Obama's Explosion of Regulation

Obama began his war on private enterprise in America. His first target was to rein in pay across the private sector. Then came credit card companies. Now its a massive attack on the entire financial industry of our nation. Two days ago, “A New Foundation: Rebuilding Financial Supervision and Regulation,” running 89 pages in length and instituting the most far reaching regulation of our financial industry since at least the New Deal. Washington Wire condensed the report to the following:

For the regulation of financial firms, the proposal:

- Creates Financial Services Oversight Council, which would coordinate activities among regulators, replacing the President’s Working Group.

- Ensures that any financial firm big enough to pose a risk to the financial system would be heavily regulated by the Federal Reserve, including regular stress tests.

- Says the Fed will have to “fundamentally adjust” its current supervision to more closely watch for systemic risks.

- Allows the Fed to collect reports from all U.S. financial firms that meet “certain minimum size thresholds.”

- Gives the Fed oversight over parent companies and all subsidiaries, including unregulated units and those based overseas.

- Says the Treasury will re-examine capital standards for banks and bank-holding companies.

- Tells regulators to issue guidelines on executive compensation, with the goal of aligning pay with long-term shareholder value, including a re-examination of the utility of golden parachutes.

- Creates a new bank agency, the National Bank Supervisor, and kills the Office of Thrift Supervision. The new agency will look over national banks, including federal branches and agencies of foreign banks.

- Forces industrial banks, non-bank financial firms and credit-card banks to become more traditional bank holding companies subject to federal oversight.

- Kills the SEC program that supervised Wall Street investment banks.

- Requires hedge funds, private-equity funds and venture-capital funds to register with the SEC, allowing the agency to collect data from the firms.

- Subjects hedge funds to new requirements in areas such as record keeping, disclosure and reporting. The oversight would include assets under management, borrowings, off-balance sheet exposures.

- Urges the SEC to give directors of money-market mutual funds the power to suspend redemptions, and take other action to strengthen regulation of money-market mutual funds to prevent runs.

- Beefs up oversight of insurance by creating an office within the Treasury to coordinate information and policy.

- Kicks off a process by which the Treasury and the Department of Housing and Urban Development will figure out the future of mortgage giants Fannie Mae, Freddie Mac and the federal home-loan banks, which could include winding them down, returning them to the private sector or refashioning them as public utilities.

For the regulation of financial markets, the proposal:

- Brings the markets for over-the-counter derivatives and asset-backed securities into a regulatory framework, strengthens regulation of derivatives dealers and forces trades to be executed through public counterparties, such as exchanges

- Toughens the regulatory regime, including more conservative capital requirements and tougher rules on counterparty credit exposure.

- Strengthens laws designed to protect “unsophisticated parties” from trading derivatives “inappropriately.”

- Gives the Fed more power over the infrastructure that governs these markets, such as payment and settlement systems.

- Harmonizes the powers and authority of the SEC and CFTC to avoid conflicting rules relating to the same products or time-wasting turf battles over who should regulate what.

- Tells the SEC and the CFTC to deliver a progress report by September.

- Requires that originators, for example, mortgage brokers, should retain some economic interest in securitized products.

- Directs regulators to “align” participants’ compensation with the long-term performance of underlying loans.

- Urges the SEC to continue its efforts to improve the transparency and standardization of securitization markets and recommends the SEC have clear authority to require reporting from issuers of asset-back securities.

- Urges the SEC to strengthen its regulation of credit-rating firms, including disclosing conflicts of interest, better differentiating between structured and unstructured debt and more clearly stating the risks of financial products.

- Tells regulators to reduce their reliance on credit-rating firms.

For regulations protecting consumers and investors, the proposal:

- Creates a new agency, the Consumer Financial Protection Agency, with broad authority over consumer-oriented financial products, such as mortgages and credit cards. The new agency would work with state regulators.

- Gives the new agency power to write rules and levy fines based on a wide range of existing statutes.

- Proposes new authority for the Federal Trade Commission over the banking sector, in areas such as data security.

- Creates an outside advisory panel to keep an eye on emerging industry practices.
Says the new agency should play “a leading role” in educating consumers about finance.

- Gives the new agency authority to ban or restrict mandatory arbitration clauses.

- Improves transparency of consumer products and services disclosures.

- Says the new regulator should have authority to define standards for simple “plain vanilla” products, such as mortgages, which would have to be offered “prominently” by companies.

- Proposes the government “do more” to promote these simple products.

- Beefs up the agency’s power to regulate unfair, deceptive or abusive practices.

- Imposes “duties of care” that will have to be followed by financial intermediaries, such as stock brokers and financial advisers.

