Obama Administration Financial Regulation Proposal - Parts I & II

A smart businesswoman in the Portland area asked for a synopsis of this proposal, saying, "It seems like everywhere we read doom and gloom doom and gloom. I would like to read some kind of balanced piece for once." Thanks for the suggestion, Kelly.

Since there are five key objectives in this proposal (which is 87 pages long), I'll do this in a series that will include

• Supervision and Regulation of Financial Firms
• Regulation of Financial Markets
• Consumer and Investor Protection
• Government Tools to Meet Objectives
• International Standards and Regulation.

We'll start with the first two - Supervision and Regulation of Financial Firms and Regulation of Financial Markets. Please feel free to comment on this, and all subsequent articles.

Supervision and Regulation of Financial Firms

To fix a problem, it must first be properly defined. The proposal notes that leverage, or borrowing, by consumers and financial institutions alike, expanded dramatically during the housing bubble. This is an inarguable fact. People were borrowing more and more money against houses with prices that were rising at an unsustainable pace. Lenders were lending more and more money against these (and other) assets, with declining lending standards. Neither consumers nor lenders were prepared for the inevitable fall in prices. The root problem, however, was that no regulatory body had sufficient jurisdiction (or power) to address these problems.

The specific problems were:

• Capital and liquidity standards were too low
• The widespread effect that financial institutions would have on the entire financial system if they failed
• Splintered, fragmented regulatory bodies, none of which had responsibility or authority for the overall system
• Insufficient oversight for investment bankers (brokerage firms)

Capital standards are the required amount of money that must be put aside, and are based on assets. At its worst, some investment banks were leveraged 47:1. That means for every $47 dollars it had in loans, swaps, etc., it had $1 in actual cash. In other words, that would be like putting $8500 down on a $400,000 house, and thinking you had a sufficient down payment.

The second issue is"too big to fail," which basically means that, if that particular financial institution failed, it would severely damage the entire financial system. This type of systemic risk was present in AIG, a mammoth insurance company. Because of the number of credit default swaps (unregulated inter-financial institution agreements to cover loan amounts, if the borrower defaulted) and other risks assumed by the company, had the government allowed it to fail, the result would likely be catastrophic for, not only the US, but the world-wide financial markets.

Regulatory oversight for financial institutions was very like the issue that arose after 9/11, when the CIA, FBI and local law enforcement agencies in total may have had the intelligence to prevent the attacks, but had no inter-communication, and in some cases competing and proprietary interests. Insurance companies are state regulated, and every state is different. Banks are regulated by the either the Comptroller of the Currency or FDIC and the Federal Reserve Bank, thrifts, by the OTC, and investment bankers, by the SEC. There's no coordination. So, when investment bankers went into the mortgage business, the OTC had no jurisdiction.

And, speaking of the investment bankers, they were convinced that, since the overall housing market hadn't fallen for 50 years, it followed that a geographically diverse portfolio of mortgages would be safe no matter how little the down payment, whether income was verified, etc., etc. After all, an overall rising market would protect investors. They even convinced the rating agencies that reviewed their portfolios that they were right. The fact that this business needs more oversight could not be more apparent in hindsight.

So, the Administration proposes seeks to put the Treasury Department in charge. They'll be the "big boss" over all the other agencies, and have the authority to stop these problems before they become systemic. A Financial Oversight Council, consisting of the heads of supervisory agencies, will be established to identify such risks before the problems become too large, and agencies will be consolidated in order that responsibilities not overlap or compete, with the Fed responsible for implementing more stringent standards for the operation of these companies.

All financial institutions will have more stringent capital requirements and executive compensation standards. Capital requirements for reserves covering potential loan losses will be set by both accounting standards boards and the SEC.

Regulation of Financial Markets

The problem having been defined, the Administration seeks to address these issues through the following regulatory reforms.

