The futility of banking regulation

A very enlightening article was published in the 4/16/12 issue of Barron's.  The title of the article is "The Big Flaws in Dodd-Frank" and it is written by Gene Epstein .  This article is an interview with Charles Calomiris the Henry Kaufman professor of financial institutions at Columbia Business School.

The purpose of the interview was to discuss the latest in federal regulation of the banking industry, the "Dodd–Frank Wall Street Reform and Consumer Protection Act". The interview quickly evolves into a historical discussion of banking regulation and the effects of banking regulation in the recent financial crisis. This article is an excellent source of information on these topics. I highly recommend that you spend the 10 or 15 minutes required to read it in its entirety. The article is at this link:

The Big Flaws in Dodd-Frank 

If you do not read the whole article the following are some of the highlights:

A section of Dodd-Frank was suggested by Former Federal Reserve Bank Chairman Paul Volcker.  This is some of the discussion of this new regulation:

The Volcker Rule tries to ban proprietary trading within banks. The first problem with that -- which I foresaw along with many others -- is that it would be hard to define proprietary trading, because obviously, an essential role of banks is to help make markets in various financial instruments and to execute trades for their clients.

So the question is, how do you define the limits of proprietary trading? From the hundreds of questions that they asked people and the thousands of complicated responses that they have gotten, it's become clear that there is no hope of being able to describe what it is they are trying to prohibit in a way that can be predictably identified, so that banks can know whether or not are they are in violation.

Even if it can't be done, might it still be helpful to get rid of proprietary trading by banks?

I don't think so. One thing for sure: there is no story about proprietary trading having anything at all to do with the crisis. Even Paul Volcker practically admits that.

Then what do you think was motivating Volcker?

We all have our laundry lists of what we would like to see done. Paul Volcker is somebody who has been around for a long time, and has a long laundry list. Proprietary trading by banks is just something he doesn't like, and Barack Obama wanted to hear Volcker's ideas. So basically he gets a free pass to bring his laundry list to the Dodd-Frank bill.

You don't let the crisis go to waste. 

You put it to a lot of different uses, except the ones that matter. Did the crisis have anything to do with women and minorities not being hired sufficiently by financial institutions? ..... I haven't heard anyone make this argument, so why has Dodd-Frank created new quotas for financial institutions to hire women and minorities? I don't think any of us believe that was a crisis-mitigation policy. It was just politics.

In the above passage we find that a "celebrity" in the field of financial regulation has a pet theory that he would like to impose upon society. Now that the government is trying to prevent any future crisis they decide to include this proprietary trading ban even though there is no evidence that proprietary trading made any contribution to the recent financial crisis. Even worse is the fact that no one is able to define proprietary trading, so now under Dodd-Frank no bank will know whether they are in violation of this statute.

Are you surprised to learn that this new regulation (that was passed to prevent a future financial crisis) includes employment quotas for hiring minorities and women?

Now the article moves on to the historical underpinnings for our current banking regulations:

Do you think the partial repeal of Glass-Steagall had anything to do with the crisis?

No, and the irony is that even the original of the Glass-Steagall Act, as passed in 1933, had nothing to do with the crisis it was supposed to address. Senator Carter Glass, who had been Chairman of the House Committee that drafted the Federal Reserve Act under President Woodrow Wilson in 1913, in 1933 played the same role as Volcker did some 75 years later.
On Carter Glass's laundry list was the notion that mixing investment banking with commercial banking was a bad idea. There was no evidence for that, and all subsequent research has rejected Glass's view. It's not even a close call. The Bank of United States' failure here in New York in 1930 had nothing to do with securities markets; it was exposed to Manhattan real estate and suffered losses related to the New York real-estate crash in Manhattan in 1929. Most of the other U.S. banks that failed in the 1930s did so as a result of farm problems and especially farm real-estate problems.