- Regulates overdraft protection plans, treating them more like credit credit-card cash advances.
- Promotes access to credit in line with community investment objectives.

- Strengthens SEC’s framework for investor protection by expanding the agency’s powers to beef up disclosures to investors, establish a fiduciary duty for broker-dealers who offer advice and expand protection for whistleblowers, including a fund that would pay for certain information.

- Requires non-binding shareholder votes on executive compensation packages.

- Requires certain employers to offer an “automatic IRA plan” for employee retirement, with investment choices prescribed by regulation or statute.

- Urges exploration of ways to improve participation in 401(k) retirement plans

To give the government more tools to manage crises, the proposal:

- Creates a mechanism that allows the government to take over and unwind large, failing financial institutions.

- Creates a formal process for deciding when to invoke this power, which could be initiated by the Treasury, Fed, FDIC or SEC.

- Gives authority to make the final decision to the Treasury, with the backing of other regulators.

- Gives the Treasury the authority to decide how to fix such a failing firm, whether through a conservatorship, receivership or some other method.

- Taps the FDIC to act as conservator or receiver, except in the case of broker dealers or securities firms, in which case the SEC would take over.

- Amends the Fed’s emergency lending powers to require prior written approval by the Treasury Secretary.

In the international sphere, the proposal:

- Recommends international regulators strengthen their definition of regulatory capital to improve the quality, quantity, and international consistency of capital.

- Recommends that various international bodies implement the Group of 20 recommendations, including requiring banks to hold more capital in good times to protect against downturns.

- Urges that national authorities standardize oversight of credit derivatives and markets.

- Recommends national authorities improve cooperation on supervision of globally interconnected financial firms.

- Recommends regulators improve the way firms are unwound when they straddle borders.

- Recommends strengthening the Financial Stability Board.

- Urges other countries to follow the U.S. lead and: subject systemically significant companies to stricter oversight; expand regulation of hedge funds; review compensation practices; tighten rules governing credit-rating firms.

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Niall Ferguson: "Calls For More Regulation Are Symptoms Of The Very Disease They Purport To Cure"

Harvard Professor of Business Niall Ferguson is a brilliant historian and economist. He states that deregulation did not cause the financial crisis and opines that calls for more regulation of the financial markets as very ill advised. Rather, he sees the problem as being poorly designed regulations currently on the books.

This from Niall Ferguson writing at the NYT:

. . . Financial crises will happen. In the 1340s, a sovereign-debt crisis wiped out the leading Florentine banks of Bardi, Peruzzi and Acciaiuoli. Between December 1719 and December 1720, the price of shares in John Law’s Mississippi Company fell 90 percent. Such crashes can also happen to real estate: in Japan, property prices fell by more than 60 percent during the ’90s.

For reasons to do with human psychology and the failure of most educational institutions to teach financial history, we are always more amazed when such things happen than we should be. As a result, 9 times out of 10 we overreact. The usual response is to introduce a raft of new laws and regulations designed to prevent the crisis from repeating itself. In the months ahead, the world will reverberate to the sound of stable doors being shut long after the horses have bolted, and history suggests that many of the new measures will do more harm than good. The classic example is the legislation passed during the British South-Sea Bubble to restrict the formation of joint-stock companies. The so-called Bubble Act of 1720 remained a needless handicap on the British economy for more than a century.

Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.

There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. . . .

We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street. New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers. And the globalization of finance played a crucial role in raising growth rates in emerging markets, particularly in Asia, propelling hundreds of millions of people out of poverty.

The reality is that crises are more often caused by bad regulation than by deregulation. For one thing, both the international rules governing bank-capital adequacy so elaborately codified in the Basel I and Basel II accords and the national rules administered by the Securities and Exchange Commission failed miserably. It was the Basel system of weighting assets by their supposed riskiness that essentially allowed the Enronization of banks’ balance sheets, so that (for example) the ratio of Citigroup’s tangible on- and off-balance-sheet assets to its common equity reached a staggering 56 to 1 last year. The good health of Canada’s banks is due to better regulation. Simply by capping leverage at 20 to 1, the Office of the Superintendent of Financial Institutions spared Canada the need for bank bailouts.

The biggest blunder of all had nothing to do with deregulation. For some reason, the Federal Reserve convinced itself that it could focus exclusively on the prices of consumer goods instead of taking asset prices into account when setting monetary policy. In July 2004, the federal funds rate was just 1.25 percent, at a time when urban property prices were rising at an annual rate of 17 percent. Negative real interest rates at this time were arguably the single most important cause of the property bubble.

