Financial Reform or Government Takeover Revisited

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
July 27, 2010

IN THIS ISSUE:

1. Financial Regulatory Reform Becomes Law of the Land

2. Doesn’t Solve “Too-Big-to-Fail” or Fannie/Freddie Mess

3. Reform Creates a Massive New Government Bureaucracy

4. Changes to Bank Regulations – Not Too Restrictive

5. Some Derivatives to be Regulated & Traded on Exchanges

6. Reform Law’s Effects on Other Financial Players

7. New Bureau of Consumer Financial Protection

Financial Regulatory Reform Becomes Law of the Land

Last Wednesday, President Obama signed into law the new financial regulatory reform bill entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act.” I wrote about financial reform earlier this year, but I want to revisit the issue again this week. Clients and readers need to have a clear understanding of what this sweeping legislation may or may not accomplish, and how it could affect not only your investments, but also the privacy of your personal financial information.

The final bill that President Obama signed was very similar to the Senate version of financial regulatory reform, which I summarized in my April 20 E-Letter. As you may recall, I argued at the time that we already have plenty of regulators and plenty of regulations, and we just need the regulators to do their jobs.

President Obama and Congress, on the other hand, delivered us a 2,300-page law that its co-author, Senator Chris Dodd, admitted publicly that no one knows what all is in it. Yet President Obama promised that “because of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more tax-funded bailouts, period.” Unfortunately, that is not true as I will point out later on.

Before I move on to more specific elements of the new financial reform law, I want everyone to understand the following point. When President Obama called for the $787 billion (stimulus) in 2009, Congress had to approve it by passing the law and appropriating the money. When President Bush called for the $700 billion in 2008 (TARP) to bail out the banks, Congress had to approve it by passing the law and appropriating the money.

Yet with the passage of the new financial reform law, appointed (unelected) bureaucrats in the Treasury Department will make those decisions, and they will not need congressional approval. Yes, Treasury Department bureaucrats will unilaterally decide under the bill’s “orderly liquidation process” how much of the taxpayers’ money to hand out to troubled firms.

Also, the Dodd-Frank bill, for the first time in our history, gives the federal government the right to seize and liquidate any businesses if they are believed to have “systemic risk” (ie - risks that could threaten the economy or the financial system). This part of the new law applies to banks, thrifts and credit unions, but also to non-banks. This authority will be vested in the yet-to-be-created Financial Stability Oversight Counsel (“FSOC”) which will consist of the Treasury Secretary, the Chairman of the Federal Reserve and eight other unelected officials (read: political appointees).

If the Financial Stability Oversight Council deems a firm to have systemic risk, it can require the company to voluntarily downsize, OR it can move in, fire the board of directors, remove and/or replace management, or it can immediately put the company into liquidation. Many view this power as a violation of the 4th Amendment (I agree), so I expect this to be fought out in the courts in the months and years ahead.

But the power grab doesn’t stop there. The Financial Stability Oversight Counsel is also empowered to create another new government agency to be called the Office of Financial Research (“OFR”). The OFR will have the power to demand any records it wants from any financial firm – repeat, ANY financial firm. If a financial firm does not cooperate, the OFR has subpoena power to seize whatever records it wants – including records on individual accounts.

Big Brother just got a whole lot bigger!

Unfortunately, this power grab is riddled with opportunities for political abuse. You have a group of hand-picked regulators making life-or-death decisions for companies that are, in their opinion, too-big-to-fail. You can just imagine how this could affect the political contributions that large companies make to influential members of Congress.

Aside from the direct political implications, the existence of the FSOC, the OFR and the Bureau of Consumer Financial Protection (discussed later on) could have potentially serious implications for the business cycle and the markets. Over time, these new regulatory agencies will make clear what types of business activities they approve of and which ones they don’t. As this occurs, it would only be natural that financial companies would adjust their business models accordingly.

Doesn’t Solve “Too-Big-to-Fail” or the Fannie/Freddie Mess

Dodd-Frank also does not solve the “too-big-to-fail” problem. Thus, Dodd-Frank does not remedy the fundamental cause of the economic meltdown of 2008, which was the government’s decision to shift the costs of bad investment decisions from corporate executives to taxpayers.

While the government now has the power to seize and liquidate any firms that it deems to have “systemic risk,” that does not mean there won’t be too-big-to-fail companies, now or in the future. Under the new law, the FDIC will still take over big troubled financial firms. It will then do whatever it must to both stabilize the financial system and maximize the value of failed firms’ assets, so to minimize the costs of the resolution process. In order to achieve financial stability, the FDIC will have to cover many of the big firm’s obligations to creditors.

