The regulation bubble

November 10, 2009 in Finance,News

Senator Dodd's proposed financial reform bill is long on words (1136 pages, but there's an 11-page summary) and short on solutions. Institutions, posts and policies will be created; reports, hearings and testimonies will be given; escape plans, living wills and registrations will be submitted; and in the end very little will actually be done.

This is what I call a "watched pot" plan - it seems to operate on the principle that with enough people staring at the economy, it won't boil over. And we better hope not, because there's not much in this plan that tells the watchers what to do differently when it does.

So, let's meet our watchers:

First up, the Consumer Financial Protection Agency: a sort of FDA or CPSA for retail financial products. I have to wonder how exactly this is going to work; what will be the determination of a "fair" financial product? There won't be a smoking gun, like contaminated food or dangerous toys. But financial products are legal contracts, meaning the specification of every product is explicitly detailed in its prospectus. The prospectus goes far beyond the nutritional facts on the side of a box of cereal, specifying the product's details down to the manner in which the number of days between interest payments should be calculated. Since that document must be provided prior to a sale, there is little for the CFPA to do in the way of information transparency outside requiring warning labels that say, "Caution: do not apply for this mortgage if you are pregnant or nursing."

Instead, the CFPA will likely focus on the manner and clarity with which that information is presented. This will effectively result in banks outsourcing their marketing operations to the government. Now, it would be great for consumers to be better educated about financial products (indeed, the CFPA will embrace a new Office of Financial Literacy) but it's hard to imagine what sort of investigative abilities the CFPA will actually bring to bear. Would they be able to declare a recall of option ARM mortgages? I can't figure out how that would work. And would better knowledge of how an option ARM works really have prevented Americans from going after them like crazy? I am not convinced that the problem is that American's didn't know their rates would increase; I think a lot of it has to do with investors' myopic views and their simply not caring.

So: it's nice to have clarity in financial marketing, but this certainly won't be "A Watchdog with Real Teeth."

Next, the Agency for Financial Stability. This group will identify systemic risks and implement barriers to growth if a firm gets too big. It's a bit like a preemptive trust buster. It also relies on the ability to predict failure, something the government has been abjectly horrible at doing. This sounds a little like a rebranding of the Fed, except it will have no natural relationships with any the firms it is charged with regulating. Perhaps a better comparison is the Basel II accords, which were set up for exactly the same reason.

Finally, the Financial Institutions Regulatory Administration will combine existing financial regulators under one umbrella in the interest of efficiency. I am always a fan of efficiency.

Below that triad, the SEC will gain oversight of investment advisors with more than $100 million in assets, including hedge funds. One must wonder, given the teams of auditors that pour over these teams every year (with mixed results), how the SEC will possibly manage to pay attention to all the firms under its jurisdiction. A possible upside would be the implementation of standardized portfolio reporting systems - but I doubt it. The Madoff scandal shows that large firms can slip under the SEC's radar. Now small firms will have that opportunity as well. I'm kidding - fraud is, of course, an important area for government regulation. Let's be sure we're not creating a backstop for imprudent investors with one hand while the other one claims it's removing moral hazard in large institutions.

Moreover, the draft is quite clear in specifying that "investors in securities will be better protected by improving the competence of the SEC." It's actually quite a relief to see that admitted in writing, especially given that the agency is going to have even more firms under its jurisdiction. May I suggest improving the competence of investors as a secondary measure?

The Office of National Insurance is a new department at the Treasury tasked with overseeing - yup - insurance companies.

The new Office of Credit Rating Agencies at the SEC suffers the same problem as its parent - how can it possibly penetrate the depths of the firms it is charged with overseeing? Here's a paraphrasing of this office's abilities:

  1. Require ratings organizations to disclose methodologies, use of third parties for due diligence, and ratings track record.
  2. Require agencies to consider information from sources other than the organization being rated if they find it credible (huge "if" there!)
  3. Compliance officers can not work on ratings, methodologies or sales
  4. Investors can sue ratings agencies for knowingly providing flawed services
  5. Require ratings analysts to pass qualifying exams and have continuing education.

On the one hand, none of this inspires any confidence in the rating agencies even after implementation. We already have their methodologies right here. On the other hand, it completely fails the "McDonald's all-white meat" test: if all of these would be new regulations, what were the rating agencies made of before??

