Tuesday, May 25, 2010

Financial Reform That Isn't

Why am I not surprised that the financial reform bill fundamentally reforms nothing?

Judd Gregg unloaded on the bill:

“The bill is a disaster because it doesn’t address the fundamental underlining causes of the economic issue, which were real estate and underwriting,” he said. “This bill became, ‘I want to score the most points against Wall Street.’ Most of the initiative of this bill wasn’t directed at solving the problem, but it was directed at scoring political points."
As previously discussed in this blog, the ultimate issue is how the bill deals with to big too fail. The linked article claims that this bill gives the feds new powers and "authorizes regulators to impose restrictions on large, troubled financial institutions. It also creates a process for the government to liquidate failing companies at no cost to taxpayers." Color me skeptical, lacking supporting detail, given prior regulatory failure, and political incentives in the bill to turn banks into engines of social justice, I don't see any hope for change at all. I think things will get worse. Note that financial markets have reacted to this "reform" bill as a non-event, focusing on the collapse of socialism in Europe instead.

Meanwhile, gold is hovering near record highs against all major currencies, the traditional investor response to global instability. Debt caused by socialist and quasi-socialist policies is the common ingredient fueling loss of confidence world wide. The Democrats in Congress are doubling down on these failed policies like some compulsive gambler convinced that the next card turned over will be the ticket to a lifetime of riches.

The fight is not over on the final details. But the fundamental approach seems flawed, whether you prefer the House or the Senate version:

The firms would face tighter regulation, such as having to keep higher capital reserves. If they failed, certain creditors would be made whole to protect the financial system, but shareholders and unsecured creditors would bear losses and pay the costs of winding them down. It would create a $150 billion fund financed by large financial companies to pay for the dissolution of failing companies. The Senate version originally included a $50 billion fund, but that was removed after critics said it would encourage bailouts and possibly limit the government's ability to assess more fees on firms.
The problem with either version is that they either implicitly or explicitly guaranty to creditors of big firms that they will be bailed out by the feds. This perpetuates To Big Too Fail as follows. The surety provided by the feds to creditors lowers the cost of capital of the "too big" firms. This yields a competitive advantage to these firms that encourages them to just keep growing bigger and to take bigger risks. Ultimately the moral hazard of To Big Too Fail is not addressed. Creditors to large firms need to realize the same risks as any other creditor in the market place.

We need a law that explicitly prevents the federal government from bailing out more firms. To prevent contagion, we may need an orderly way to divest the assets are still performing, even as the holding firm is bankrupt. Part of the problem is that in the chaos of a massive bankruptcy, assets cannot be properly valued to allow creditors to receive a just portion of the divested assets. Slowing this process may be necessary, it prevents a form of fraud for you libertarians, but I remain adamantly opposed to my taxpayers ponying up to prop up this process.

This is why I oppose this so-called reform, even though it continues to be incrementally improved, it does nothing to fix the underlying issues behind this crisis, in fact, the consumer protection agency looks like a way to double down on Fannie and Freddie foolishness.

1 comment:

  1. Gotta love the fact that the responsible financial institutions will be punished by funding this $150 billion bailout slush bucket.