Varieties of Reform…

Within hours, we’ll know how at least this round of the health care reform battle has turned out (at this writing, passage seems likely)…  and then the spotlight will shift.  There is a stupefying stack of issues on deck, from foreign policy through immigration to education.  But financial reform is surely a candidate for “the next big thing,” if only because after as devisive an issue as health care, one with such broad public support must be attractive.

Indeed, the question doesn’t seem to be if there will be action on the financial sector; the question is what kind of action…  and a very important question it is.

source: Huffington Post

By way of gauging, Frank Rich’s column in this morning’s Times draws the comparison between the villains of Stieg Larsson’s The Girl With The Dragon Tattoo and the leadership of America’s major financial institutions over the last decade:

“A bank director who blows millions on foolhardy speculations should not keep his job,” writes Larsson in one typical passage. “A managing director who plays shell company games should do time.” Larsson is no less lacerating about influential journalists who treat “mediocre financial whelps like rock stars” and who docilely “regurgitate the statements issued by C.E.O.’s and stock-market speculators.” He pleads for some “tough reporter” to “identify and expose as traitors” the financial players who have “systematically and perhaps deliberately” damaged their country’s economy “to satisfy the profit interests of their clients.”

To that lattermost point, Rich cites the relationship between the late-and-unlamented Lehman Bros. and its auditors:

…we now know, as we didn’t in September 2008, that Lehman’s collapse wasn’t exactly an unexpected, unpredictable calamity to those in its executive suites. The 2,200-page bank examiner’s autopsy released 10 days ago concluded that Lehman, in league with its auditor Ernst & Young, used “materially misleading” accounting gimmicks to mask its losses, duping investors and the ever-credulous Securities and Exchange Commission alike.

Far from being held liable for the chicanery and recklessness that would destroy their company and threaten their country’s economy, these executives benefited big time. In a study late last year, three Harvard Law School researchers examined public documents to assess whether one “standard narrative” of the crash was true — that “the meltdown of Bear Stearns and Lehman Brothers largely wiped out the wealth of their top executives.” It turned out to be a fairy tale. “In contrast to what has been thus far largely assumed, the executives were richly rewarded for, not financially devastated by, their leadership of their banks during this decade,” the Harvard Law team wrote. The top five executives at both Lehman and Bear collectively took home $2.4 billion in bonuses and equity sales — that’s nearly a quarter-billion dollars each — between 2000 and their 2008 demise.

We have yet to hear how their co-conspirators– the partners at Ernst & Young– fared; but given that all of their advice was denominated in hefty fees, we can only imagine, quite well.

It wasn’t always like this.  Accounting firms like E&Y had a heritage of objective honesty; Hollywood– an industry well-known for it’s “management” of news and events– succeeded in giving the Oscars the patina of legitimacy by hiring Price Waterhouse to manage the voting and calculate the results. For much of the Twentieth Century, auditors were paid by the companies they reviewed; but they worked for the commonweal, assuring and attesting that financial reports were accurate and representative, that taxes were fully and fairly calculated– that things were as they were reputed to be.  Auditing fees were, in effect, a public company’s investment in the public confidence and trust that are essential to the effective working of a public market; the auditors’ independence and objectivity were the basis for establishing that trust.

But as the Worldcom, Enron (and contemporaneous) scandals demonstrated, that independence and objectivity had seriously eroded by the turn of the century.  Auditors were at the center of the crimes and misdemeanors that came unraveled.  As a result of those escapades, Arthur Andersen, Worldcom and Enron’s auditor, paid the ultimate price; Sarbannes-Oxley was passed… and, as we’ve seen, things got even worse.

Just after Sarb-Ox passed in 2002, I attended a breakfast held by one of the major auditing firms for members of public company audit committees.  The program was devoted to explanations of the new law, but there was a special guest– the Managing Partner of the firm, who happened to be in San Francisco on his global tour of the firm’s offices.  These were tough times for “independent accountants,” who were being pilloried in the press; the Managing Partner was riding the post to assure his flock that all would be well.

Indeed, when he rose to address us, he could barely contain his enthusiasm; Sarbannes-Oxley, he gushed, would be the best thing that ever happened for the accounting profession….  an odd remark to make to a room full of clients, but absolutely true.  The tangle of new rules and regulations drove unprecedented demand for accounting advice.  The cost of compliance with the new statute became unavoidable overhead for public companies; it was as though a new tax had been passed, to be collected– and kept– by the big accounting firms.

We might have imagined that the windfall from compliance revenues would be enough to satisfy the accounting firms– that those riches, along with the cautionary example of the “death penalty” received by Arthur Andersen, would encourage them back onto the high ground, back to independence, objectivity and a sense of duty to the commonweal.

