[corp-focus] The Good, the Bad, the Ugly: Financial Sector Reform

[robert weissman]

Links and forum to comment on this and other columns at:
<http://www.multinationalmonitor.org/editorsblog>

The Good, the Bad, the Ugly: Financial Sector Reform
By Robert Weissman
June 17, 2009

There are major gaps and shortcomings in the Obama administration's 
financial regulatory proposals, formally released today, and the 
proposals alone leave the financial sector vulnerable to future crisis. 
Still, it's nice to be able to say that the proposal does contain 
meaningful reforms.

Whether those meaningful reform proposals become law is no sure thing, 
and will depend on the administration's willingness to stare down Wall 
Street -- which still retains immense political power, despite its 
partial self-immolation -- and on whether a mobilized public demands 
Congress act for consumers, not contributors.

The 85-page draft released today is qualitatively different than the 
bullet-point plans previously issued by the Treasury Department. It 
contains detailed proposals, spanning across the financial regulatory 
spectrum, not easily summarized. Here are only some key elements -- 
first, the good, then the bad.

The Good

1. The administration supports creation of a strong Consumer Financial 
Regulatory Agency.

It proposes to give this new agency very strong powers, and jurisdiction 
over consumer protection rules -- taking away authority from existing 
regulators (like the Federal Reserve) that have failed utterly to 
protect consumers. It favors simplicity and gives the new agency the 
authority to mandate financial firms offer "plain vanilla" loans along 
with the more complicated packages they prefer. It gives the agency 
authority to ban mandatory arbitration provisions that strip consumers' 
right to go to court for redress of scams and rip-offs. And it 
establishes that the new agency's rules will be a regulatory floor, with 
states permitted to adopt stronger protections.

2. The administration proposes to reduce speculative betting, through 
new standards on leverage.

One reason the financial crisis spun out of control was financial firms' 
excessive use of "leverage" -- borrowed money. Heavily leveraged, the 
top commercial banks and investment banks overreached with very risky 
loans and investments. The administration proposes that all systemically 
important financial firms be subjected to higher capital reserve 
standards (meaning they can rely less on borrowed money). The 
administration properly says these rules should apply to any 
systemically important firm, whether or not it is a bank. It defines 
systemically important as a firm "whose combination of size, leverage 
and interconnectedness could pose a threat to financial stability if it 
failed." There are still important details to be worked out here, 
including how much capital such firms must maintain. And there is the 
very worrisome element that it is the Federal Reserve that is given 
primary responsibility for overseeing these systemically important firms.

3. Through "skin-in-the-game" rules, the administration aims to prevent 
predatory and reckless lending.

One reason lenders were willing to make so many predatory and 
bad-quality mortgages -- including but not limited to the class of 
"subprime" loans -- was that mortgage originators did not hold on to the 
loans. Mortgage brokers cut deals on behalf of banks and non-bank 
originators, which in turn sold the resulting mortgages to other banks. 
These banks, in turn, sliced and diced the mortgages, combined them into 
packages of pieces of thousands of other mortgages, and sold them to all 
kinds of investors. Because the initial lender did not maintain an 
ongoing interest in the mortgage, they did not have any incentive to 
ensure they were making a quality loan.

The administration proposes that loan originators be required to keep, 
at minimum, a 5 percent exposure in loans.

4. The administration seeks power to take over failing, systemically 
important financial firms.

The government already has such "resolution" power for commercial banks. 
The Federal Deposit Insurance Corporation regularly takes control over 
failing banks and "resolves" them outside of the bankruptcy process. 
This typically means selling off the failing bank to another bank, often 
after separating its good assets from bad. FDIC is expert at this 
process, moves very quickly, and averts the harmful consequences from 
extended bankruptcy processes.

The government does not have the legal authority to undertake comparable 
measures for important non-bank firms. This includes investment banks 
(think Lehman Brothers) and insurance companies (think AIG). Giving the 
government resolution power for non-banks should help control financial 
panic.

The Bad

1. The administration does not propose to do anything serious about 
executive pay and top-level compensation for financial firms.

The administration does support "say-on-pay" proposals, which give 
shareholders the right to a *non-binding* vote on executive 
compensation. But a non-binding vote isn't worth too much; and, more 
importantly, shareholders are often willing to support excessive 
compensation while risky bets are paying off.

In terms of financial stability, the imperative is to do away with the 
Wall Street bonus culture, where executives and traders are given 
extraordinary bonuses -- often four or more times base salary -- based 
on annual performance. This bonus culture gives traders and executives 
alike an incentive to take big bets -- because they get massive payoff 
if things go well, and don't suffer if they go bad, or go bad sometime 
in the future.

This is a structural problem, not a symbolic one. Anyone who thinks pay 
isn't of overriding importance in financial regulation should have been 
set straight by the desperation of the bailed out Wall Street firms to 
pay back their loans from the government. That desperation is 
overwhelmingly tied to a desire to escape the extremely modest pay 
standards issued by the Obama administration.

Besides financial stability, there are important questions of economic 
justice and taxpayer rights related to executive compensation. The Wall 
Street hotshots -- including the major hedge fund players -- have paid 
themselves unfathomable amounts of money over the last decade. They have 
set an aspirational standard for other executives and professionals, and 
helped drive wealth and income inequality to outrageous and unhealthy 
levels. Ultra compensation should be taxed at very high rates; and, at a 
bare minimum, the loopholes that let hedge fund managers pay taxes at 
about half the rate of regular folks must be closed. The case for 
aggressive tax reform on ultra rich financiers was overwhelming last 
year; now, with the financial system completely dependent on taxpayer 
largesse, there shouldn't be anything left to debate. No one in finance 
can say they made their money just by working hard or being clever -- 
their system was saved by the government.

