CRA

Allow me to rant:

We deserve better than this. We really do.

We have now reached that part of the Obama administration’s agenda where we can start to assess the reality of the intent to introduce change. The core of the next few months, and perhaps the entire first term, rests squarely upon the nature of the reforms being introduced for health care and banking. Is Obama shooting for FDR status and enduring legacy, or is he content with a more modest agenda.

It’s too early to tell with respect to health care, which is a subject that Obama must have been wrestling with for a long time. But as for banking reform: he is no FDR. The announcement today outlines a bureaucratic rather than robust response to the central cause of our crisis: the systemic failure of finance.

This is very disappointing.

“Most of the true innovations in finance occurred before this explosion: ATM’s, and debit and credit cards are obvious examples. They are actually useful. That other stuff? Junk. No use except to generate fees and bonuses. What Minsky would call Ponzi finance. Therefore not just rubbish, but dangerous rubbish.”

Let’s start by recalling what went wrong:

• We walked away from the safety and soundness doctrines introduced after the Great Depression.
• We substituted market forces for regulatory constraints.
• We relied on ‘self-regulation’ and ‘personal ethical standards’.
• We became lax in enforcing what rules were left.
• We encouraged innovation in finance, but never monitored its value.
• We ignored the concentration of power and influence in the major banks.
• We allowed Wall Street to push aside the main street banks in core financial services.
• We extended the government safety net into Wall Street activities.
• We ignored asset price inflation.
• We ignored the steady ratcheting up of risk and leverage caused by competition and lax oversight.
• We ignored the absence of objectivity of the rating agencies.
• We ignored the effects of a disconnect between performance and reward in Wall Street compensation.
• We forgot all the lessons of the Great Depression.
• We relied on false economic theories.
• We forgot that extending a safety net to huge banks without constraining them produces moral hazard.

We became fat, happy, complacent and far too reliant on short term memory: we ignored history. Which as we all know condemned us to repeat it.

In short, we screwed up royally.

We had a self induced systemic melt down of historic proportions.

The upshot is that we tore apart the firewall FDR built around the financial system and replaced it with an odd combination of big government subsidies and safety nets to banks, reduced oversight, deregulation, and quiescent or benign attitudes towards obvious excesses. This was Big Government and NeoCon thinking all rolled into one. It is a sure sign of the extent to which financiers captured control of the legislative and oversight systems that no one noticed the contradictions. The wool was pulled firmly over our eyes, while to corrupting power of big money ‘free speech’ did the rest.

Ah! But the market is always beneficent. It is efficient. Rational. And so so special that we had better never get in its magical ability to innovate.

Like credit default swaps on treasury bonds. Or reverse convertible stocks. Or all that jumble of derivatives. Or sub-prime mortgages. Innovations one and all.

Most of the true innovations in finance occurred before this explosion: ATM’s, and debit and credit cards are obvious examples. They are actually useful. That other stuff? Junk. No use except to generate fees and bonuses. What Minsky would call Ponzi finance. Therefore not just rubbish, but dangerous rubbish.

That’s the unfettered financial market at work.

Ugh.

The plain fact is that financial systems simply do not conform to the economics text book model of equilibrium seeking. In fact they have an ugly tendency to veer off course and spin violently into unstable and destructive mayhem.

Bankers need to be kept firmly in a box. We should never, ever, let them play with the matches of financial innovation without firm parental controls in place.

This observation is not new. Keynes, Minsky, and others like Mandelbrot and Roubini have talked about the inherent instability of finance before. We forgot or ignored their work. We had to learn or rather re-learn their insights for ourselves.

Which we just did.

Given the epic destruction of wealth that the financial system just wrought I would have thought that draconian efforts would be made to re-erect a wall around it so it cannot repeat itself any time soon, if ever. This is especially so given the sterling work of analysts who have studied the outcomes of financially induced recessions: all studies point to the massive devastation such recessions cause. Financially created recessions are far more severe, last longer, cut deeper, and destroy more wealth than other recessions. This should cause us to re-double our efforts to take the toys away from the superannuated children who prowl around Wall Street.

So. Is this what we got?

No.

Instead we have a financial regulatory reform proposal that plays lip service to some of the key things we need to eliminate.

But let me be fair. The paper has some merit. It attempts to throw a rope around ‘systemically’ dangerous companies. These are the ‘too-big-to-fail’ businesses that threaten to wreck the economy every time they sneeze. The good news is that the administration wants to place such dangerous firms under stricter control, with tougher capital standards and central supervision. It even wants, if I read the text correctly, to extend regulation to all financial firms, not just banks, who could wreck our economy. Don’t forget that it was in this ‘shadow banking’ part of the system that the really big problems cropped up.

Great. But if these businesses can really destroy us, which they just proved is the case, why let them exist at all? Why isn’t ‘too-big-to-fail’ simply ‘to-big-to-exist’? Why is it that we tolerate the cuckoo in our nest? Have we no say in this? Or have we lost control?

