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Posts Tagged ‘financial reform’

Dodd-Frank

Former Fed Chair Alan Greenspan in today’s Financial Times:

The financial system on which Dodd-Frank is being imposed is far more complex than the lawmakers, and even most regulators, apparently contemplate. We will almost certainly end up with a number of regulatory inconsistencies whose consequences cannot be readily anticipated. Early returns on the restructuring do not bode well.

Greenspan goes on to note: “The act may create the largest regulatory-induced market distortion since America’s ill-fated imposition of wage and price controls in 1971.”

For those who have watched the financial reforms, this judgment (and much of the Greenspan’s comments) comes as no surprise.

Far more surprising:

Bill Murray has been cast to play FDR (brilliant choice)

Christine O’Donnell has a book contract (insert punch line here)

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The Treasury has been spinning TARP as a victory in the months leading up to midterm elections. I have a lot of respect for Elizabeth Warren (former Chair of the Congressional Oversight Panel for TARP, currently helping in the early work for the Consumer Finance Protection Agency she promoted) and the work she has done on bankruptcy.

As John Maggs reports in Politico, it appears that Elizabeth Warren is not too cheery on TARP’s performance.

Money quote:

“The rescue of AIG continues to have a poisonous effect on the marketplace,” said one critic recently. “By providing a complete rescue that called for no shared sacrifice on the part of AIG and its creditors, the government fundamentally changed the rules of the game on Wall Street. As long as the biggest companies in America believe that you and I will bail them out, the worst effects of the AIG rescue will linger.”

The critic was not a Republican politician or some conservative think tank. It was Elizabeth Warren, President Barack Obama’s choice to set up a new agency that will protect consumers from financial system abuses, and her blunt assessment is shared, to some extent, by critics on the left and the right.

Of course, Warren is correct, particularly in her observation: “The greatest consequence of TARP may be that the government has lost some of its ability to respond to future crises.”

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When Reform Isn’t Reform

In the months leading up to the passage of the financial reform legislation, Congress decided to segregate the issues of financial regulation and the government sponsored enterprises (GSEs) that were central to the collapse. Now that Dodd-Frank is in the bank, Congress and the White House are turning to Freddie and Fannie, the two GSEs that have already  sopped up $150 billion in taxpayer money. Will this process lead to meaningful reforms?  An article by Binyamin Appelbaum in yesterday’s NYT does not give me much hope.

The financial crisis came in the aftermath of the collapse in the real estate bubble. The bubble was created, in part, by government efforts to promote high levels of home ownership, particularly among low income citizens. This was justified in the 1990s through evidence suggesting racial discrimination in credit markets; during the Bush presidency it was promoted as part of the effort to create the so-called “ownership society.”

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 mandated that the Department of Housing and Urban Development set quantitative targets for GSE purchases of mortgages serving a low and moderate-income clientele.  Between 1993 and 2007, the target increased from 30 percent to 55 percent.  Even if we stipulate arguendo that the goal of extending home ownership to low income borrowers was laudable, it was nonetheless the case that this population—and the speculators that moved in to take advantage of liberalized underwriting standards—were highly vulnerable to economic fluctuations.

Let me be clear: I am not claiming that the housing policy of the Clinton and Bush administrations and Congress was the sole source of the financial crisis. But without the bubble it created (facilitated by a number of other factors, including the Taxpayer Relief Act of 1997, the Fed’s policies, and private sector chicanery), the crisis would not have occurred.  Clinton, Bush, and congressional majorities of both parties embraced a set of social goals and decided to use the GSEs as the instruments of choice in realizing these goals.

The NYT article contains some quotes that should disturb anyone hoping for genuine reform.  Appelbaum reports:

Mr. Geithner said continued government support was important “to make sure that Americans can borrow at reasonable interest rates to buy a house even in a downturn.”

While a range of options are on the table, Appelbaum notes:

The choice will reflect in large part a judgment about how hard the government should try to increase homeownership. Broader guarantees create greater risks for taxpayers, but also lower interest rates, bringing ownership within reach for more families. Shaun Donovan, the housing secretary and a host of the conference with Mr. Geithner, said that the administration remained committed to “broad access to homeownership, including options for those families who have historically been shut out of these markets.”

The conclusion: clear evidence that efforts to use the GSEs to engineer a predefined level of home ownership has had no discernable impact on policymakers’ desire to continue using the GSEs for this purpose.