2. The administration does not propose structural reform of the 
financial sector.

Although it proposes some meaningful regulatory reform, and modest 
alteration of the structure of regulatory agencies, the administration 
does not propose to alter the structure of the financial sector itself.

There is no discussion of returning to Glass-Steagall principles, to 
separate commercial banking from other financial activities including 
the speculative world of investment banking. Glass-Steagall was adopted 
during the Great Depression, as a response to financial abuses that 
closely parallel those of the previous decade. Repeal of Glass Steagall 
-- following a decades-long erosion -- came in 1999, and helped pave the 
way for the present crisis.

Nor is there any discussion of shrinking the size of goliath financial 
firms. Everyone now recognizes the problem of too-big-to-fail and 
too-interconnected-to-fail financial firms. The administration proposes 
to deal with the problem through regulation alone; a more fundamental 
approach would break up giant firms (or at least commit to prevent 
further consolidation going forward).

Addressing structure and size is important not only because of the 
economic power accreted by the goliaths, but because of their political 
strength -- about which, see below.

3. The administration's approach to regulating financial derivatives is 
too timid.

To its credit, the administration proposes to repeal recent deregulatory 
statutes and establish regulation of financial derivatives. But its plan 
does not go far enough. It creates a regulatory exemption for customized 
derivatives -- a loophole that will create lots of business for 
corporate lawyers ready to change terms in derivative contracts so that 
they differ somewhat from standardized terms.

Nor does the administration propose to ban classes of dangerous 
financial instruments that cannot be justified. A clear example of a 
product that should be banned is a credit default swap -- a kind of 
insurance against a certain outcome, like the inability of a bondholder 
to make required payments -- in which neither party has a stake in the 
underlying transaction. Such credit default swaps have no insurance 
component, and are nothing more than bets -- but they are bets that can 
vastly exceed the value of the transaction being bet on, and can spread 
financial contagion, as AIG demonstrated. George Soros argues that all 
credit default swaps basically share this feature, and should be banned 
altogether.

The administration proposal also fails to require that exotic financial 
instruments be subjected to pre-approval requirements. Under such an 
approach, financial firms would be required to show that new instruments 
offer some social benefit, and do not pose excessive risk.

4. The administration does not propose to empower consumers.

There is enormous merit to the proposal for a Consumer Financial 
Products Agency. But it is not a substitute for giving consumers the 
power to organize themselves to advance their own interests. Simply 
mandating that financial firms include in bills and statements (whether 
mailed or e-mailed) an invitation to join an independent consumer 
organization would facilitate tens of thousands of consumers -- and 
likely many more -- banding together to make sure the regulators do 
their job, and to prevent Wall Street from "innovating" the next trick 
to scam borrowers and investors.

The Ugly

Identifying the merits and gaps in the administration's proposal is 
important. But the proposal does not exist in a vacuum, and it doesn't 
become law just because the administration has proposed it.

The Wall Street types don't know shame. Having benefited from literally 
trillions of dollars of taxpayer largesse, one might expect that they 
would be embarrassed to lobby on Capitol Hill. Or, that Members of 
Congress would be unsympathetic to their pleas.

But that's not how Washington works. Having spent $5 billion on 
political investments over the last decade, Wall Street continues to 
pour cash into the political process -- and those investments continue 
to pay handsomely.

To understand how things work, consider the fate of the proposal to give 
bankruptcy judges the power to adjust mortgages, so that they could 
reduce the principal owed on loans on homes now worth less than value of 
the loan. Then-candidate Barack Obama campaigned in favor of such 
"cram-down" provisions. In a rational world, banks would agree to these 
adjustments to principal on their own, because they do better if people 
stay in their homes and continue paying on the loan, rather than by 
forcing foreclosure. Not long ago, it was widely expected that cram-down 
would quickly become law. But the banks deployed their lobbyists, and 
this vital though totally inadequate measure was defeated in May. The 
Obama administration sat quietly by.

http://www.nytimes.com/2009/06/05/business/economy/05bankrupt.html?hp

Now, Wall Street is already trashing the good parts of the 
administration's proposals.

"Congress is not going to impose a 'skin-in-the-game' requirement on all 
loans," Jaret Seiberg, an analyst with Washington Research Group, a 
division of Concept Capital, flatly tells American Banker.

The Chamber of Commerce and other industry groupings are attacking the 
idea of a Consumer Financial Product Agency, including with the 
extraordinary claim that it will improperly relieve consumers of their 
duty to do "due diligence" on financial products.

Hedge funds are hiring ever more lobbyists and floating the claim that 
the administration's requirements for some modest disclosure 
requirements for secretive hedge funds could do more damage than good. 
One purported reason: the disclosures may be too complicated for regular 
people to understand.

There's no question that Wall Street is going to mobilize -- is already 
mobilized -- to defeat the administration's positive proposals.

What remains very much in question is the administration's willingness 
to engage in bare-knuckled political fighting to defend these proposals, 
as well as whether the public will be mobilized to support these and 
other moves to control Wall Street.

A new public interest coalition -- Americans for Financial Reform -- 
aims to do just that, but they are fighting on occupied territory. As 
Senator Majority Whip Richard Durbin says, "the banks are still the most 
powerful lobby on Capitol Hill. And they frankly own the place."


Robert Weissman is editor of the Washington, D.C.-based Multinational 
Monitor, <http://www.multinationalmonitor.org> and director of Essential 
Action <http://www.essentialaction.org>, a member of the coalition 
Americans for Financial Reform.

(c) Robert Weissman

This article is posted at: 
<http://lists.essential.org/pipermail/corp-focus/2009/000321.html>.