All of these were sins of commission, not omission, by Washington, and some at least were not unrelated to the very considerable political contributions and lobbying expenditures of the financial sector. Taxpayers, therefore, should beware. It is more than a little convenient for America’s political class to blame deregulation for this financial crisis and the resulting excesses of the free market. Not only does that neatly pass the buck, but it also creates a justification for . . . more regulation. The old Latin question is highly apposite here: Quis custodiet ipsos custodes? — Who regulates the regulators? Until that question is answered, calls for more regulation are symptoms of the very disease they purport to cure.

Read the entire article. And someone distribute this to Barney and Barack, please.

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Wall St., Credit Default Swaps, Glass-Steagall, The Subprime Crisis . . . & Black Tuesday

"September 30 is the day when positions unwind and this is when the pain on Main Street will really start."

That dire prediction comes from Dinah Lord. Ms. Lord is a blogging friend who spent her formative years as a trader on Wall St. She has been kind enough to do a post explaining the role of deregulation of the finanicial industry with the repeal of the Glass-Steagall Act in 1998 as well as the credit default swaps that are at the crux of the subprime crisis. It fills in an informational gap that I have not seen anywhere else. This is mandatory reading for all taxpayers.

This from Ms. Lord:

. . . Starting back in 1995, the masters of the bond and credit market universe got too cute by half and structured a new and exciting financial instrument, the credit default swap and it's these credit default swaps that are the crux of the problem. The magnitude of the fallout from this hairy piece of "financial engineering" is staggering. Believe me, when I tell you that these things are so wrapped around the axle I don't think anyone knows who's got what.

Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.

Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means "recession-proof").

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

But they didn't work out that way...the real estate bubble burst and the mortgage market melted down, factors of life their models didn't take into account. Which brings us to another Gods of the Copybook Heading meets Gordon Gecko Greed is Good moment...the moment when "Wall Street" took over and expanded the volume far beyond what was required for hedging risk. The traders at commercial banks and insurance companies, freed from the constraints of Glass-Steagall by Bill Clinton era deregulation, jumped in with both feet.

After all, bonuses depend on the volume of business. Therefore, bank traders sold the credit risk of a loan not just once, but as many as 10 times. And they sold it not to solid banks and insurance companies, but to three solid banks, one solid insurance company, three dodgy brokers and three hedge funds. Then the traders went out and sold other CDS products that were not even related to actual loans on the books, but to imaginary indices of credit quality in the "widget" industry.

The credit risk of the system was hugely multiplied.

Instead of one $10 million credit risk loan, there are now ten $10 million credit risks on just one loan.

See what I mean about being wrapped around the axle?

Because of this axle, banks around the world are under tremendous pressure. They've even stopped loaning to each other which tells you how bad it is. Bond traders have been standing around with their hands in their pockets - no one is making trades. LIBOR is quaking under the weight of the stress and the short term paper market has pretty much seized up. Commercial paper is how companies finance their day to day operations and make payroll. September 30 is the day when positions unwind and this is where the pain on Main Street will really start. A flood of redemptions is preparing to swamp Hedge Funds. The US Mint has stopped production of gold coins due to soaring demand. Tonight's Asian market open will indeed be interesting. . . .

This isn't over by a long shot. Unless this can get things moving quickly (and have you ever known anything to happen quickly when the US govt is involved?) havoc will continue to wreak the credit markets, the relief rally in the stock market will be brief. Will smart money continue to stay on the sidelines? Will there be any smart money left? At heart, financial markets are about confidence in the system and confidence has been gravely shaken.

In other words, the jig is up.

How bad it will be is anybody's guess. . . . I believe we will all muddle through somehow.

I'm also a free market trader and believe that the market has to work this out. These type of bailout programs just tend to delay the pain and there is going to be some pain, my friends. I oppose the structure of this bailout on principle, so watching these government types preening and posturing in front of the cameras this weekend was like watching a train wreck in slow motion. They are beyond clueless. And infuriating. For Nancy Pelosi to call the House Republicans for not attending negotiations that they weren't invited to attend is an outrage. To see these Democrats stand up in front of the cameras and outright lie their a$$e$ off just shows you what we're dealing with.

. . . If you are interested in learning more, this piece . . . is a good place to start and this will provide you a window into what's been going on with the banking side of the equation. If you want to laugh and learn as you get up to speed on these magillas go here and check out this horse race analogy.) . . . Some of Dinah's other Wall Street [blog posts] can be found here.

And please be reminded that the fasten seat belt sign is still illuminated. It's gonna be a bumpy one.

The full post contains much more in the way of musings, and I highly recommend her blog to all readers.

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