• Strengthening of "firewalls" between banks and their affiliates to curtail conflicts of interest
• Closing loopholes in bank regulation (to prevent financial institutions from changing their charter from one type of bank to another to enable certain practices)
• Eliminating the thrift (the old "savings and loan") charter and unifying those institutions under the supervision of commercial banks
• Hedge funds will no longer be unregulated
• Insurance companies will be regulated on the federal, instead of state level
• The future of Federal "agencies" (Like Fannie Mae and Freddie Mac) will be considered
• Regulating "over-the-counter" instruments, like credit default swaps, derivatives and commodities
• Strengthen regulation of securitization markets (like "asset backed securities" that consist of mortgages)
• Tie compensation with long term performance
• Provide means to eliminate conflict of interest by the Rating Agencies

That's a synopsis of the proposals. So, where is the "doom and gloom?"

Too Powerful Treasury

First, many people feel that this proposal gives the Treasury too much power. I agree that the "regulator's regulator" is a powerful position. But, I have heard no one provide an alternative. In reading this objection by many authors, I have noticed a common thread. Generally, the objectors seemed more concerned about the current Treasury Secretary than the fact that Treasury is the agency in charge. After all, what is the alternative? The Fed? Another agency? I agree that, as with all complex issues, often the key players are more important than the structure in which they operate. But, that argument is fallacious in criticizing the structure.

Reinstate Glass-Steagall

Many feel that strengthening firewalls between banks and their affiliates is an inadequate solution, and want the Glass-Steagall Act, repealed under the Clinton Administration, to be reinstated. While that may or may not be a valid point, the fact is that those who recommend this action do not say how it will be accomplished. Since most investment bankers now operate under a commercial bank charter, would you require that the banks divest themselves of the investment banking portion of their operation? This would require a new board of directors, management team, central operation, etc. Who would pay for the additional expense this would require?

Government Has No Business in the Compensation Business

Many object to "capping" executive pay. I am one of these people. However, close reading of the proposals does no such thing. It ties compensation with long term, as compared with short term objectives. While I concur that this will be difficult, allow me a bit of pontificating. Short term financial goals can be achieved by taking action that is not necessarily in the best long term interests of a company.

As an example, lax underwriting standards for mortgages may allow people who really can't afford a home to qualify to buy one. When one significantly increases the demand for something, many more people are bidding on that thing, and the price goes up. That is called demand-push, and that pushes up prices. At some point, demand will level off. During the "push" prices - and profits - increase. If "everybody's doing it," and you are the company that is NOT, your profits are lower, and your stock is less valuable. However, your decision not to participate (if you survived), was in the long term interests of your company, your stockholders and the economy.

It's not going to be easy to change the short term profit motive, but it's worth a try.

Banks, Especially Multi-National Banks, Will Be Less Profitable

With stricter capitalization requirements, this is undoubtedly true. After all, if you're putting more money aside to cover potential problems, that money will not be earning what it would if it were invested. But, the profitability that was derived from participation in the unsustainable rise in housing prices cannot be considered "the norm." To compare properly regulated bank profits with those derived during the housing bubble is inappropriate when considering that the goal is long term sustainablility as compared with short term profitability.

These are the major objections I've seen raised and what I believe to be an appropriate response. Feel free, as mentioned before, to comment, and I'll do my best to answer.