The Steagall part of the 1933 Act was federal deposit insurance, which was actually opposed at the time by Glass, the secretary of the treasury, the Federal Reserve, and President Franklin D. Roosevelt himself. But who did want it? Small banks in rural areas; Steagall was from Alabama. So we had ideology without evidence combined with special interests, and we got Glass-Steagall.

But what about the Glass part of Glass-Steagall? Did the ability of commercial banks to merge with investment banks have anything to do with the crisis?

Probably even less than the under-representation of women and minorities. Remember some of the illustrious names that got into deep trouble during the crisis -- Bear Stearns, Lehman Brothers, Merrill Lynch. They were all stand-alone investment banks at the time, unaffected by the partial repeal of Glass-Steagall. And we can only wish that commercial banks had done more of the relatively low-risk underwriting of securities that the repeal of Glass-Steagall permitted them to do, instead of accumulating toxic mortgages, which Glass-Steagall had not prevented them from doing.

And to make the whole argument about Glass-Steagall even more ludicrous, the repeal of the Act in 1999 made it possible for JPMorgan Chase [ticker: JPM] to acquire Bear Stearns and for Bank of America [BAC] to acquire Merrill Lynch, which helped stabilize the system.

You mention toxic mortgages. How does Dodd-Frank address that problem?

Not at all. There is no attempt in Dodd-Frank to address the key problem of government subsidization of mortgage risk, and the exposures of Fannie Mae [FNMA], Freddie Mac [FMCC], and the Federal Housing Administration are still growing.

How do you explain the omission?

There is a powerful political interest that wants real-estate lending to be sponsored by the government........Organizations like Acorn [the Association of Community Organizations for Reform Now] and other urban community activists led the fight to subsidize risky mortgage lending. Christopher Dodd and Barney Frank of Dodd-Frank, our supposed reformers, have been poster-politicians for this movement.....But Democrats were not the only ones; President George W. Bush and Speaker Newt Gingrich were also prominent proponents of subsidizing mortgage risk and facilitating the political deals that made so many risky mortgages possible.

The experience of the 1980s alone should have taught us to limit government subsidies of real-estate lending risks. There was the savings and loan crisis, which was all about speculation in real estate. There was the commercial real-estate crisis in the east after the 1986 Tax Reform Act caused some problems in commercial real-estate values.
So what did we do? In 1989 and 1991, we tinkered with capital ratios. But did we do anything to limit government subsidization of real estate risk? Quite the opposite -- the government doubled down.

Doubled down as in blackjack?

Yes, except the blackjack player doubles down by just doubling his original stake. The government effectively multiplied the bets many-fold.

How so?

The government geared up Fannie Mae and Freddie Mac -- "government sponsored enterprises" -- by allowing them to operate on very thin capital and by imposing new mortgage-lending mandates through the Department of Housing and Urban Development beginning in 1995. These mandates set growing minimum proportions of Fannie Mae and Freddie Mac mortgage lending targeting inner cities, low-income borrowers, and minority groups.

Dodd-Frank is the latest in a long history of government regulation of banking.  As  we examine these regulations a pattern appears.  The regulations are passed after a financial panic but the new regulations do not address the root cause of the recent panic.  Worse is that the regulations serve merely as a vehicle for politicians to extend favors to their supporters.  As Charles Calomiris so vividly stated " ideology without evidence combined with special interests".  Each round of government intervention has created a more fragile financial system.

Let the buyer beware

The Securities and Exchange Commission recently settled a fraud claim against the State of New Jersey.  The details are in this Bloomberg News article:

http://www.bloomberg.com/news/2010-08-18/new-jersey-settles-sec-claims-of-misleading-bond-investors-on-pension-fund.html

Here are the highlights:

New Jersey settled claims that it misled investors in $26 billion of municipal bonds by masking underfunding of its two biggest pension plans, in the first Securities and Exchange Commission case to target a state.