But all of that complexity created a further opportunity as well; with each new rule came the challenge of figuring out how to push, then to contravene it.  And, it turns out, those new opportunities were just too lucrative to ignore.  The accounting firms’ culture of “service to the client” strengthened, at the expanse of duty to the public.  Books got cooked once again.

Lord knows, the zeitgeist of the decade seemed to encourage it.  Rating agencies were taking money from the issuers of CDOs to certify junk as AAA; the SEC and other regulators were (to put it politely) asleep at the switch; and professional investors (many of whom were part of organizations pulling these tricks, so had to have had at least an inkling) seemed wholly unconcerned.  Everyone in the financial community was in on the gag; and even the individual investor, who wasn’t, was doing OK.  So long as the bubble was expanding, the ride was good.  And in the immortal words of Sam Goldwyn, “you don’t f*** with a hit.”

But then, of course, the bubble burst.  And now we find ourselves challenged to find ways to learn from what happened, and to prevent a recurrence.

source: SEIU

To that end, the legislative and regulatory proposals fly; for a skilled and thorough analysis of their particulars, I recommend The Baseline Scenario, Brad DeLong’s blog, and/or Calculated Risk.  The point to be made here is at a higher and more directional level.  To oversimplify only slightly, there are two approaches to addressing financial reform being mooted today: the first is largely incremental, suggesting that, with a few tweaks and a little more attention from the current players in (more or less) their current roles, the system will be fine.  The second argues that, as the problem was a systemic one, the solution must be systemic as well.

The incremental approach has many backers.  Senator Chris Dodd’s Financial Reform Bill, the lead horse in Congress, falls squarely into this category; and while there’s much arguing over just how much (or little) regulation is necessary,  from the financial community itself to most senior economic and finance players in the White House there seems to be much agreement that the fundamental issue is “tinkering” with the current system to get it back into balance.

But this incremental approach is tantamount to “punishing” crooked cops by giving them new guns.  In some ways, it’s worse than no action:  it gives the illusion of a fix when in fact the real structural problems remain… thus doing little or nothing to alleviate the prospect of a repeat of the horrors of the last decade, but encouraging the illusion that things are safer.

Systemic problems do demand systemic solutions.  If we’re going to step out of the cycle of bubble – burst that’s developed, and restore trust and confidence to the market, we must certainly take some of the steps that Dodd and followers propose to strengthen regulation– and we must match them with real enforcement.  But we must also take more fundamental action; we must correct the structural flaws that have grown in the financial arena.

For my money Paul Volcker has it right.  The “Volcker Rules“  (which would, among other things, limit the size of institutions insured by the government, and restrict those organizations using guaranteed funds from making speculative investments) are both prudent and practical–  and they have a real chance of preventing a recurrence of the troubles that they address.  Senators Jeff Merkley, Carl Levin , Ted Kaufman, Sherrod Brown, and Jeanne Shaheen  have introduced legislation that would largely accomplish the Volcker Rules (release here; pdf of full text of bill here).

If that’s news to readers, it should come as no surprise: the noise around Dodd’s bill has effectively drown out the Merkley-Levin move.  Indeed, all of the entrenched incumbents have everything to gain by guiding the public discourse so that it is an argument over the details of an incremental approach.  And so millions of dollars is being invested to do just that.

But everyone else– we all– have everything to lose if we fail to fix the problems that have cost us so very much over the last decade.

There will surely be “financial reform” forthcoming from Congress.  The question is whether or not it will actually be reform.

Just a second…

source

This is a post on a pretty specific point– a lesson from the troubled and troubling market in secondary mortgages in the U.S…  but a post that’s hard (for me, anyway) to write without reference to the context that gives it significance…

On the heels of the 9-15-08 financial meltdown, everyone seems to agree that something needs to change.  But what it is that needs to change, and how– on these details there’s no consensus at all.

A central point of “dissensus” goes to the regulation of financial players.  There are nearly as many opinions and proposals as there are interested parties and observers; but one fundamental question seems to define what are two divergent camps:  if we are to prevent the re-emergence of the conditions that brought the house down…

- Is it enough, as the financial community argues, simply to strengthen regulations (and enforcement), or

- Or, as past Federal Reserve Head Paul Volcker and others insist, should the financial industry also be fundamentally restructured?

More specifically– and emblematically–

- Is it enough simply to watch more closely the behemoth financial institutions that have arisen (and gotten even bigger in the wake of the crash)?

