President Obama's Financial Regulation Proposal - Part V

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. Parts I through IV of the proposal were discussed in the three previous posts. Here's the fourth, and final installment.

Raise International Regulatory Standards and Improve International Cooperation

As we discussed previously, without international cooperation, money will move to countries with the most lax regulation and continue the type of high risk/high reward behavior that caused our current crisis. A good example is Stanford Financial, which is under investigation for defrauding investors, where the Texas founder operated freely in the Caribbean. Last April, the G-20 issued a declaration which included:

1. Strengthening the 1988 "Basel Accord" to include financial institution capital requirements that are consistent throughout the world
2. Define "capital" consistently, i.e., what can and cannot be used to substitute for cash in meeting capital requirements
3. Define how leveraged a financial institution may be
4. Set accounting standards that are similar throughout the world.

To improve oversight, the G-20 is working on contracts, to be available this Fall, to standardize and centralize the clearing of derivatives, e.g., credit default swaps, options, etc., as well as strenthening the oversight of all goals stated in the declaration.

So, where's the "gloom and doom?"

US

The US is pushing for financial reforms to address problems that we caused. This weakens our negotiating position for countries that object to more stringent financial requirements, at a time when they are weakened because of buying our Auction Rate Securities and the like.

Some countries are telling us to clean up our mess before telling them what to do. It's hard not to see their point.

Overall, these proposals are strong, having defined the root causes of the problems we face and providing logical, if sometimes politically based, solutions. The weaknesses in the proposal seem to be outweighed by the strengths. To attack the weaknesses without providing a superior solution IS politically based, and to fail to address these problems will all but guarantee that they are repeated.

The full draft of these proposals can be found at http://documents.nytimes.com/draft-of-president-obama-s-financial-regulation-proposal#p=1 I welcome your comments and discussion about any points in this proposal. And thanks, Kelly, for your suggestion to discuss this important issue.

President Obama's Financial Regulation Proposal - Part IV

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. Parts I, II and III of the proposal were discussed in the two previous posts. Here's the third installment.

Creation of the Consumer Financial Protection Agency

The seven government agencies named in the prior post did not prevent or address financial problems adequately during the recent crisis. The administration has proposed the creation of the Consumer Financial Protection Agency as one solution. The creation of this agency was discussed in the prior post. In addition to this agency, the administration also seeks to create "resolution regime" for failing Bank Holding Companies and so-called "Tier 1" (too big to fail) Financial Holding Companies.

Resolution Regime

This "regime" will be led by the Treasury Department, and can act only after

• consulting with the President, and
• having obtained the approval of 2/3 of the Fed board, and 2/3 of the FDIC board (if the failing institution is a bank) or 2/3 of the SEC commissioners (if the failing institution is a brokerage firm)

This, with the previously discussed increased capital requirements for "too big to fail" financial institutions, is the solution proposed to avoid situations like those seen recently with AIG and Bear Stearns. Again, the Treasury is the "big boss" when institutions that are large enough to cause widespread financial harm are seen to have significant developing problems.

As the "big boss," the Treasury now must approve loans made by the Fed to such institutions.

Where's the doom and gloom?

MORE Power for the Treasury?

Many people, as discussed before, are uncomfortable with the Treasury Department in the position as the "regulator's regulator." Now, the Fed has to consult with Treasury prior to authorize lending practices related to "too big to fail" institutions.

In reality, the Treasury Secretary was consulted in every instance when action was recently taken by the Fed. This provision makes that practice mandatory.

More Power for the President?

The Treasury must consult with the President before initiating the resolution regime for failing institutions. Some worry that the President may take the initiative and pressure Treasury to take such action. Those who make such accusations fail, in my opinion, to consider that 2/3 of the Fed board and 2/3 of either the FDIC board or SEC commissioners must also approve taking such action. The checks and balances, in this case, seem to be in place to assure that the Executive Branch not have undue influence in making these decisions.

I look forward to your comments, and will address the final part of these proposals in the next post.

Obama Administration Financial Regulation Proposal - Part III

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. Parts I and II of the proposal were discussed in the previous post. Here's the second installment.