Documents for 79 bond offerings from 2001 to 2007 “created the false impression” that the Teachers’ Pension and Annuity Fund and the Public Employees’ Retirement System were adequately funded, hiding that the state couldn’t make contributions without raising taxes or cutting services, the SEC said in a statement today.

The suit marks the first time the SEC has sued a state for violating federal securities laws and marks an early salvo in the agency’s plan to crack down on fraudulent practices in the $2.8 trillion municipal bond market.

State and local governments all across America have substantial unfunded pension liabilities. Can bond holders now file claims against these bond issuers due to misrepresentation of their pension liabilities? If so this could be a bonanza for trial attorneys.

Kill off “too big to fail”

Kansas City Fed President Thomas Hoenig understands the root cause of our financial crisis. Read the following Reuters article:

http://www.reuters.com/article/topNews/idUSTRE5AF17U20091116?feedType=RSS&feedName=topNews&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+reuters%2FtopNews+%28News+%2F+US+%2F+Top+News%29&utm_content=Google+Feedfetcher

The following quotese from Hoenig cuts directly to the heart of the problem:

• "As we look at reform and the way forward I think the most important think we need to do is to make first of all an accurate assessment of fundamental weaknesses in our financial system and then begin to create better foundations," he said.
  
• "Our institutions must be allowed to fail no matter what their size or political influence," he said.
  
• "Our reluctance to deal with 'too big too fail' provides these largest institutions with important advantages over any competitors who are not seen as important," Hoenig said.

A better economic and social contract

The following article from Reuters provides insight concerning the origin of our recent worldwide financial crisis:

http://www.reuters.com/article/businessNews/idUSTRE5A60NF20091107?feedType=RSS&feedName=businessNews&pageNumber=1&virtualBrandChannel=11604

There is a lot of liberal doublethink quoted in this article. Doublethink is a process defined in George Orwell’s novel 1984. Doublethink is defined as: Reality Control, the power to hold two completely contradictory beliefs in one's mind simultaneously, and accept both of them.

We must be aware that all doublethink propaganda is intended to provide the casual reader with will only the rosy scenario portrayed by the speaker. This is of course the intent of the speaker.

Consider the content of the Reuters article:

• World governments should consider urgently a levy on banks to fund future bailouts, British Prime Minister Gordon Brown said on Saturday, departing from London's longstanding resistance to a global tax.
  
• "We should discuss whether we need a better economic and social contract to reflect the global responsibilities of financial institutions to society," Brown told a meeting of financial policymakers from the G20 nations in Scotland.
  
• "There have been proposals for an insurance fee to reflect systemic risk or a resolution fund or contingent capital arrangements or a global transaction levy," he said.
  

“A better economic and social contract” is a liberal doublethink slogan that in reality means increased government intervention that will result in worse economic and social outcomes.

The purpose of this meeting is to promote the concept of a worldwide tax on financial transactions. This is being promoted as a method to prevent future financial crisis. The rosy scenario is that if a financial crisis is looming then the taxes collected will be waiting in a “rainy day” fund and these funds will be used to offset the effects of the crisis.

The reality is that financial institutions will accept more risk if they have an explicit guarantee of bailout. The recent crisis has as its root cause this exact mechanism, the belief in the “too big to fail” myth.

I am surprise to read that U.S. Treasury Secretary Timothy Geithner (king of bailouts) is opposed to this idea for exactly the reason stated above:

• In recent Congressional testimony, U.S. Treasury Secretary Timothy Geithner was cool to an idea from a domestic regulator who called for big financial firms to pay risk-based assessments into a fund that would be available for use if they hit trouble. Geithner opposed pre-funding bank bailouts on the basis that it makes banks less wary of risk taking.
  

The real motive behind this new global tax is revealed in this paragraph:

• Officials at the G20 meeting said a levy and the funds raised could be used not only to pay for future bank bailouts but also to fund development and other areas.
  