- Or do they need to be broken up, Glass-Steagall-like, to prevent the commercial banking that has become infrastructural to our economy from falling prey to speculative investment, and to prevent banks that are “too large to fail” from operating as an oligopoly with unfair advantage at the expense of other businesses, consumers, and taxpayers?

There are many, many reasons why I fall squarely into the Paul Volcker camp– “too big to fail” is just too big– and believe that reform will require both regulation and restructuring.  The case is elegantly made by Simon Johnson and James Kwak in their forthcoming book, Thirteen Bankers, and in their blog Baseline Scenario, e.g., in this post.

Here I want to address just one of the arguments advanced by incumbents– the big banks– and other defenders of a status quo only lightly modified by regulation:  the suggestion that the meltdown was a product of exotic derivatives and other “sci-fi” investment vehicles gone wrong.  If we simply increase regulatory attention to those, the big banks argue, we’ll be fine.

A post from Felix Salmon, in Seeking Alpha, suggests otherwise.  Writing about the crisis in second-mortgages, he observes:

All those second-mortgage-backed CDOs which have gone to zero, causing enormous losses? They’re in that tiny little purple wedge at the bottom. The overwhelming majority of second mortgages, it turns out, are held the old-fashioned way, on the books of banks, credit unions, and savings institutions.

Now this goes strongly against the dominant narrative of the subprime crisis, which is that the originate-to-distribute business model was largely responsible for the disastrous collapse in underwriting standards. Here, there was no originate-to-distribute business model, and clearly most of these seconds should never have been written — but they still were, and what’s more they were underwritten disproportionately by the big four commercial banks. (Actually, I’m not clear on if they were underwritten by the big four, or if the big four have just acquired them through the acquisition of companies like Countrywide (BAC) and Wachovia (WFC).)

What explains the commercial-bank loan officers taking toxic second mortgages onto their own books? I think it’s a combination of factors. Firstly, they believed the hype. Secondly, they were reaching for yield in the Great Moderation just like everybody else. And thirdly, the originate-to-distribute model still existed in a smaller form: the banks were acquiring these loans from mortgage brokers who got paid at close, whether or not the loan was a good one.

Salmon goes on to discuss what to do about the second-mortgage issue, and his thoughts are well worth reading.

But the point in this context is– surely obviously– that it wasn’t exotic instruments nor “weapons of mass financial destruction” that dug this ditch, it was “old fashioned” banking… gone horribly wrong.

Clearly, banks need to learn from this experience.  And surely the smaller ones, feeling real pain, have.  But the Big Four are “too big to fail”– and they know it.  When we take away moral hazard, we eliminate the need to learn lessons like these– indeed, we create incentives not to learn them.  If the Big Four make money, they keep it; if they get into trouble, they get bailed out.

So instead of figuring out how to prevent a recurrence of the mortgage disaster, the Big Four are blaming it on a few bad apples and a few bad instruments– nothing, they’d have us believe, that a little more scrutiny and self-regulation can’t handle.

History suggests that this simply isn’t true.  And so we need to limit the size banks that enjoy a federal guarantee.  There are other compelling reasons to limit the size of banks– the unfair advantage (in raising capital) that being “too big to fail” gives the giants viz their smaller, exposed competitors, the punitive behavior toward consumers that it allows (indeed, encourages).  But even if we leave those aside, the need to protect the viability of the economy– the precautionary principle– makes the case for structural change.  Otherwise, we are just asking for an amplified repeat of the boom-bust cycle the last wave of which nearly swamped our economy.

Still, the debate over approaches to financial reform rages even within the White House.  Indeed, until recently Wall Street vets like Tim Geithner and Bob Rubin, along with Larry Summers, had been successfully arguing to protect the status quo.   But after last month’s Democratic senatorial defeat in Massachusetts, there was a seeming about-face:  the previously-marginalized Paul Volcker stood beside President Obama as the President declared himself the Reformer-in-Chief.

source

And not a moment too soon:  a wave of financial turmoil has built in Europe, threatening economies around the globe (the currently-discussed “firewall bailout” notwithstanding)– reminding us that strengthening the foundations of U.S. capital markets is critically important– and terrifyingly timely.

Even so, only a month after the President’s adoption of Volcker’s line, the financial reform spotlight is shifting toward the Senate– and the encouragement generated by Obama’s epiphany is dissipating.  The Senate always looked a harder slog for real reform than the closer-to-the-aggrieved-citizenry House… even before the Supreme Court encouraged corporations to dangle even tastier carrots and to wave even bigger sticks.

As it is, all we can do is plead with our elected representatives to represent us– to enact real structural reform.  It’s that, or make sure that the lifeboats are well-stocked for the next financial catastrophe.