Financial Reforms: no dearth of suggestions, but a lack of action

by Linda Beale

Financial Reforms: no dearth of suggestions, but a lack of action

As economists track the signs of a possibly receding recession, investors test the waters for investing, and Congress is pushed to focus more on deficit reduction than on economic stimulus (probably wrongly), the financial institution imbalance that started it all goes on unabated. We still have huge financial institutions risking not just their money but ours, under the implicit federal guarantee that lets them borrow for less and earn more than similarly situated banks that don’t enjoy that federal guarantee. We still have endless variations of derivative instruments available for custom delivery, instruments that were ill-understood by the market participants before the crisis burst andthat remain problematic from tax and regulatory perspectives. Swaps, CDOs and other securitization instruments continue to be traded between counterparties without the widespread knowledge of important market information to inform the trades. Banks continue to hold onto loan portfolios, unwilling to acknowledge–either in their “mark” for financial and tax accounting purposes or in their relationships with borrowers–the appropriate decline in the principal amount of the loans.

What are the solutions, if any, that will be imposed. Two figures from prior administrations have suggestions about what they should be. Not surprisingly, the focus, and corollary impacts, are profoundly different.

Robert Reich, labor secretary under Bill Clinton, looks at the bank bailouts and the banks’ failures to modify principal amounts on mortgage loans and sees what many other commentators have seen–socialization of bank (i.e., manager and shareholder) losses, privatization of gains. Welfare for Wall Street, Free markets for the rest of us. Salon, Feb. 12, 2010. Reich reminds the President that there is not that much differnce between the “lower” bonuses paid to Goldman CEO compared to other big investment bankers ($9 million versus $17 million)–those are both stratospheric pay amounts, entitling their recipients to live in the exclusive realm of the top percent of all households in this country–kings in their privileged domain, and both paid for by taxpayer largesse, which bailed the companies out of inevitable huge losses and possible insolvency (if counterparties hadn’t paid on their debts, if AIG had defaulted on all of its guarantees, if the government hadn’t made credit available on very easy terms, etc.). Meanwhile, they contrast sharply with the economic situation of ordinary Americans–millions with lost jobs, millions more with “furloughs” and other forms of pay cuts, millions with real fear of imminent job loss, and almost all with homes whose values have tanked and retirement accounts whose funds are now much less than adequate for the years ahead. Wall Street is making hay, but Main Street is suffering. And the banks that securitized those mortgage loans–and pushed homeowners to take out new loans, to get equity out of their homes, to refinance so that banks would have more product to sell in securitizations to earn more fees–are not doing the one thing that could make the biggest difference in ending the struggles of this recession for many people–modifying the principal amount of mortgages by writing them down to reflect the true value of the homes on which they were granted. Here is Reich’s argument in his own words.

Bankruptcy has been part of the “free market system” for hundreds of years, but its details are determined through politics — the same politics that arranged the $700 billion bailout of Wall Street. In fact, you might say that during 2009, Wall Street went through its own kind of bankruptcy restructuring, with the generous aid of American taxpayers. JP Morgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup and Wells Fargo, along with their top executives, traders, and major investors, have benefited handsomely.

Now, a quarter of American homeowners need help restructuring their loans, but Wall Street is blocking the way.

Rather than defending the outsized paychecks of Dimon, Blankfein, and the rest of Wall Street as part of the free market system, the President needs to demand that Wall Street help homeowners on Main Street. The Obama White House should have made this a condition of getting the giant bailouts in the first place. The least it can do now is to is to make the free market system work for everyone.

Meanwhile former Treasury Secretary Paulson doesn’t seem to be thinking much about ordinary Americans. He is worried about the financial system, as we all should be. But his solution is the one that seems worrisome for the power it vests in the Fed and the failure to change the “too big to fail” status. He wants a systemic risk regulator and a pre-crisis liquidation process. See How to Watch the Banks, Henry Paulson, Op-Ed, New York Times, Feb. 15, 2010. Moreover, he suggests that decisions about banks’ size can only be made through an international regulator–the Financial Stability Board–which would broker international agreements regulating size and capital requirements.

Yes, we need to be cognizant of systemic risk factors and take action, but is a “systemic risk council” (Congress current idea) or the Fed as a systemic risk regulator the way? A systemic risk regulator is subject to capture–as the Fed arguably was during the Greenspan years of watching the housing bubble grow while mouthing paens to the free market’s ability to self-regulate. The Fed’s actions to deal with the bailout could have been less bank friendly and more ordinary American friendly–more control of salaries and risk taking for the billions pumped in, exaction of an agreement to support legislation on modifying loans in bankruptcy before any money was made available, refusal to “solve” the too big to fail problem by letting corporations consolidate and become even larger, etc.

And yes, plans for dissolution of insolvent banks are important, but they will not work if 1) we don’t have the will to allow them to go bankrupt and 2) we don’t exact from these banks a sufficient fee, as times goes on, for the protection that we provide them in the form of lower credit, liquidity facilities, and other guarantees.

But we have a real problem with financial institutions that are, as my grandmother used to say, “too big for their britches.” Brokering agreements through an international board sounds as fruitless as the endless proposals for commissions to study tax reform. We need Congress to take real action, now. We can’t wait for an international agreement, that would take years to work through and becomes less likely as the crisis recedes and the banks exert lobbying pressure.

So while a systemic risk regulator is probably important, controls on leverage ratios are more important. And while a plan for dissolution of insolvent banks is important, it is even more important to charge the banks an appropriate fee for the support provided by the government. Obama’s suggestion for a fee related to the amount of leverage is possible–it should be permanent, high enough to result in a pull-back in the amount of leverage in order to reduce the rate, and calculated in a way that will not be hard to manipulate (perhaps using a debt to basis ratio rather than a debt to fair market value ratio). And while all of those are important, we need to figure out how to break the big banks up into smaller pieces that are not as capable of wrecking the entire economy.

We probably need both Reich’s suggestions and some of Paulson’s. Modification of loans in bankruptcy seems a no-brainer, though Congress cannot get beyond the lobbyists’ grasp. Attention to systemic risk is required, but that is much more than the Fed as regulator–we need to repeal the Commodities modernization act and regulate all derivatives, requiring transparent terms via trades through exchanges. Somehow we need to find the will to break up the big banks–without that step, they will amass both economic power that can be devastating when misused and move the economy from crisis to bubble to crisis and political power that will insulate them from any remedial action by Congress, especially after the Citizens United case.

(By the way, Paulson goes on to throw out the GOP party line by treating the social welfare programs (Medicare, Medicaid, Social Security) as just as troubling as the bank bailouts in terms of problems that need to be gotten a handle on–he suggests by paring down the entitlements. This is the old bait and switch gimmick. Move the focus from the banks, which have reaped enormous rewards for their joint folly in economic engineering, to the folks who rely on these various safety net programs for a decent standard of living.)
crossposted with ataxingmatter by Linda Beale