Wednesday, April 21, 2010

Wall Street: Financial Regulatory Reform 101

OK, so we've been hearing this and that about the financial reform legislation pending in Congress. And already, we're hearing misleading spin trash-talking efforts to curb Wall Street abuses. Sound familiar?

So what's this all really about? Desert Beacon, as usual, does a great job of explaining what happened on Wall Street:

Shift 1: Back in the day investment and commercial banking were two discrete and totally separate activities. Now they aren't. We can argue about the Volcker Rule or about bringing back the Glass-Steagall Act, but the bottom line is that investment and commercial banking are now being done by divisions of the same bank holding companies. We have rules and a regulatory structure that still assume investment and commercial banking are separated, in an era in which both are done under the same roofing.

Shift 2: The old American financial system included investment banks that were private partnerships, with bankers who had their entire worth (right down to their homes and property) on the line with every trade. When Donaldson, Lufkin & Jenrette went public in 1970 all bets were off. DLJ "established a holding company that was exempted from the stock exchange's restraints on member firms." It wasn't long before other investment banks on Wall St. followed suit. Investment banks were no longer trading with their own funds, but with shareholder's money. The old, often clubby, ultra-conservative restraints on the investment bankers were loosened under the holding company structure; now revenues lines could come from a variety of sources, and the investment banks could make money not just by underwriting corporate bonds and other offerings, but by selling things, lots of different things. We have rules and a regulatory structure that still assume the existence of discrete investment banks -- after the meltdown of '07-08 there are no more investment banks. The major investment banks have been subsumed by commercial bank holding companies.

Shift 3: There was nothing in the wind in 1933 that would have caused anyone to believe that one day there would be hybrid financial corporations such as exist today. GMAC, for example, was incorporated in 1919 as a wholly owned subsidiary of General Motors to offer credit to dealerships to purchase inventory, and to assist individuals to buy GM cars. In 1985 the company expanded to create GMAC Mortgage, and in 1999 it purchased the Bank of New York's asset based lending and factoring business. GMAC begat DITech, and the International Business Group, and in 2005 begat the Residential Capital LLC (ResCap). Then the wheels came off. In 2006 GM sold its controlling stake to Cerberus, a private equity firm, and the company became GMAC Financial Services. In 2008 it restructured as a bank holding company, making it eligible to receive TARP funds to offset the drumming it had taking in the mortgage finance debacle. More changes came in 2009 as GMAC entered into an agreement with Chrysler to provide auto loans for their products, and morphed into Ally Bank. [GMAC timeline] There's been more restructuring since.

The moral of this story is that in the days of the Tail Fins, GMAC simply financed cars; but, in the days of the hybrid fuel models, GMAC became a hybrid itself in the form of a bank holding company. The same sort of timeline could be constructed for insurance giant AIG, once an insurance company which collapsed under the weight of its own Financial Products division based in London.

Basically, Wall Street firms reorganized into holding companies to start using shareholder money to make investments. And as financial regulations were loosened in the 1980s, 1990s, and 2000s, this paved the way for these investment banks to be gobbled up by larger consumer banks to become massive financial conglomerates. GMAC's story looks quite a bit like AIG's, Citigroup's, JP Morgan Chase's, Bank of America's, and so many others.

So how has our federal regulatory system kept up with the times? It has not, and that's the problem here. While these Wall Street firms were becoming gigantic multinational, multi-sector, financial conglomerates, the US regulatory system remained fractured, piecemeal, and completely unprepared to handle the Bear Stearns crisis, the Lehman Brothers crisis, and the start of "The Great Recession" as the financial houses were collapsing all around us.

So that's what this financial regulation legislation is all about. Here, I'll let Ezra Klein do some more explaining.

The underlying issue here is, as per usual, the too-big-to-fail problem. "When big financial institutions fail," says Raj Date, a former managing director at Deutsche Bank Securities and the founder of the Cambridge Winter Project, "they have an immediate, catastrophic impact on the financial system. They live on borrowed money, and as they approach failure, their creditors try to get all their money back at once. So the firm begins selling all its assets into the marketplace very quickly. But when you're large, there's no way to move that volume of assets without cratering their prices. So now the types of assets the firm is selling drop in value. That means that everyone else's balance sheet is worth less, at least if they have these assets, too."

Here's the problem: Banks don't fail. They explode. They take other banks down with them. The easiest analogy is to a bomb. What happened with Lehman Brothers is that the bomb went off, and it took the financial sector with it, at least temporarily. That's, well, one way of handling a bomb. But it's not the preferred way. The preferred way is to defuse it. That's what resolution authority does, at least in theory.

These firms were sucking up more and more and more debt. They were growing and growing and growing, but their whole foundation was made on "financial quicksand" like mortgage backed securities that looked far less "secure" once the housing bubble started to burst. Bond agencies were allowed to market these extremely risky loans as "safe bonds". Banks were allowed to prey on consumers with subprime mortgages, and these same banks were allowed to profit off them by financing them with these very mortgage backed securities that were then used to finance even more borrowing. What was supposedly a "strong economy" five years ago in George Bush's supposedly successful "ownership society" was really more of a very high stakes poker tournament that made any of our Las Vegas poker rooms look like a "safe investment".

And again, we get back to the problem of the feds not being properly prepared to handle this crisis. Robert Kuttner properly diagnosed this crisis in 2008, and offered some specific solutions to get us out of this mess.

What all of these sins had in common was that they led financial markets to misprice assets. In plain English, that means buyers were purchasing securities based on bad information, often with borrowed money. When firms started losing money on sub-prime in mid-2007 and other owners decided it was time to get their money out, the whole miracle of leverage went into reverse. And it spilled over into other securities that had been mispriced thanks to all the conflicts of interest tolerated by regulators.

That's why, no matter how much taxpayer money the Federal Reserve and the Treasury keep pumping in, they can't turn dross back into gold. The next administration and the Congress need to return the financial economy to its historic task of supplying capital to the real economy -- of connecting investors to entrepreneurs -- and shut down the purely casino aspects of the system that have only enriched middlemen and passed along huge risks to everyone else. [...]

Barack Obama said it well in his historic speech on the financial emergency [on] March 27[, 2008,] in New York. "We need to regulate financial institutions for what they do, not what they are." Increasingly, different kinds of financial firms do the same kinds of things, and they are all capable of infusing toxic products into the nation's financial bloodstream. That's why [then] Treasury Secretary Hank Paulson has had to extend the government's financial safety net to all kinds of large financial firms like A.I.G. that have no technical right to the aid and no regulation to keep them from taking outlandish risks. Going forward, all financial firms that buy and sell products in money markets need the same regulation and examination. That will be the essence of the 2009 version of the Glass-Steagall Act.

And while the current Wall Street Reform legislation isn't a panacea, it's a start... And hopefully, it will lead to stronger We need stronger oversight, and we definitely need a regulatory system that equipped with all the proper tools to deal with future crises in a way that doesn't just leave us the taxpayers holding the bag for another no-strings-attached Wall Street bailout.

But as usual, the GOoPers are trying to spin this to look like supporting financial reform is "supporting more bailouts".

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They've pretty much taken Frank Luntz's language, word for word, and tried to run with it. But instead of looking "principled", they just look foolish.

So Republicans want more no-strings-attached Wall Street bailouts? More unregulated Wall Street firms making risky bets, but keeping all the rewards for themselves while making us pay when their risk taking fails? I guess so.

But hopefully, they won't succeed. We can't afford any more inaction on a broken regulatory system and a new generation of "robber barons" that keep stealing from us to make themselves even richer.

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