I can imagine a principled argument from the Right that the level of home ownership is an emergent property of incomes and preferences. Rather than trying to achieve some politically-defined level of ownership, we should create the preconditions for growth and make certain that lenders bear the risk for the loans they make, even if this results in more stringent underwriting standards.

I can imagine a principled argument from the Left that the real problem has been the nation’s failure to invest in public housing for low-income households. Under the sway of neoliberalism, Democrats and Republicans alike gravitated toward “third way” solutions that effectively allowed them to move their responsibility to the poor off budget.

What I cannot imagine is a principled argument for a continuation of the status quo.

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Freddie and Fannie are in the news again.

Freddie is currently seeking an additional $1.8 billion in funding (to be added to the $160 billion that has already been spent on the two government sponsored enterprises or GSEs). This recent news has led me to pose an account of how a standard political choice story of political exchange evolved into one of state vampirism. Let us review some of the facts.

The financial collapse revealed the weakness of many institutions, much to the surprise of regulators. No one in government fully appreciated the fragility of AIG or Lehman, for example.  But the same cannot be said of the GSEs. A partial accounting of the warning signs:

  • When accounting scandals led to the collapse of Enron in 2001 and WorldCom a year later, attention turned to the misapplication of accounting standards in other large firms. In January of 2003, Freddie Mac admitted that it had engaged in creative accounting to “smooth out” its earnings growth and mask underlying volatility.
  • That same year, the IMF  identified a host of problems at the GSEs including the “systemic risks inherent in the agencies’ large mortgage portfolios and their hedging operations” and the “lack of transparency.”
  • In 2004, the OMB warned: “The GSEs are highly leveraged, holding much less capital in relation to their assets than similarly sized financial institutions….a misjudgment or unexpected economic event could quickly deplete this capital, potentially making it difficult for a GSE to meet its debt obligations. Given the very large size of each enterprise, even a small mistake by a GSE could have consequences throughout the economy.”
  • Congress held hearings over the course of the next several years to consider strengthening the oversight of the GSEs  and limiting the size of their portfolios. Greenspan—usually skeptical of regulation—testified that the GSEs should be forced to reduce their trillion dollar portfolios to $100 or $200 billion, a position echoed by Treasury officials. Although proposals to create a new agency to oversee the GSEs were introduced in both chambers, Republicans and Democrats blocked reforms—refusing to place restrictions on the size of their portfolios, preventing the regulator from considering systemic risk, or tying passage to the creation of an affordable housing fund to make grants to advocacy groups.

The GSEs avoided the kinds of regulations that, if introduced early enough, might have limited the extent of the crisis.

Making Sense of Nonsense

The above pattern might not seem to make sense until once considers it through the lens of public choice.   The GSEs, although private in the pre-crash days, benefitted dramatically from the implied backing of the US government. They were able to attract capital more cheaply because investors believed that their debt was as good as T-bills.

The GSEs preserved their status by funneling large amounts of money into politics. As Open Secrets noted in a brief 2008 piece on Freddie, Fannie, and political giving:

Fifteen of the 25 lawmakers who have received the most from the two companies combined since the 1990 election sit on either the House Financial Services Committee; the Senate Banking, Housing & Urban Affairs Committee; or the Senate Finance Committee. The others have seats on the powerful Appropriations or Ways & Means committees, are members of the congressional leadership or have run for president.

During the 1989-2008 period, Open Secrets reported that “Current members of Congress have received [as of 2008] a total of $4.8 million from Fannie Mae and Freddie Mac, with Democrats collecting 57 percent of that.” Top recipients of GSE largess for the period 1989-2008:

  1. Christopher Dodd (D-CT)
  2. John Kerry (D-MA)
  3. Barack Obama (D-IL)
  4. Hilary Clinton (D-NY)
  5. Paul Kanjorski (D-PA)

Obama’s performance is pretty amazing given his short tenure in the Senate. In case your are wondering, the top 25 also included Barney Frank (D-MA), Rahm Emaunuel (D-IL), Nancy Pelosi (D-CA), and Steny Hoyer (D-MD) were also in the top 25. And even if the top of this list was full of Democrats, Republicans were recipients of GSE funds as well, claiming a majority in 2006.

So, we have profit-maximizing firms (in this case the GSEs) investing in vote-maximizing politicians (see above) and receiving special regulatory treatment. The costs were borne by consumers and taxpayers. Many members of Congress undoubtedly thought they were doing good while doing well. By requiring via statute that the GSEs make 55 percent of their mortgage purchases from low and moderate income borrowers, they were furthering pressing social goals and contributing to the creation of an ownership society.