Thus, too-big-to-fail is still alive and well. Rather than eliminating too-big-to-fail and government bailouts, the new reform law will institutionalize them. Even the Congressional Budget Office agrees that taxpayer-funded bailouts are still possible.

Nor does the bill do anything to remove the elephant in the room – Fannie Mae and Freddie Mac – neither of which are mentioned in the new law. The costs of the Fannie/Freddie bailout will reach nearly $400 billion this year, according to the Congressional Budget Office, and could approach $1 trillion before all is said and done. Roughly 70% of all US mortgages are held by Fannie and Freddie, which between them hold $5 trillion of home mortgages in their portfolios.

Fannie and Freddie are still losing billions by the month on bad mortgage investments and taxpayers are still on the hook. This means the housing crisis is far from being resolved and, thanks to the continuing high rate of foreclosures, could plunge the economy back into recession at any time. Of course, Fannie and Freddie reportedly continue to make lavish campaign contributions to politicians on both sides of the aisle (including Chris Dodd and Barney Frank), and that may explain why they were left untouched by the new financial reform bill.

Reform Creates a Massive New Government Bureaucracy

As you probably have heard, this new reform law will create another vast government bureaucracy over the next two years. A total of 13 brand new federal agencies will be created. Thousands of new federal employees will have to be hired, trained and housed in new government facilities. We will very likely never know how much money this will cost, since some of the new agencies will be funded by the Federal Reserve (that’s a whole other story).

As discussed above, the Financial Stability Oversight Council (“FSOC”) will be the first new agency created, and it will oversee the other 12 new federal agencies, including the Office of Financial Research which will have subpoena power to demand private records from any financial firms it chooses.

But the FSOC also has another daunting mission. Its 10-member unelected council is charged with peering into the future and identifying new financial threats before they become systemic. That’s a tall order, especially when financial crises are always different. Somehow I don’t quite see Tim Geithner, or Hank Paulson before him, being able to foretell the future!

Surprisingly, the 2,300+ page financial reform bill fails to address the hundreds of specific rules and regulations that will have to be devised and written by Washington bureaucrats over the next year and-a-half. Harvey Pitt, a former SEC Chairman (2001-2003), said the following shortly after the Senate passed the financial reform bill: We’re about to receive legislation that could be entitled “The Lawyers’ and Lobbyists’ Full Employment Act.”

Changes to Bank Regulations – Not Too Restrictive

At this point, let me summarize most of the new regulations on banks and financial institutions in the financial reform bill. First, a new national bank regulator, the Financial Stability Oversight Counsel noted above, will replace the two agencies that currently oversee national banks and thrifts – the Office of the Comptroller of the Currency and the Office of Thrift Supervision (“OTS”). Before the financial crisis of 2008, the OTS provided loose oversight of banks and S&Ls.

For example, the OTS let banks avoid setting aside money for future losses. Specifically, banks were allowed to assume that even the riskiest mortgages would be repaid. That’s why many risky lenders chose the OTS as their main regulator. The reform law seeks to prevent so-called “regulator shopping” by creating one regulator for all national banks and thrifts and other financial firms.

Next, banks will be required to maintain higher internal capital requirements. Capital is the stable money banks sit on. It includes money not at risk, such as shareholder equity. Regulators will decide how much more capital banks must have to cover unexpected big losses. The law instructs regulators to raise these standards, but they apparently will have some discretion.

The bill purports to ban “proprietary trading” by banks. That’s when banks place bets for their own profit, rather than for their clients. It’s unclear how strictly the ban will be enforced, and there are loopholes as I will discuss below. Also, it can be hard to tell, for example, whether an investment is intended to benefit a bank or its clients, and whether federally insured deposits could be put at risk by these trades. Regulators will draft rules after doing a study.

The proprietary (“prop”) trading ban is part of the so-called “Volcker Rule,” named for former Fed Chairman Paul Volcker, which was loosely incorporated into the new financial reform bill. Volcker, who is now a White House adviser, argues that banks should stick solely to holding deposits and making loans. He thinks deal making and investment banking should be left to firms that taxpayers wouldn’t have to bail out, as was the case when the Glass-Stegall Act was in place from 1932 to 1999. But the powerful banking lobby was successful in preventing a return to Glass-Stegall.