At least the proposal sets up a method for government seizure of these dangerous behemoths. It was because there was no law allowing such seizure that AIG was dealt with in the ad hoc way is was. Such a new power would be very useful: Citigroup needs to be seized. But the issue is not getting the power, it is having the will to use it. The tone of this proposal suggests we may have to wait a while for that will to pop up somewhere.

Next up. I like the idea of coordinated oversight. It’s about time. But why walk away from regulatory consolidation? Are we scared of our own bureaucracy? Make the oversight agency big enough and tough enough to stare down the big shots at the big banks we have admitted we can’t downsize. Put the entire thing under one roof and do away with the unseemly regulatory turf fights and public spats that have bedeviled recent efforts to get a coordinated approach.

As for derivatives. When folks like George Soros and Warren Buffet say that derivatives need to be either eliminated or severely reduced I take notice. So why just set up an exchange? Why just forbid trades by ‘unqualified people’? Given the performance of the geniuses who invented the mess I doubt whether any of them are ‘qualified’. Tell me: were the people who built the AIG book of credit default swaps qualified or not? These are the very clowns who destroyed our economy and we are restricting the derivatives business to them? That makes me feel a lot safer.

Don’t get me wrong: I am all for ‘transparency’. Which is essentially what’s being proposed as the cure for the mischief wrought by derivatives traders. But there’s transparency and then there’s transparently stupid. Much of the so-called innovation that Obama wants so dearly to protect falls squarely into the latter category. Market forces didn’t root them out in the past, what makes us sure that they will in future?

As for the Consumer Safety pieces of the proposal: good idea. But we need to extend product oversight beyond consumer protection. It was the professionals who sank the ship. They had no clue what they were buying either. We should keep the gunpowder from them too. I understand that consumers need better protection against all those terrible mortgage products that implode at the slightest interest rate hike, but what about credit default swaps? Will we see better standards there too? I suspect the administration thinks its new derivatives exchange will accomplish that. That market magic once again.

And I like the notion of making sure asset generators keep some ‘skin in the game’ when they package up and securitize those assets. But 5% is anemic. They should be forced to keep 10% or even more. One of the great mistakes the market made was to think that securitization spread risk. It didn’t it concentrated it. Plus it separated the ultimate asset owner from the debtor. Hence the problems in the mortgage market and trying to induce mortgage owners to renegotiate the loans rather than simply foreclose on them: they have no idea who the borrower is and they don’t have any expertise in mortgage lending. They merely own paper. This is another ‘innovation’ we could do well without.

Another good part of the proposal is that it shoots at the silly notion being promulgated by right wingers that somehow the Community Reinvestment Act [‘CRA’] created the sub-prime mortgage debacle. This is scurrilous nonsense. The sub-prime market was built mainly by businesses not covered by the CRA. More to the point the CRA had been around for almost three decades prior to the invention of sub-prime mortgages. It is an absurdity to try to pin the disaster on CRA. At least the proposal acknowledges that.

Finally: why no word about compensation? I suppose that’s become taboo already. The plain fact is that the incentive structure in finance drove anti-social behavior. Short term gains were paramount. Long term losses were left to the taxpayers. By offering unlimited guarantees to the entire industry we let them gamble with our money. They set up their compensation to benefit, while shareholders and ultimately taxpayers were assumed to carry the losses. There are very few impoverished bond traders, even today, but there are tons of regular folks paying a huge price because the boys had no limits set on them. At a minimum bonuses should be limited to stock payments and spread over very long terms. No trader should ever collect an annual cash bonus again. Incidentally I have argued this one before: the whole thing unravelled even faster once the old time partnerships converted into public companies. They kept their partner style pay methods but no longer had any significant personal risk. They pretended to be partners still, but they were actually bureaucrats. Entrepreneurs and equity partners can gamble all they like: it’s their money. Bureaucrats should never gamble the way the managers of Bear Stearns, Lehmann Brothers, Goldman Sachs, Morgan Stanley did. So compensation is a big deal. Getting the incentives aligned should be a major legislative priority. This proposal fails on that count.

Obama was careful in his introduction of the proposal to pay homage to market forces. That’s all we need to know. The administration’s heart simply isn’t in this one. The bankers still have too much influence , and the administration is littered with market apologists.

The proposal is being presented as a major effort. But it seems more window dressing than profound course change. It certainly pales in comparison to the sea change that emerged form the New Deal era.

Perhaps this is all politics: the hope is that the regulations will emerge tougher once Congress gets involved. Perhaps Obama fears that he cannot get tougher laws passed. He may be right: already even some Democrats are taking pot shots at the proposal. But that merely makes my case: bankers can pour tons of money into politics. They have legislative muscle. They have captured the system to prevent a loss of power. Which is why stronger reform is needed.

My prediction:

If this is all we get, then there will be a new bubble. All we are doing is putting the boys on a short term probation. We are not stopping the game.

We deserve better than this.

So ends my rant!