From Political Exchange to Political Vampirism

As we know, in 2007-2008, many of the misguided policies interacted to produce a daunting financial crisis and the largest issuance of debt relative to GDP since World War II.  Freddie and Fannie, carrying large portfolios that had been politically insulated by Congress, all but collapsed, forcing a government bailout that has cost, to date, $160 billion.

In 2010, Congress passed the financial reform legislation (formally, the Dodd-Frank Wall Street Reform and Consumer Protection Act).  As noted in a previous posting, Dodd-Frank was expansive enough to cover everything from conflict metals to the racial composition of financial institutions. What was left out? The provisions of the act did NOT cover the GSEs.

One reason for leaving the GSEs alone may have been their continued utility as instruments of social policy.  As Zachary Goldfarb notes in today’s WaPo:

Since then [the collapse], they have been run by government overseers who have told the companies to help carry out the Obama administration’s housing policy. They have focused on continuing to guarantee mortgages to keep interest rates low and on reworking unaffordable home loans so borrowers can avoid foreclosure. The federal government has pledged to keep the companies solvent.

One might be surprised that the administration is using the GSEs to promote the same kind of credit policies that contributed to the housing bubble—on second thought, who would be surprised, since the clownish and melodramatic explanations of the collapse are the ones that have prevailed politically.

Some things did change with the collapse of the GSEs. When the government stepped in with a bailout, new bans were placed on campaign donations. Amazingly enough, Congress believed that once it owned an entity, it might be somewhat unseemly for it to extract donations from it.  Some predicted that after decades of Freddie and Fannie dominance of housing policy, this would have some profound implications. As the WaPo noted on August 7: “now Fannie Mae and Freddie Mac, titans of the mortgage finance industry, are wards of the state, bailed out by Washington to the tune of $160 billion and banned from political activity.”

But even if political donations are temporarily off the table, there are other ways to extract blood from Freddie and Fannie.  From today’s WaPo:

The firms are also paying steep dividends to the government in return for the aid. The dividend rate, 10 percent, is far more than the companies would pay to raise money in the capital markets. After the latest round of assistance, Freddie will be required to pay $6.4 billion in annual dividends to the government. “This dividend amount exceeds the company’s annual historical earnings in most periods,” Freddie said in a statement. “Freddie Mac expects to request additional draws under the Purchase Agreement in future periods.”

So let us review the key facts: Initially, Congress provides the GSEs with an implicit guarantee in exchange for a steady flow of donations and lax oversight. That equilibrium proved quite stable for decades and delivered the goods for legislators regardless of their political stripe. However, exogenous and endogenous shocks punctuated this equilibrium and gave rise to the political vampirism witnessed today. The GSEs are given a lease on life, but a life that might feel more like a slow death as its resources are being drained away.

How are things working out? In Goldfarb’s words: “Now, it is government decisions that are driving a good bit of the companies’ losses.”  How great are these losses? Since the collapse, Freddie has received over $60 billion from the public coffers, and now it is approaching Congress for an additional  $1.8 billion in government aid.  The combined GSE bailout has cost a mere $160 billion, as if anyone other than bondholders are counting.

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As commentators begin to read the Dodd-Frank Wall Street Reform and Consumer Protection Act, they are discovering some hidden gems. The most recent discoveries:

Diversifying the Portfolio (via Carrie Budoff Brown at Politico):

Congress gives the federal government authority to terminate contracts with any financial firm that fails to ensure the “fair inclusion” of women and minorities, forcing every kind of company from a Wall Street giant to a mom-and-pop law office to account for the composition of its work force.

Maintaining Transparency (via Ed Morrissey at HotAir):

Under a little-noticed provision of the recently passed financial-reform legislation, the Securities and Exchange Commission no longer has to comply with virtually all requests for information releases from the public, including those filed under the Freedom of Information Act.

Controlling the Market in “Conflict metals” (via Michael Tennant at NewAmerican):

it includes language compelling American-listed “companies to certify whether their products contain minerals from rebel-controlled mines in Congo and surrounding countries.”

Since gold is on this list of “conflict metals,” conspiracy theories are beginning to blossom.

What readers will NOT find: reforms of Freddie Mac and Fannie Mae, the two government sponsored enterprises that were embroiled in the financial meltdown (see Colin Barr, Fortune). Not to worry…hearings are scheduled.

Meanwhile…

Congress, in its infinite wisdom, is prepared to provide  the Financial Crisis Inquiry Commission an additional $1.8 million to continue its work. Daniel Indiviglio (the Atlantic) wonders why, given that Congress leapfrogged the commission:

At a time when both sides of the aisle are worried about excessive government spending on waste, it’s hard to justify providing more funding to a commission whose purpose has become questionable, at best.