In the end, the ultra-strong banking lobby was able to block the complete ban on prop trading, and instead got Congress to limit prop trading to 3% of the banks’ internal capital holdings, which is still a very large number, especially among the nation’s largest banks. The new reform bill, as best we can tell at this point, does not limit the amount of leverage that banks can use in their prop trading activities. Thus, the 3% limit effectively does little to avoid another financial crisis.

Another part of the Volcker Rule that was adopted will limit banks’ investments in hedge funds and private equity funds. The new rules limit banks from having more than 3% of their capital in such funds, but here again, 3% among the nation’s largest banks is still a very large number.

Finally, I should point out that these new bank regulations and requirements, some of which seem appropriate, will result in higher costs to bank customers over time. As always, corporations pass along higher operating costs and taxes to their customers in the form of higher fees. So as these new rules and regulations are put into place over the next two years, we will very likely see costs and fees increase on almost all financial transactions.

Some Derivatives to be Regulated & Traded on Exchanges

Many financial derivatives will be regulated for the first time. Derivatives are investments whose value depends on the future price of some other investment. Stock options and commodity futures are examples. Many companies use derivatives to reduce risk (hedging). A company might hold a derivative whose profit would allow it to recoup part of the cost if a raw material’s price soared. Before the crisis, some investors used derivatives purely for speculation. Some, for example, made side bets on the housing market going up or down.

Under current rules, many derivatives are traded outside of the view of regulators. The new law requires that most derivatives will be traded openly on exchanges and will be monitored by clearinghouses for the first time. These intermediaries settle trades and are on the hook if the owner can’t pay off on its derivatives contracts. Clearinghouses will require derivatives buyers and sellers to set aside money (margin) for each contract in case their bets go bad.

Banks and other financial firms supposedly won’t be able to trade derivatives that are thought to pose the most risk. It will not be clear which derivatives are considered the most risky until the new regulations are written. The ban is designed to protect taxpayer-insured bank deposits from being used to cover losses caused by derivatives trading. If derivatives losses wiped out a bank’s capital, taxpayers could still have to pay up. But under the new law, banks will still be allowed to trade most derivatives, thanks to the powerful banking lobby.

Other derivatives operators will face tougher oversight. Examples include companies that sell purely speculative derivatives to hedge funds and wealthy investors. Derivatives companies will be required to set aside money to cover possible losses. And the companies can be punished for using derivatives to mask the health of a business or a foreign government. The idea is to block deals like the one in which Goldman Sachs was accused of arranging to help Greece hide its deficit.

There are exceptions to the clearinghouse and exchange-trading requirements. One is for non-financial companies that use derivatives solely to offset business risks (hedging). They can still trade derivatives outside of exchanges and clearinghouses. And they won’t have to set aside money to cover possible losses. They will have to report their trades to regulators, however.

Reform Law Effects on Other Financial Players

Credit rating agencies will be held more accountable. Before the financial crisis, they gave high ratings to some investments that turned out to be worthless. Under existing case law, the agencies can’t be sued for ignoring an investment’s risks, except in cases of fraud. The new reform law would eliminate much of that protection, and investors will be able to sue credit rating agencies for recklessly ignoring risks. Also, the agencies must explain more fully how they assign ratings. If an agency performs poorly over time, the Securities and Exchange Commission could cancel its registration.

The new law will also reduce the influence of the three big rating agencies – Moody’s, Standard & Poor’s and Fitch Ratings. Regulators and government agencies have used their ratings to decide which investments are appropriate for, say, banks and pension funds, which enjoy some government backing. But the reform overhaul lets the SEC and other regulators develop new ways to grade investment risk.

Still undecided is how to address the rating agencies’ conflicts of interest, in that they’re paid by the banks whose investments they rate. Before the crisis, the agencies lowered standards to compete for banks’ business. One option is to randomly assign investments to agencies to rate.

On another front, shareholders of public companies will be allowed to weigh in on pay packages for top executives. They can vote to approve or disapprove of pay deals as part of the proxy process. That’s the annual ballot that shareholders use to elect boards of directors. The votes on pay will be held at least once every three years. But shareholders will not be able to block pay packages they see as excessive, as their votes will be nonbinding.

Shareholders may also find it easier to nominate board members and therefore have a chance to influence a board’s decisions. Fewer shares will be required to qualify a stockholder to nominate a director. Under the new reform law, directors who represent shareholders may be more likely to vote to limit pay and/or reduce the company’s financial risks.

