take any losses (which they are doing now).

This also plays into the second point, that the rating agencies gave many mortgage back securities AAA ratings. What in hindsight could be considered extremely risky and small return securities received the highest ratings possible. Why? Well first there are tremendous conflicts of interest associated with these agencies. They are paid by the sellers, so they have strong incentive to inflate their ratings to make their clients happy and earn repeat business. The ratings agencies should work for the buyer, as they are evaluating risk for the buyer, not the seller. However, only federally approved agencies can perform this work, and the federal government dictates their structure. Until the federal government gets out of the rating picture, forcing buyers to independently rate potential securities investments by use of private rating entities, thereby imposing on the buyer the known risk of what happens if they trust a faulty rating, these mistakes will continue.

Lastly the federal reserve fueled a bubble mentality by keeping interest rates artificially low for too long, making them effectively negative in terms of real dollars. An effectively negative interest rate makes it more profitable to borrow money even if you don't have too, because you will be paying off the loan with a dollar that is worth less in value in the future. This lower dollar value even made up for the interest being paid on the loan under prevailing rates. By flooding the system with excess liquidity, the fed ensured that more risky investments would be made for less chance of profit. The result is the bust we are currently enduring.

So how is the Obama administration solving the problem. BY GIVING THE FED MORE POWER. He is giving an unelected body that already wields way too much power in our monetary system even more influence. It is outrageous. They will now have the power to inspect the books and require certain actions to be taken by any entity that the chairman deems to be a "systematic risk" to the financial system. Not to mention the rating agencies are not being reformed at all. For an example of how ignorance at the fed has contributed to the current collapse please read the following three articles in order: Speed Demons at the Fed, Slack Labor Markets Will Hold Down Prices, and Bernanke at the Creation. The first is an editorial by the WSJ in 2003 which predicted many of the problems were are seeing today, and criticised the fed as creating the environment for them. The second is Bernanke's remarks from a 2003 open market committee meeting were he dismisses the journal as being out of touch. The final is an editorial which points out why the journal was right, Bernanke was wrong, and that he is now pursuing the same type of policies that caused the problems in the first place. So get ready for another boom/bust cycle, except this one will probably be marked by much higher inflation. So what is the only logical thing to do? I know, let's give the fed even more power.