I am sure that this was an unintended admission by the bureaucrats. The real purpose of this new tax is not for a financial backstop but is instead a redistribution of wealth. The taxes paid on financial transactions will be spent on “development and other areas”. If this tax is put into effect financial institutions will be encouraged to engage in excessively risky speculation under the pretext that an insurance fund is available to bail out any failing firms. In reality the fund will be empty as it will be looted for spending on pork barrel projects.

A subprime primer

In commemoration of the first anniversary of the Lehman Brothers Holdings' bankruptcy please enjoy the following Power Point presentation (a brief account of the technicalities behind the financial nonsense that helped to put us all in the poor house). Please note that there is some obscene language in this presentation.

http://docs.google.com/present/edit?id=0ATCcaHAnYX28ZDJtMnhqMl80YzdieDVtaGY&hl=en

The decline and fall of the Wall Street Empire

The following article is by Luigi Zingales a business school professor at the University of Chicago. (As you may remember President Obama was a faculty member of the University of Chicago Law School.) This article discusses the ebb and flow of financial centers:

http://www.forbes.com/2009/07/13/wall-street-changed-opinions-contributors-luigi-zingales.html

Professor Zingales' outlook for the future of New York as the financial capital of the world can be summed up in these 2 parpgraphs:

• The biggest threat of all to the Big Apple's financial supremacy, however, comes from Washington. The Founding Fathers wisely decided that the nation's political capital should be separate from its financial capital (in both senses of the word). Now this splendid segregation has ended. If the outcome of the Chrysler bankruptcy is any indication, Washington is willing to flex its muscle in financial decisions, altering the substance of contracts freely agreed to by private parties. In so doing, the national government has undermined the certainty of the rule of law, which was the American capital market's strongest asset.
• 
  Unfortunately, since Washington is the source of the problem, New York City can do little by itself to defend its position. Perhaps the city's best bet is to offer favorable tax treatment to the financial industry--but to do that, it had better first put its finances in order.

An admission of guilt from Timothy Geithner

In an appearance before the House Financial Services Committee and the House Agriculture Committee today Timothy Geithner made a startling admission. The following article gives the overview of this testimony:

http://hosted.ap.org/dynamic/stories/U/US_FINANCIAL_OVERHAUL?SITE=OHWIL&SECTION=HOME&TEMPLATE=DEFAULT

Geithner’s admission:

1. …the ease with which derivatives were bought and sold in an era of easy credit encouraged financial institutions and investors to take on too much risk.
2. The federal regulatory system "failed in its most basic responsibility to produce a stable and resilient system for providing credit and protecting consumers and investors," he said.
   

The Secretary of the Treasury has finally admitted that the Federal Government was responsible for the current financial crisis. Statement 1 above is an admission that easy credit encouraged financial institutions and investors to take on too much risk. Statement 2 above is an admission that the most basic responsibility of the federal regulatory system is to produce a stable and resilient system for providing credit and protecting consumers and investors.

The Federal Reserve was then and is now guilty of a reckless policy of easy credit. In an effort to support maximum employment the Federal Reserve created a financial bubble in the housing market by forcing interest rates to below market levels. The actions of the Federal Reserve were compounded by the expansion of Federal intervention in the US housing mortgage market. The Federal regulators ignored obvious acts of fraud by Fannie Mae and Freddie Mac.

His testimony is designed to convince congress that the Federal financial regulators should be granted more powers. To prevent future financial bubbles the Federal financial reform that should be enacted is a rewriting of the Federal Reserve mandate. The Federal Reserve’s current mandate is as follows:

"conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates"

The new mandate should eliminate the pursuit of maximum employment clause. If the Federal Reserve only concentrated on stable prices and moderate long-term interest rates we would have a smoother business cycle without the huge financial bubbles that we have suffered in recent years.

The following quote from Milton Freidman is listed in the “Quotation section” in the right column of this Blog page:

"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. ... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society."