Hedge funds have previously been only lightly regulated, but the reform bill requires those with $150 million or more in assets to register with the SEC as a Registered Investment Advisor (“RIA”). This will subject hedge funds to periodic examinations (audits) and be required to disclose more information about their trades. This is a big change for hedge funds.

New Bureau of Consumer Financial Protection

The new reform law calls for the creation of a vast new agency, the Bureau of Consumer Financial Protection (the “Bureau”), which will have broad sweeping powers with the specific mandate of consumer protection on financial products. The Bureau will be housed in the Federal Reserve and the Fed will fund its budget, yet the reform law states that the Bureau will be independent of the Fed (… hmmm).

The Bureau will have the authority to write rules for consumer protections governing all financial institutions – banks and nonbanks – that offer consumer financial products or services. Only the Financial Stability Oversight Council, by a 2/3rds vote, can overturn a Bureau rule. State attorneys-general are empowered to enforce certain rules issued by the Bureau.

The Director of the Bureau will be appointed by the President and confirmed by the Senate. Elizabeth Warren, the director of the Congressional Oversight Panel (and who I quoted at length in last week’s E-Letter), is considered the favorite to become the Director of the Bureau.

The scope of this new agency will be huge, as it will oversee all of the large banks, all mortgage-related businesses, payday lenders, student loan lenders and also any large non-bank financial firms. Smaller community banks must comply with the Bureau’s rules and regulations, but enforcement will be carried out by existing bank regulators. The only financial entities with an exception to the Bureau’s rules are auto dealers and mobile home sellers that offer financing, along with real estate brokers and accountants.

Conclusions – Another Government Power Grab

Financial regulatory reform was President Obama’s top legislative priority after healthcare reform was passed, despite widespread public disapproval. The Senate passed the financial reform bill only with the help of three Republicans. The final financial reform bill signed by the president was over 2,300 pages long. No one has read the entire bill, save for some congressional staffers. Thus, no one knows what all is really in it, as Senator Dodd admitted.

At least 13 new federal agencies will be created, and hundreds of new rules and regulations will have to be written over the next two years. Thousands of new federal employees will have to be hired, trained and housed in new federal buildings. This will add tens of billions to the budget deficits each year going forward.

As noted above, the main new agency with the most power, the 10-member Financial Stability Oversight Council, will be made up of the Treasury Secretary, the Chairman of the Federal Reserve and eight other presidential appointees. These will be very cushy jobs that will rotate whenever the party in the White House changes. It is only reasonable to expect at least some of these jobs will go to people to whom the president owes favors, rather than based solely on qualification.

These people will identify those companies – banks and non-banks – that they deem to have “systemic risk,” and they will have the power to unilaterally seize these companies and shut them down if they so choose. It is widely expected that this particular power will be challenged in the courts as a violation of the 4th Amendment (search and seizure rights).

Just as important, the financial reform bill transfers many key functions and oversight away from Congress (elected officials), and its approval, to the Treasury, the Fed and the SEC (un-elected officials). Think of President Obama’s $787 billion stimulus program and President Bush’s $700 billion TARP program, both of which had to be approved by Congress. Going forward, these new Treasury agencies will make those decisions with no authority needed from Congress. This is a huge power grab for the president and the Treasury Department. Frankly I’m surprised Congress went along with it.

We needed a streamlined regulatory reform bill, one that addressed “too-big-to-fail,” among other things. Instead, the new reform bill institutionalized bailouts. We didn’t need a huge new bureaucracy. We didn’t need legislation that will further restrict bank lending, especially for small businesses and individuals. We didn’t need another two years of uncertainty while these new regulators write hundreds of new laws that may affect virtually all types of businesses. We didn’t need legislation that will likely result in higher fees for all Americans who have a bank account.

But President Obama wanted it, and Congress was happy to oblige, if only by the narrowest margin thanks to three Republicans in the Senate.

Wishing you smaller, not bigger, government,

Gary D. Halbert

SPECIAL ARTICLES

The Ugly Truth About Financial-Regulatory Reform (from former SEC Chairman)
http://www.thedailybeast.com/blogs-and-stories/2010-07-14/a-failed-financial-bill/

Financial Reform: Wall Street Outsmarts Congress – Again
http://www.thedailybeast.com/blogs-and-stories/2010-07-15/financial-reform-how-wall-street-will-outsmart-congress/2/