Sunday, April 25, 2010

Financial Regulation Shell Game

Nothing demonstrates the sad state of Washington politics more than the financial regulation going on in Washington at the moment. Over the last couple of elections, the American people, both left and right, have said “enough” to special interest influence and government handouts. But like addicts, Washington can’t stop itself.

Everyone agrees that America’s financial regulations are a mess. There are dozens of different, overlapping regulatory schemes, many created during the Great Depression and supplemented ad hoc as problems arose. These piecemeal regulations overlap and conflict, but also, strangely, leave glaring gaps. This has allowed savvy financial institutions to slip between cracks by cherry picking the regulators they wanted and then sliding through those gaps. This was a disaster waiting to happen, and the financial meltdown was that disaster.

The problem, however, with fixing this is fully on display at the moment. Rather than approaching these regulations rationally, as the public demands, or vindictively, as the left demands, Washington has turned this into an orgy of interest group politics. Money is pouring into both parties in record numbers. Obama took in $40 million dollars from the financial sector during the 2008 presidential campaign -- McCain took in $29 million. This year, the DNC has taken in $9.9 million from the sector. The RNC has taken in $5.2 million. Individual Senators and Representatives have taken in even more.

And, of course, you get what you pay for. Republicans and Democrats both have bent over backwards to hand out favors. The Republican Congress and Bill Clinton removed Depression-era safeguards that kept commercial banking and investment banking separate -- this allowed the creation of these mega financial institutions (“too big to fail”). The Democrats, particularly Barney Frank, kept expanding the scope of Fannie Mae and Freddie Mac, the cause of the financial meltdown. Moreover, in 2003, the Democrats, led by Frank and his many connections at Fannie and Freddie, resisted Bush administration efforts to strengthen the regulation of those institutions. And in 2008, Bush and the Democrats passed the biggest bailout in human history.

So now they try again. But once again, the interest groups are running the show. The Democrats talk big about punishing Wall Street to placate their followers, but they have managed to produce regulations that are truly staggering in how interest group friendly they are. When the Democrats introduced the original bill it contained dozens of new provisions that were intended to clean up these regulations. Many of these regulations were quite good. Some were horrible.

Slowly but surely, the good regulations were snuffed out after the “Wall Street bashing” Democrats met secretly with the likes of Lloyd Blankfein of Goldman Sachs and their friends at JP Morgan. Soon, all that was left in the bill were massive bailouts and some “restrictions” that favored large industry players. It should thus come as no surprise that Goldman Sachs lobbied in favor of these regulations. . . at least until the SEC came after them recently. JP Morgan still lobbies in favor of these regulations, except for the part that would hurt them.

Right now, the regulations create a massive pool of taxpayer money and taxpayer guarantees that are ostensibly intended to allow the government to wind down “too big to fail” institutions that fail. What this really means is that (1) there will be no attempt to break up or limit these huge institutions, i.e. too big to fail can continue, and (2) the government is guaranteeing that taxpayers will pick up the tab if one of these institutions fails. In other words, investors and business partners of these institutions don’t need to worry about getting hurt if they take risky bets that don’t pay off, because the taxpayers will protect them -- all in the name of “protecting the system from the failure of an institution that is too big to fail.”

These regulations also will force small players to sell their derivatives through an exchange, the same kind of exchange that sells favors to the big boys. And they will create a “consumer protection” agency, which will be run by industry friendly regulators that are dominated by the big players. This will effectively put the big banks in a position of controlling regulators who have the power to tell smaller banks what they can and can’t do. Must be nice.

Interestingly, the one group that escapes regulation is Fannie Mae and Freddie Mac, both of whom give heavily to Democrats. Moreover, Fannie and Freddie have become a dumping ground for former Democratic lawmakers and their friends who want to earn large amounts of money. Fannie and Freddie, by the way, were at fault for the financial meltdown. . . the rest of Wall Street just profited like mad off of it.

What makes this so disturbing is that this financial regulation is a clear indication that Washington doesn’t get it. The Democrats were elected on a platform of putting the boot to Wall Street in favor of the “little guy” -- a standard socialist trope. But once they were in power, they did nothing more than open the government vaults and let their Wall Street friends plunder away. The Republicans, for their part, mindlessly defend every indefensible practice Wall Street can come up with.

