Monday, July 19, 2010

"Financial Reform - A Lawyer's Dream"

Sydney M. Williams

Thought of the Day
“Financial Reform – A Lawyer’s Dream”
July 19, 2010

Whether the $862 billion stimulus bill added a couple of million jobs, as the White House would have you believe, or whether it hastened the decline of a roughly equal number of private sector jobs, as Republicans would tell you, one thing is certain – the President’s two landmark pieces of legislation (Health Care and Finance Reform) are certainly LEGAL (literally, Employment Guarantee Acts for Lawyers.)

“With passage [of finance reform] we will have a clear sense of the rules of the road.” So spoke a “senior” Treasury official, according to Friday’s Financial Times. However, after reading reports of the bill in the New York Times, the Wall Street Journal, and Investor’s Business Daily, it is my sense that there are no clear rules. The bill creates a council of regulators, led by the Treasury Secretary. It is regulators who will decide, for instance, which derivatives must trade through clearinghouses. Senator Chris Dodd of Connecticut, the principal architect of the Senate’s legislation, said, according to the New York Times, that the bill’s success “ultimately would depend on regulators’ performance.” Binyamin Appelbaum and David Herszenhorn, in the New York Times, write, “The legislation will be carried out mostly by the same federal workers who were on duty as the financial system collapsed.” And one should not forget the loose practices of Fannie Mae and Freddie Mac; both institutions were instrumental in the financial collapse and are not included in the reform bill. Notably, both GSEs were particularly close to Senator Chris Dodd and Representative Barney Frank, leaders respectively of the Senate and House committees responsible for the Act’s passage.

Critics on the right and the left, according to the Wall Street Journal, say that one of the bill’s key flaws is that it relies on the judgment of officials rather than hard rules.

As a comment on the bill’s complexity, a front page article in Friday’s Journal noted: “J.P. Morgan, one of the biggest U.S. banks by assets, has assigned more than 100 teams to examine the legislation.”

Lawyers at Davis, Polk & Wardell declared that the bill will “unleash the biggest wave of new federal financial rule-making in three generations.” In their summary to clients (itself requiring 150 pages) they estimate that it will require no fewer than 243 new formal rule-makings by eleven different agencies, unleashing, as the Wall Street Journal put it on Friday’s front page, “a lobbying blitz from banks – that will determine the precise contours of this new landscape…Decisions will be made by officials from new agencies, obscure agencies and, in some cases, agencies like the Federal Reserve that faced criticism in the run-up to the crisis.”

What is needed are a few commonsensical rules, clearly written and easily understood, that addressed some of the root causes. Growing disparities in incomes, as we’ve written about before, created tensions between “haves” and “have-nots”. Those tensions were temporarily masked as many consumers, in a bid to “keep up with the Jones’”, borrowed at unsustainable levels. They were encouraged to do so by the Federal Reserve, which kept short term rates low in the early years of the last decade, a decision which abetted asset inflation, particularly houses. Government policy, with passage of the Community Reinvestment Act of 1977 and regulatory changes in 1995, effectively endorsed the notion of living beyond one’s means. Passage of the Financial Modernization Act of 1999 repealed part of the Glass-Steagall Act that had prohibited a bank from offering a full range of investment, commercial and insurance services. The Bureau of Labor Statistics, which computes the CPI, does not include home prices, only rents; so run-away home price increases, as a determinant of inflation, were ignored, helping the Fed justify the continuation of low interest rates. Despite convincing information brought to their attention, the SEC failed to nab Bernie Madoff from defrauding thousands of people of millions of dollars. The elimination of Glass-Steagall permitted banks to use depositor’s money to make bets which served to enrich a small number of employees at the expense of depositors, lower level employees, the community and shareholders. Technology permitted the leveraging of bets to a size where the notional value of the financial industry’s derivative bets dwarfed, by a factor of ten, the economies of the world.

The bill does have its good points. In time, rules are expected to be set prohibiting deposit taking institutions from proprietary trading and limiting their investment in private equity and hedge funds. Most derivatives, but not all, will be forced to trade through clearing houses, thereby reducing the risk of counterparty bankruptcies. Consumers should be better protected, as “abusive” practices will be more closely regulated. It should be understood, however, that the costs will include higher fees and more restricted credit. “Too big to fail” banks have now become “systemically significant” and will face stricter capital, leverage and liquidity standards, but will remain too big.

The bill reminds one of the old cliché: “A camel is a horse designed by a committee.” At 2300 pages, it is a bill that few understand and is immeasurably complex. In adding new bureaucracies, it dramatically increases the size of government. It gives more power to agencies that failed earlier and creates new ones; a host of derivative products may or may not be subject to clearinghouse rules; politicians, many of whom fomented the problem in the first place will largely remain in Washington, revered and untouched. It is a bill which will take years to implement; it is one which will provide employment for lawyers for years to come.

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