Financial Regulation
Even though the Financial Times’reporters in Washington are still firmly in Barack Obama’s camp the editorial writers are rapidly losing faith in the president. The reason is the new financial regulation proposal. The FT says the White House has been “seized by political panic. A return to radical insecurity was the last thing we needed.”
Our financial system is complicated. There is room for many different opinions about what needs to be done to achieve stability. It is even more complicated because of politics. Politics makes it impossible to analyze in an objective manner what caused the financial panic.
The Wall Street Journal is more supportive than critical of what Obama is proposing. He has finally joined the most important policy discussion, which is how to deal with moral hazard.(This has do with the idea that people and institutions will be willing to assume more risk if they are protected from the consequences stemming from mistakes. We are more likely to jump out of a plane if we are attached to a parachute than if we are not). Under the new proposal, banks would no longer be able to engage in proprietary trading for their own accounts. They will not be permitted to invest insured deposits in securities or commodities.(Moral hazard also extends to the idea that some institutions are so big the government will not allow them to fail).
The WSJ, like the FT, is suspicious of Obama’s motives. They write:
“The days ahead will demonstrate whether Mr. Obama is serious, or if this is merely a political tactic to encourage Republicans to defend big banks.”
If Obama’s objective is political he will have to contend with powerful people in his own party. The WSJ writes that the House and Senate bills written by Barney Frank and Chris Dodd seek to “expand the universe of too-big-to- fail companies eligible for taxpayer rescue.” He could show he is serious by adding “an exit-strategy from the most expensive bailouts–at Fannie Mae and Freddie Mac,”says WSJ.
The WSJ writes that even if banks are prevented from proprietary trading using their own money it would not solve the “too big to fail” problem. Bear Stearns was not a bank and yet it was not allowed to fail. Goldman Sachs might decide to sell its bank, and investors would still believe it was too big to fail. The FT agrees. The alternative financing markets are huge and if they stop functioning, financial stability is clearly in jeopardy, the FT writes.
Obama is still peddling the illusion the entire crisis was caused by bankers, even though the root cause was a credit mania, courtesy the Federal Reserve. The mania, says WSJ, was concentrated in the housing market, courtesy Congress and several Presidential Administrations.
The WSJ says that since we have a reckless Fed and political class we need a more comprehensive answer to financial risk. The best option is to allow bankruptcy for risk takers. Next best is strict limits on margin and leverage, especially for holders of tax payer protected deposits. Limits on institutional size is more problematic.
The FT points out that even if banks are not allowed to invest in securities, participate in private equity, or own hedge funds they will still be able to make risky investments. Individual mortgages are risky, not just those that are packaged to become part of a bond. When small banks fail it can destabilize the financial system. This is what caused the savings and loan crisis a few decades ago.
The FT prefers to let Congress take the lead on financial reform, partly because it is connected with world-wide reform. The FT writes:
“For all its warts, a genuine effort at regulatory reform was wriggling its way through Congress–and at least a modicum of attention was being paid to co-ordinating such reforms at a global level.”
Massachusetts seems to have been a wake-up call even for the FT. It will be interesting to see how a populist attack on Wall Street can mesh with a renewed focus on jobs.
2 Responses to “Financial Regulation”
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You know, for the past couple of years or so, I have heard so many supposedly smart and connected people say, uh, “It’s almost impossible to recognize a bubble when you’re in it” when the subject of our last el-grande bubble of real estate comes up. You know, the housing bubble I recognized in maybe ‘02, that 90% of others were ‘blindsided” by, including geniuses like Greenspan, Bernancke, 99% of the banks in the WORLD, rating agencies, investment houses, insurance companies, 75 % of the American public, and, of course, Fannie/Freddie, the black hole for the right side of my pay stub. But, for the past almost year, I’ve heard many smart and connected people tell me that the safety of bonds and bond funds are in a bubble. They were in a bubble last summer, and they are more than certain about that, it seems.
Seems like the term “Bubble” in relation to any asset class is this years equivalent to 2007’s term “a perfect storm”. It’s a great term for cocktail party conversation but it isn’t particularly useful in assessing an investment strategy. A bubble is only recognized in hindsight. People were predicting a real estate bubble as early as 2000. It wasn’t until 2008 that the prediction came true. Every asset class with returns that exceed the long term averages is potential bubble. If you