What they should be doing is what the public wants: the public wants an end to influence peddling. They want Washington to do the right things, not the things the people with the biggest checkbooks want. They want rational regulations that allow the free market to work, but protect people from predatory practices. They don’t want the government propping up institutions, guaranteeing their risk taking, or letting these hazard grow to the point that an institutional failure can wipe out our country.

It’s time for someone to take a stand. The Democrats won’t do it, maybe the Republicans should.

Update: The Republicans have blocked the first round of this "reform," after they were joined by Ben Nelson (D-Nebraska).


Anonymous said...

Andrew: Good points all. I think the problem is that neither side has a long-term strategy. It's all reactive tactics without a coherent scheme. And of course, much of it is old bad habits (Republicans) and leftist "eat the rich" politics (Democrats). FDR has a strategy (with plenty of nasty holes, admittedly) of protecting the investor. Not a bad idea to a large extent. But the tactics over the years have been, as Bette Davis said about getting old, "patch, patch, patch."

It's time for a fresh strategy that retains the best of investor protection with the vigorous encouragement of investment. Nothing I have seen coming out of Washington from either party fills that bill so far. That means not only a completely revamped bill that doesn't throw investors to the winds when corporations behave badly, but also encourages investment and (that dirty word) profit. That means overhauling the tax laws for corporations as well (Sarbanes-Oxley, anyone?). It also means an overhaul of the SEC and IRS regulations.

Strategy, not mere tactics. Right now, it looks like enough Republicans are willing to jump on board if the bail-out provisions are stricken. The Democrats were probably willing to do that anyway, in order to divert attention from the fact that the current proposal stinks, with or without the bail-out provisions.

AndrewPrice said...

Lawhawk, The Democrats aren't being socialists on this, they just talk that way. They are purely in the back pocket of the big banks and big business.

The Republicans are more honest about it, but that doesn't make their behavior any better. They need to start listening to middle America, not corporate America.

Anonymous said...

Andrew: I agree. "Eat the rich" is more populist know-nothingism than socialism (although I am still convinced that their peerless leader in the White House is a socialist who will just use class warfare to get his progressive/socialist paradise incrementally). The Democrats aren't being socialists on this, just tools and fools.

AndrewPrice said...

Lawhawk, and that's why I think their followers are so surprised at the moment. They really believed all the socialist talk, and they aren't seeing it put into action. Instead, they're seeing the same things they hated about Bush.

Ironically, the Democrats think this financial regulation will energize their voters. LOL! No way, no how.

Writer X said...

The only idea either party comes up with to fix anything is more regulation, rather than looking first at the root of the problem. And more regulation generally means higher taxes, higher prices, and more headaches for the consumer and small business owner. Watching Pres. Obama talking about financial regulation as he's flanked on either side by Dodd and Frank is laughable at best.

AndrewPrice said...

Writer X, I agree, they have no credibility on this issue and Obama is a fool if he thinks he's going to score any points with the public on this.

The problem as I see it with the regulations are that they aren't even rational, they're not designed to create a smoother running market with less danger, but instead to make sure that only certain players can play and to reward the politically connected.

That's what needs to stop.

Individualist said...

Goldman Sachs 10Q


Goldman Sachs gets 12 billion bailout

Here are the 10Q for AIG and Goldman Sachs. You'll note that the debt to the US government is not a line item on Goldman Sachs Financial Statements.

In reading these we see that while the Fed has a "veto" power over AIG's board the other restrictions on these companies as a result of the bailout or the ownership of their stock by the US government cannot be discerned by this information at least that I can see.

If these companies are owned or controlled in part by the federal government how can we trust the regulation of them by the federal government. Especially when the F/S do not clearly state the % of ownership by the government.

AndrewPrice said...

Individualist, They've hidden the ownership interest through a series of warrants that would let the government come in at any time, but keep them off the books at the moment.

And you're right, you can't trust the government to regulate an industry when it owns some of the players in that industry. It's the same thing with GM, how can we believe that Ford is getting a fair deal now that Uncle Obama owns GM?