Michael Smallberg and Rick D’Amato (the Project on Government Oversight) are concerned about the burdens that the new rules and mandated studies will place on regulators:

we’re concerned that Congress may be burdening regulators and watchdogs with unnecessary studies, rather than putting hard-and-fast rules in place. Many of these studies will simply provide another avenue for the financial services industry to exert its influence on the process, and in the meantime, the studies could impose a significant burden on regulators and watchdogs that are already short on funding, staff, and resources.

Of course, one man’s burden is another’s opportunity. The new regulations this should provide a great source of employment opportunities, thereby contributing to the ongoing success of Recovery Summer. As Julie Steinberg notes:

With the passing of the financial reform bill, the SEC, CFTC and FDIC are all on the hiring warpath. The new CFPB and the beefed-up OCC are also expected to join hiring fray once they figure out staffing needs. The creation of at least 1,343 jobs across two of the agencies has already been announced (SEC and CFTC), and more hiring announcements are expected to follow.

Undoubtedly, there will be thousands of more jobs to come. Ms. Steinberg provides useful information on how to snag a job as a regulator.  What is unclear is whether currently unemployed Census workers will have a suitable skill set. If they do, the last month of Recovery Summer may fulfill the administration’s promises.

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Even though the President should have been able to claim some political credit for the financial regulation legislation (regardless of its ultimately efficacy), defeat was once again snatched from the jaws of victory. The  White House became embroiled in the USDA’s firing of Shirley Sherrod, losing control of the news cycle. As WaPo noted:

Remember that old adage that the secretary of agriculture is meant to be seen but not heard? (You know that one, right?).Tom Vilsack broke that rule this week with his dismissal of, doubling down on dismissal of, apology to and attempted rehiring of (it reads like the 12 stages of grief) a midlevel Department of Agriculture employee named Shirley Sherrod.

Ah the drama! This is precisely the kind of story the media likes—oh those “teachable moments”–and so much time to reflect on “what has happened to the news,” the evils of Glenn Beck, the possibilities for a national dialog on race…..zzzzzz.

Administration embarrassment and amateurishness aside, the story drew attention away from FinReg, one of the two key achievements of the Obama administration thus far. The news cycle on July 21st focused on FinReg. The next day, Vilsack’s firing of Sherrod  and the ongoing saga quickly displaced it (as seen by these story counts from Google).

As the White House is finding it difficult to extract much in the way of political gold out of FinReg, we are beginning to witness the slow drip of “unintended consequences” stories.  Daniel Indiviglio  (the Atlantic) provides one example with rating agency liability:

Only a few days old, the financial reform bill is already making trouble for the markets. One new provision holds credit rating agencies liable for their ratings. Scared about future lawsuits, the agencies have forbidden issuers from putting their ratings in official bond offering documents this week, which shut down the asset-backed securities market.

At 2,315 pages—likely all of which have never been read by a single human being—we can assume that the unintended consequences will continue for some time to come.

Have  a great weekend!

Stories: financial regulation

Stories: Sherrod firing

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The President is scheduled to sign the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act at the Ronald Reagan building today, July 21, 2010.

His prepared remarks read:

These reforms represent the strongest consumer financial protections in history. And these protections will be enforced by a new consumer watchdog with just one job: looking out for people – not big banks, not lenders, not investment houses – in the financial system. Now, that’s not just good for consumers; that’s good for the economy.

In case you find the full legislation to be too demanding, the White House blog has presented what it refers to as “the online attention-deficit version.” I am always pleased to see elected officials raising the level of policy discourse.

Of course, the 2,315 pages is only the beginning. As MarketWatch reports:

The Securities and Exchange Commission is expected to begin shortly an “extremely labor intensive” and “logistically challenging” effort to write a large number of regulations based on sweeping bank-reform legislation on the verge of approval, agency chairwoman Mary Schapiro said Tuesday in prepared remarks at a hearing on Capitol Hill.

Meanwhile…the Financial Crisis Inquiry Commission continues its investigation, hoping to provide its final report to Congress on December 15, 2010 (as mandated by the Fraud Enforcement and Recovery Act of 2009).

Given that the basic regulatory architecture will have been put into place and agencies will be embroiled in rulemaking, one can predict that the final report  will have minimal impact. Thankfully, understanding the core causes of the financial crisis is immaterial to designing a solution.

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