Finally, the Municipal Securities Rulemaking Board is going to protect municipalities so that they aren't fleeced a la Jefferson County. It's unclear to me why that would be handled by a separate body than anything else - the interest rate products that were sold in Alabama weren't municipal; they were merely sold to a municipality. Misleading the client by any other name...

So, we've got all these people watching the system. The hope is obviously that they prevent anything bad from happening, and the major tool they have for ensuring that outcome is their ability to enhance financial transparency. While no one would deny that transparency can be helpful, is it really going to prevent a systemic failure? Hardly; but it might yield an early warning. ("Might" is a very strong word. How about "it might yield an early warning if the various regulators tune in to the right firm at the right time and accurately predict how future events will affect that firm's ability to do business as well as its relationships with other firms and their respective operative conditions.")

So what will our watchers do as the pot starts to bubble? Not much. Most of the options outlined in the draft would either have little impact or be impossible to carry out in practice.

One of the big bullet points is breaking up large companies. I don't see how this makes a dramatic difference - GM had to go into bankruptcy before it was broken up, and by then it was too late to stave off a failure (by definition). Breaking up a hurt company would be a gesture at best - imagine telling Citigroup today they had to split in two. For that matter, imagine telling them that in 2007, on the basis that "we think you're going to be dangerous in two years."

The regulators will have much more success with their second bullet: increasingly strict rules as financial firms grow larger. At least, they will have more success if progress is measured by "fewest number of large companies." There are not - and have not been - any monopolies in financial markets. Goldman Sachs has demonstrated that there is absolutely nothing universally systemic about this failure; they have succeeded despite the crash. So why are we afraid of large companies? Because of our fear that their failure could trigger Armageddon? Is there anyone who believes that if Lehman Brothers had not gone bankrupt, the economy would be healthy? Bank failure is a symptom of a dying economy, not a cause. There is no such thing as "too big to fail"; there is only "we're too scared to let you fail".

But don't worry - there won't be any government intervention. Companies will be required to provide their own capital injections by issuing hybrid securities. Will it work? Sure, as long as anyone's willing to provide them with capital. This worked extremely well for banks when the FDIC backed their debt. It didn't work so well without a guarantee.

And should the grim reaper come to take your firm to the giant trading floor in the sky, the company will have been required to provide a plan for its "rapid and orderly shutdown"  - a living will. The regulators will basically say, "Hey, Large Firm - we want to be able to close out your operations quickly and smoothly. Provide us a plan for doing so. Keep in mind that in such an event, you've likely lost most of your employees, have no excess cash or liquidity, and are inundated by screaming customers trying to extract what little value they can before you inevitably disappear. Don't forget that the market won't give you a good price on anything. Oh, and if you can provide a simple map of your subsidiaries, that would be great."

Meanwhile, derivatives will be traded on an exchange with a central clearinghouse. Nevermind that neither of those can provide any utility unless the derivative in question is widely adopted and traded. And banks that securitize products will be required to keep 10% of the credit risk. What does that mean? They must keep 10% of the exact product, by notional? Can they keep a different tranche, if the credit exposure is the same? What risk is it, exactly? None of these questions are answered, because they would require a definition of "risk".

So, we have a lot of new eyeballs on the scene and a few new ways to keep firms from getting big. I remain unconvinced that size is the qualifier here - firms don't have to be very big to do a lot of damage. Long Term Capital Management had fewer than $5 billion in assets when it required a government bailout. I don't really see how all of this will prevent another economic disaster. A lot of it is fine - the efficency, the education - but let's not delude ourselves into thinking everything is ok because we've designed a way out of the mess. Anyone who bought portfolio insurance in 1987 will agree.

Remember how a decade ago everyone was putting money into firms that produced nothing and had no assets, but sounded really good? More recently, banks started handing money to anyone who said they wanted to buy a house - just because they could. Now we have the government pursuing actions because they would have helped if they'd been in place before (according to the people implementing them). It looks like a regulation bubble from here, complete with shaky reasoning and all.

And the next time that the pot boils over, we'll be able to go back and see who wasn't watching whom the way they were supposed to. And maybe we'll assign someone to watch them in the future. Because the future, you see, always happens like the past.

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