Belmont Club

Holding the Bag

The House and Senate were rushing new regulation of the finance industry to get it ready for President Obama’s signature.  The bill was touted as a comprehensive guarantee against another financial crisis, but as of this writing, nobody was even sure what it would finally contain. Elements of the 2,000 page bill was being negotiated literally in the hallways.

A panel of 43 lawmakers spent two weeks reconciling differences between a bill that passed the House in December and the Senate in May. They concluded their negotiations along party lines at a little after 5 a.m. ET in a Capitol Hill conference room marked by tension, levity and exhaustion. …

Major components of the bill, including the derivatives provisions, were negotiated in the hallway of the Dirksen Senate Office Building as the clock neared midnight. At one point, after hearing of an offer from Senate Democrats, Rep. Melissa Bean (D., Ill.) exclaimed: “Are you flipping kidding me? Are you flipping kidding me?” …

“My guess is there are three unintended consequences on every page of this bill,” Rep. Jeb Hensarling (R., Texas) said of the nearly 2,000-page bill.

It is so complex that the Democratic Chairman of the Senate Banking committee Christopher J. Dodd said “no one will know until this is actually in place how it works. But we believe we’ve done something that has been needed for a long time. It took a crisis to bring us to the point where we could actually get this job done.” Some legislators across the aisle thought it would make things worse.

“This legislation is a failure on both counts,” Sen. Judd Gregg (R-NH) said in a statement that denounced the compromise as failing to address “shoddy underwriting practices” or problems with the government-sponsored entities Fannie Mae and Freddie Mac. “It will not encourage much-needed stability and confidence in our financial markets. It will not significantly reduce systemic risk in our financial sector.”

Fannie Mae and Freddie Mac, those government sponsored corporations whose operations were suspected of being one of the major causes of the subprime crisis were excluded from the coverage of the bill. Forbes wrote that “it left for later any restructuring of the government-related mortgage giants Fannie Mae and Freddie Mac. Time and again, Republicans tried to shift the debate to the mortgage purchasing firms, to no avail.” But while Fanny and Freddie were absent from it, lots of little bits and pieces were stewing in it. New fees and regulations for businesses as disparate as check cashers and auto dealers were in the corners of the proposal.

In a blow to Obama, the consumer protection agency would not regulate auto dealers, even though they assemble loans for millions of car buyers. Payday lenders and check cashers would be regulated, but enforcement would be left to states or the Federal Trade Commission.

To pay for the costs of the bill, negotiators agreed to assess a fee on banks with assets of more than $50 billion and hedge funds of more than $10 billion in assets to raise $19 billion over 10 years.

But the centerpiece of the bill is supposed to be a tighter regulation of banks. One of the major elements of the legislation was a proposal to force banks to divest themselves of risky trades, marking the return of the so-called “Volcker Rule”. But Joshua Brown writing in the Christian Science Monitor argues most of the restrictions were for show; that loopholes ensured it is Volcker only in name.

Wall Street wins this round. The “teeth” of the Volcker Rule have been kicked in and there are enough holes elsewhere for White & Case to exploit on behalf of their clientele til the cows come home. The Dems unanimously voted for it. Interestingly, Republicans all voted against it. They didn’t think the final version was strict enough or that it did enough to prevent Too Big To Fail. … There will be some limitation to what large banks can do on a proprietary basis, but they will still be de facto giant hedge funds, albeit hedge funds with higher capital reserve requirements.

Since the central goal of the bill was to manage risk one might ask, ‘where does the risk go?’ Public policy analysts will have to spend hours is figuring out who ultimately holds what in the 2,000 page bill. Financial risk cannot be legislated away. Like energy, once in existence risk cannot be destroyed. It can only be moved around; assumed by someone. When it assumed for a fee the risk transfer is called insurance. When it is assumed by the taxpayer the result is something like Freddie Mac and Fannie Mae. Yet public or private the it remains in the system for so long as the transactions which gave rise to it are allowed. It is the distribution of risks that is affected by the bill. In that sense the spin-offs on derivatives trading mandated by Blanche Lincoln do not reduce total risk within the system. They simply prohibit banks from assuming it, assuming they do not simply reallow under other color through loopholes. Shara Tibken at the Wall Street Journal reports that that banks are expected to adapt happily now that the obligatory theatrics are over.

“The banks can get around this stuff,” Rochdale Securities analyst Dick Bove said, adding they can raise prices on the products they sell, as well as create separate entities and move them offshore. “Banks are not going to suffer here.”

He added that bank stocks are likely to rally over the next couple of weeks as people turn more positive on the sector.

“The industry has been subjected to 18 months of vilification by the press, Congress and everyone else, but that will now stop,” Bove said. “Not only will it stop, but now the government has to go out and support the industry because they said they fixed it.”

“Fix” in this context is a word with a slightly ambiguous meaning because if not even Chris Dodd can say for sure how things will work until the switch is thrown it is to some extent a matter of wait and see. But the risks remains, both inherently and because a newly redesigned complex system will give rise to behavior that nobody has seen before. Some very simple things, like a cornstarch and water behave very differently under different speeds and conditions. The financial system is far, far more complicated and can be expected to throw up a surprise. Now, with the “fix” in, either all our worries are temporarily over or the next financial crisis has just been designed.

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