Financial Services Reform: The Good, the Bad and the Ugly
Last Friday’s fraud complaint filed by the SEC against Goldman Sachs highlights three of the critically important areas of reform tackled by the bill: (1) lack of transparency in the derivatives market, especially the market for credit default swaps; (2) the utter failure of the three primary ratings agencies in classifying the risks of credit-default obligations—the securities at the heart of the housing crisis; and (3) too-big-to-fail (TBTF)—the inability of governments to deal with the financial collapse of large, systemic institutions such as AIG or Goldman Sachs. (A summary of the bill's provisions appears here.
Reining in Derivatives: No one really knows how big is the over-the-counter (“OTC”) market for credit default swaps (“CDS”) market because these swaps are simply bilateral insurance contracts between two parties who usually prefer to remain anonymous. Industry estimates put a value of around $60 Trillion (yes, trillion with a capital TEE—trillion is the new billion!) at the beginning of the crisis in 2007 and currently at about $30 Trillion. By comparison, the entire U.S. bond market is valued at about $30 billion. Most economists now agree that credit default swaps played a crucial role in the financial crisis by obscuring who owed what to whom. Because there is no central registry of these transactions, no one could evaluate the true creditworthiness of counterparties. When it was revealed in September 2008 that AIG has written insurance on more than $100 billion in CDS contracts that it did not have sufficient capital to honor, creditors around the world almost instantaneously began to cease lending. Central banks around the world stepped in to intermediate, saving the world financial markets from a total meltdown.
The proposed legislation would force standardized contracts onto exchanges. This move would all but eliminate the counterparty risk, as exchanges require margin accounts that are marked-to-market daily, and positions are closed when a party cannot make its margin call. The problem with this approach is that exchange-traded contracts need to be highly standardized, whereas CDSs are typically highly customized. Consequently, it simple will not be possible to put the vast majority of CDSs onto exchanges.
Many in academia and industry are pushing an intermediate step, which is to force CDS contract onto clearinghouses, where, at a minimum, the identities of traders and sizes of exposures are collected, providing transparency to all market participants regarding aggregate exposures of each firm.
Regulation of the Ratings Agencies: The financial crisis could not have taken place without the complicity of the three primary U.S. ratings agencies—Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s. Ratings by these agencies are ensconced in statutory and regulatory limitations on investments by mutual funds and money managers, who typically can only invest in so-called “investment grade” assets. Without an investment grade rating, a security can only be sold to a small group of investors. By slapping triple-A ratings on the bulk of CDO securities, the ratings agencies gave a seal of approval to these toxic securities, leading financially unsophisticated investors to buy what they thought were extremely safe securities—equivalent to the risk of U.S. Treasury bonds. Instead, these investors would have been no worse off had they placed their money with Bernie Madoff himself.
The proposed legislation strikes at the ratings agencies from a number of directions. It bars the agencies from consulting with any company that they also rate. During the crisis, reports emerged in the Wall Street Journal and elsewhere regarding how employees of the ratings agencies worked together with investment bankers to maximize the percentage of a securities pool that would receive the highest ratings and minimize the percentage that would not be rated—the so-called equity tranche, also known as “toxic waste.” The bill enhances transparency by requiring agencies to disclose the amount of fees paid by an issuer, by requiring different symbols to be used for structured products than are used for traditional corporate bonds, and by requiring additional disclosure of the risks measured by the agencies, such as probability of default, estimated loss given default and sensitivity of ratings to changes in assumptions.
Unfortunately, the legislation fails to address the fundamental conflict of interest arising from the business model of the ratings agencies, where the issuers of financial securities pay the ratings agencies to rate those securities. This is equivalent to the now widely discredited model in residential real estate where brokers were paid by sellers and had not fiduciary duty to the buyer. In most states, buyers how have their own brokers who represent them and have a fiduciary duty to the buyer rather than to the seller. The legislation also perpetuates the oligopoly created by statutes and regulations that only recognize ratings by these three fundamentally conflicted agencies.
What the legislation fails to do the market may take care of. What investor in his or her right mind would place an credence into a structured product rating, given the agencies’ track record with CDOs? If you ate at a five-star restaurant and got food poisoning, would you trust Michelin to help you choose a restaurant your next dinner out?
Ending Too-Big-To-Fail: The most contentious parts of the bill relate to Democrat claims that the bill “Ends Too Big to Fail Bailouts.” The Republicans are dead on when they dispute this claim. There is one way—and only one way—to end too-big-to-fail, and that is to limit the size of financial institutions, as has been proposed by Simon Johnson and others. Professor Johnson has proposed 4% of GDP as an upper limit, which, in the U.S. today, would translate to about $500 billion. In my opinion, this is far too generous. One percent of GDP would be more appropriate—limiting U.S. banks to about $130 billion. Currently, the four largest U.S. bank holding companies—BofA, Citi, JPM and Wells Fargo—are larger than $1 Trillion.
The proposed bill includes the so-called Volker provision, which would prohibit banks from so-called proprietary trading and investments in hedge funds, and an amendment by Blanche Lincoln would go even farther, prohibiting banks from trading derivatives. What is really called for here is a return to the Glass-Steagall Act, which mandated a separation of commercial banking from investment banking. Glass-Steagall was repealed in 1999 on a bipartisan basis by the Gramm-Leach –Bliley Act, which was signed by former President Clinton.
With the exception of Wells Fargo, the remaining four largest bank holding companies have substantial investment banking subsidiaries. Even worse, the only two large stand-alone investment banks—Goldman Sachs and Morgan Stanley—were converted to bank holding companies by Bernanke in order to give them access to loans from the Fed. Talk about a move in the wrong direction. It is time to remove the “casino” from the FDIC-insured commercial bank.
The proposed bill would require large financial institutions to submit so-called “funeral plans” documenting how they could be rapidly shut down, but, as we know, in times of crisis, plans are changed. This provision, and several others, only serves to provide cover for the failure of the bill to address the real issue—the continued existence of trillion-dollar companies.
One of stupidest provisions of the bill is the creation of a $50 billion fund that would be used to cover the costs of liquidating a large financial institution. This fund would be capitalized by charges on the largest financial firms. Why would anyone propose sucking $50 billion in scarce tangible capital out of the thinly capitalized large banks, especially at a time when the Administration and Congress are seeking ways to expand bank lending? That $50 billion can support $500 billion or more of bank lending. Sucking it out of the banking system would virtually guarantee a credit contraction in the range of $500 billion. Moreover, we already know that $50 billion would be woefully inadequate—even if only a single firm got into trouble. The U.S. government pumped $180 billion into AIG alone during 2008. Where would the additional $130 billion come from? Guess. The answer is you, me and the rest of U.S. taxpayers.