Executive Pay

Lexington, Kentucky realtor Diana Nave suggested, “I think it is important for people to understand the spread between executives and workers and how far apart it has become.” Agreed. Let’s take a look.
A Little History
In 1940, executives (the three highest-paid officers in the 50 largest US companies) earned 56 times their average worker’s pay. In 1950, that ratio slipped to 34 times, and fell further in 1960 and 1970 to 27 and 25 times, respectively.
Then, in 1980, executive pay grew to 33 times their average worker, and in 1990, to 55 times, approximately equal to that of 1940. In the year 2000, executives were paid nearly 120 times that of their average worker.
So, what was the economic situation in 1940, how was it similar to 1990, and what happened between 1990 and 2000 that caused the average worker to lose so much ground?
1940
The Great Depression may have improved to a recessionary status from 1938 to early 1940, but no economic recovery of significance could take place without government fiscal intervention. The recovery would have likely taken much longer if left to the private sector.
The US Gross National Product had passed the $100 billion mark in 1940, but was just 9 percent above the GNP level of 1929. It was the federal purchases of goods and services for national defense in the pre-war period - a rise from $1.2 billion in 1939 to $2.2 billion in 1940 - when the economy felt the rise in government spending that marked the end of an economically depressed era through the injection of government funds directly into the economy. While many credit the “New Deal,” evidence points more heavily toward defense spending.
After a protracted period of 14%+ unemployment, a combination of a “take any job” mentality, and a new, somewhat underpaid female workforce during the war exacerbated the CEO vs. average worker chasm during this decade, which was not again achieved until fifty years later in 1990.
1990
After a protracted recession in the 1970’s, the 1980’s was a decade during which economic growth depended on a steady rise in consumer spending supported by both increasing debt and prices of stocks and homes. The present U.S. slump signals the end of that consumption-led growth, with an overbuilt housing market and an over employed consumption sector, from car dealers to malls. The question is whether our system can adapt to create new growth to fill the void left by embattled consumers.
The 1940s was a “boom” cycle due to government defense spending, and the 1990s, a “boom” cycle due to consumer spending. Neither was sustainable.
However, in the 1990s, a fundamental economic change took place – a “monetizing” of the financial asset growth – that largely rewarded the financing side of cash flow more than the operating side. Basically, there are three components of Cash Flow:
· Operating Activities, or producing revenue by operating the business at a profit
· Investing Activities, or buying and selling investments like property and equipment
· Financing Activities, or issuing/repaying long term debt (bonds) and issuing/buying back company stock.
As seen in both the Internet bubble in the 1990s and housing bubble in the 2000s, investors often were more highly rewarded for “flipping” their investments (or selling after owning them for a very short period) than for investing for the long-term. Both capital (stock and bond) and real estate investors saw a dramatic increase over the historic long term returns during these periods, and accepted and expected a continuation of those unsustainable returns.
Further, with the focus upon “short term” returns, management compensation became rooted in their ability to produce and sustain those returns by lessening their percentage of “salary” and increasing their percentage of “stock options” and the like, justified by their having the same stake in achieving profitability as their stock holders. Unfortunately, as seen by the collapse of the financial system, incenting management to achieve short-term profits over long-term viability can have disastrous consequences.
Now What?
It’s back to basics, now, for the capital and real estate markets. Real estate loans are again being made as they were for decades – 20% down, 30 year terms, with housing costs no more than 30% of gross income to borrowers with good credit. Stock prices are again reflecting management’s ability to turn a long term profit on the business more than their ability to buy back their own stock at a high return on investment. And executive pay is again reflected primarily in salary rather than stock options.
Are salary caps now appropriate? In my opinion, no. Any attempt to artificially cap prices, as was attempted in the 1970s, has ended in disaster. But, it has also not worked well to “let the market dictate,” as we are well aware now.
Companies must find a way to have the freedom to “bid” for talented people to run their businesses without undue interference, while recognizing that paying those talented people 120 times the salary of their average worker is a poor investment. It’s a complex problem that is fraught with both the tendency to over regulate and do nothing, both of which would be a terrible mistake.
And, while consumer consumption is severely mitigated by unemployment rates not seen since the 1980s, a return to conspicuous consumption seems, at least for the foreseeable future, passé. It is incumbent upon the US to convert the financial to the operating side of its future cash flow by innovating, i.e., producing new goods and services that address the needs of a global population in need of sustainable sources of food, housing and energy. As those businesses form, those who provide capital for their formation must demand a more horizontal business model that compensates innovators more closely to the level of their managers.
It’s a big job.