Yesterday I reviewed key sections of Obama’s speech on Wall Street here: Obama On The Street.
In general I liked the speech, but think that the steps he has proposed are, at best, only a good first step. I hope that the proposals are strengthened in Congress, but have zero hope of that happening. More likely they will be watered down significantly. The end result is that we will face another market meltdown in the future; the only question is when.
Regulation of the financial industry is one of those extremely important, yet dry and dull subjects, that the general public will ignore, and the lobbyists will own. The bank lobby is extremely powerful and is going to fight things tooth and nail. Obama got a distinctly cool reception from the financial executives in the audience, with only a single round of applause.
However, one year after the government spent hundreds of billions to save the banking system, not a single major bank CEO even bothered to show up for the speech. The sense of entitlement and the lack of gratitude by Wall Street is simply stunning. Look for a big push by the industry to preserve the status quo, probably with folksy TV ads full of dishonest scare tactics. It could include stuff about killing innovation and all that, attempting to convince people they are safer without someone in D.C. trying to protect consumers from abusive financial products. How many really useful financial innovations have there been in the last 30 years that have helped consumers?
The big useful innovations like credit cards and ATMs all happened back in the 1960s and 1970s, when banks were more closely regulated. Back in the days of 3-6-3 banking, when a banker would borrow at 3% in the form of checking and savings deposits, lend at 6%, and be on the first tee by 3 PM. When that was the shape of banking, we didn’t have to worry about meltdowns.
On the other hand, bankers were just members of the upper middle class, not regularly bringing home 8 figure compensation packages. The proposed consumer protection agency for financial products is probably the most important part of the reform package. It is also the one that the banks are going to try the hardest to kill. It is the acid test if the reform package is real, or just a fig leaf. I’ll go one step further and say that any congressman of either party who votes against this is representing his big campaign contributors on Wall Street, and not the interests of his or her constituents.
Some of the proposals that Obama has made sound reasonable and possibly workable, but the real devil is in the details. He will attempt to solve the ‘too big to fail’ problem by requiring the bigger, TBTF banks to hold higher levels of capital than smaller non-systemically important banks. The big question is how much higher?
If it is only a nominal difference, then the big banks will be in a great position. The Federal government will be in effect guaranteeing the debt of those banks (just like it did for Fannie (FNM) and Freddie (FRE) before taking them over). This will result in a much lower cost of capital for a TBTF bank like J.P. Morgan (JPM) than for your average mid sized bank. The big banks will then be free to take the money and pile it all on 23 red on the roulette wheel (metaphorically). If they win, the bank makes a fortune, which it will then share generously with its top executives. If they lose, the taxpayers will pick up the tab if the amount lost exceeds the bank’s capital. Debt obligations of the big banks will be almost as safe as treasuries.
On the other hand if the higher capital requirements are big enough, the lower leverage will greatly reduce the ROE of the big banks. The big banks will have more of their shareholders money at risk and might want to play it much safer.
Putting the Fed in charge of being the overall systemic risk regulator is somewhat problematic, given how slow the Fed was in recognizing the severity of the problems last year. However, I don’t see a better alternative among the existing agencies.
A case could perhaps be made for the FDIC, but their expertise is only with the banks, and the shadow banking system was a big part of the problem. Putting it in the hands of a committee of different agencies is just an excuse to do nothing. Would you be reassured if it was in the hands of some inter agency council? I know I would not be. I would however couple the increased authority for the Fed with the requirement that the Fed actually be audited, a proposal that Rep. Ron Paul has been pushing.
So given how complicated financial regulation is, how should consumers try to follow it? Perhaps the best way is to look at who is pushing for what. If the mortgage bankers association is pushing for a change in the regulation package, you should know that it is not in the best interests of consumers.
For more on this subject, I highly recommend reading this post by Simon Johnson, the former chief economist at the IMF over at the Baseline Scenario.
Read the full analyst report on “FNM”
Read the full analyst report on “FRE”
Read the full analyst report on “JPM”
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