What's even more suspicious is that all of the regulators who watch companies like Goldman are former Goldman people (or people from similar firms) who've gone to work for the government or the treasury and will soon return. If my mother and best friend were appointed to regulate my business, would you trust the regulators? Why should we see this situation any differently?

Tennessee Jed said...

I suppose turning financial regulation into an orgy of special interests should surprise nobody. Part of the problem is I have yet to see anyone demonstrate a clear understanding of exactly what needs to be done.

A couple of different points of view I have recently read are telling. Along with Andrew and Lawhawk, a blogger I really respect is Randall Hoven over at American Thinker. On April 15th, he blogged on the subject: "Fixing the Financial Crisis" which in turn links to a very interesting article by Jeffrey Friedman and Vladmir Kraus of American Enterprise Institute that talks about the possible impact of the 2001 "Recourse" rule on the financial lending meltdown. Both articles can be accessed via American Thinker.

A second "read" I highly recommend is "After the Fall- Saving Capitalism From Wall Street and Washington" by Nicole Gelinas.

I am not sure that if you read both you will be any closer to definitive answers, but they both were written in a way that non-financial professionals could better understand some of the issues.

StanH said...

“When E. F. Hutton talks, people listen!” …that is except Ronald Reagan! James Baker came to Reagan in 10/87, saying the financial world was coming to an end, wherein the great Reagan replied, “markets go up, markets go down.” We had a shallow recession and lost E. F. Hutton. In other words he refused to intrude into a free market adjustment, we came out stronger with lessons learned…we thought.

Senator Phil Graham Republican TX, Bob Rubin (Clinton treasury secretary, former CEO Goldman Sachs) got together and repealed Glass-Steagall with Clintons signature in 1999. This allowed “too large to fail,” era to begin, mingling commercial and investment banking, adding “sophisticated investor” risks too your local bank.

Shoot ahead to the fall of 2008, and “W” with Hank Paulson (former CEO Goldman-Sachs interesting coincidence…huh?) And we begin the bailout era and TARP.

If you want to fix the financial market, get out of the way, let some of these brokerage houses fail and they will get their own houses in order without a dime of taxpayer funds.

AndrewPrice said...

Jed, There are definitely disagreements, but certain things are fairly obvious.

1. Regulations should lead toward transparency and consistency, which many of the proposed regulations do not.

2. They should apply in a uniform manner, which again they do not.

3. They should be administered by knowledgable but independent persons (meaning an end to the revolving door).

4. They should be intuitively "fair" meaning that they don't create unnecessary barriers to entry for competitors.

5. And they need to realistically balance the interests of the public, investors, and companies. Right now the regulations basically allow large companies to get as large as they want in as many fields as they want, take as many chances as they want, disclose virtually little in the way of conflict of interests. . . which wouldn't bother me EXCEPT then the public is expected to bail these companies out when they fail because their size is so large that one failure acts like a domino falling, and they are able to pick and choose between which investors suffer and which don't when things go wrong.

If reasonable changes aren't put into place to fix those problems, then the public will never be satisfied with the regulations and worse regulations will eventually be imposed, which will hurt everyone.

AndrewPrice said...

Stan, Exactly correct. Capitalism does not mean everything thrives. Markets go up and down. If we panic every time markets go down, then we aren't in a capitalist system, we're in a "crony capistialist" system where companies get the rewards of success and the government backs their failures. And that's unsustainable and it's wrong.

Individualist said...

@Andrew Price "Individualist, They've hidden the ownership interest through a series of warrants that would let the government come in at any time, but keep them off the books at the moment."


Wasn't there a company that caused a lot of issues when it used financial gimmicks to keep ownership interest and debt off their books. I for get their names but the NY Times says they were the smartest men in the room.

Who were they....

Enterprise Rentacar - nope
Nikon Cameras - nope
Ralphs pharmacy - not a company
Orion Films - don;t think so
NEver Never LAnd Inc,

Sorry I can;t remember

AndrewPrice said...

Individualist, LOL! I think I know the one. Something in Texas, En...something. Enbob. Enrick. Elron. Something like that. ;-)

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