Protect Consumers and Investors

The Administration seeks to protect consumers against fraud and promote understanding of financial products, like credit cards, savings vehicles, mortgages, and the like. This goal is addressed through the creation of the CFPA (Consumer Financial Protection Agency), which is charged with the responsibility to ensure that consumer protection regulations are "written fairly and enforced vigorously." This new agency will have no jurisdiction over financial products governed by the Securities and Exchange Commission or the Federal Trade Commission, but both existing agencies will have new authorities and resources.

When non-traditional mortgage lenders entered the mortgage market after new mortgage securitization produces were developed by Wall St., the regulatory framework that protected consumers of banks and thrifts did not cover those new lenders. Countrywide Mortgage, for example, incented its sales staff to sell mortgage instruments that were not necessarily risk appropriate for borrowers. While other more traditional mortgage products were available, loan agents were encouraged by amount of incentive paid by product to sell Adjustable Rate Mortgages through "no-doc" (no, or low documentation required) programs that had high up-front fee structures.

And, with respect to credit card lending, certain "fine print" issues have arisen that clearly show that, if given the power to raise interest rates for situations unrelated to current repayment history (like applying for additional credit elsewhere), financial institutions can, and will, categorically raise expenses. In the past, this situation could have been rectified by the market, i.e., customers could merely close accounts with more onerous conditions and transfer them to institutions with more consumer friendly agreements. But, as credit lines froze, such alternative credit providers were unavailable.

The mission of this new Consumer Financial Protection Agency is to ensure that

1. Consumers have the information they need to make responsible financial decisions
   
   
2. Consumers are protected from abuse, unfairness, deception and discrimination
   
   
3. Consumers' markets operate fairly and efficiently with ample room for sustainable growth and innovation
   
   
4. Traditionally underserved consumer markets have access to lending, investment and financial services
   

The CFPA will be the "consumers' seat at the table" as regards the

• Truth in Lending Act
  
• Home Ownership and Equity Protection Act


• Real Estate Settlement and Procedures Act


• Community Reinvestment Act


• Equal Credit Opportunity Act


• Home Mortgage Disclosure Act


• Fair Debt Collection Practices Act

All those Acts were in place during the mortgage crisis. The Administration proposes to solve the lack of understanding by consumers that played some part in this crisis by creating another agency and ensuring a "consumer voice," noting that its mission is to provide "a floor, not a ceiling." This means that the Agency will represent minimum and consistent standard

Examples?

• No more "mandatory arbitration clauses."


• Requiring "plain English" disclosures.


• Holding brokers to a "fiduciary" as opposed to "suitability" standard.


• Holding companies responsible to clients, as well as investors.


• Require "non-binding" shareholder votes for executive compensation.


• Increase retirement savings incentives.

So where's the "doom and gloom" here, you ask? Well, it certainly isn't in the rhetoric.

ANOTHER Agency?

I add my voice to this groan. Government agencies are expensive, unwieldy and, judging from the number which existed prior to the crisis, ineffective. The fact remains that, even with those seven agencies listed above, the housing crisis ensued.

I hesitate to unilaterally cry, "Poor little consumer" in every case. Many borrowers who KNEW they couldn't afford a $400,000 house with a $50,000 annual salary, bought one anyway. I cringe at the thought that the we as consumers are too stupid to make up our own minds. Then, I look at my credit card statement, and pause. It's ridiculous. It's incomprehensible.

So, what's the answer? The fact is, it doesn't matter. The consumer has screamed to the top of Congress that every Tom Dick and Harry financial whatever has received a squillion dollar bail-out, and she the individual is left to mind her finances properly and pay her bills on time with no help. Consumer protection is going to be written in this proposal as a political reality.

It is my hope that we don't over-correct. It is my hope that we do not swing to the extreme of the so-called "nanny state," and attempt to hold everyone's hand, make doing business more costly, and become non-competitive in world financial markets. But, reality is reality and consumer protection is the current political reality.

As a matter of full disclosure, I come from the financial industry. As a matter of fuller disclosure, I spent years in "Regulatory Compliance," which was charged with the responsibility of taking recently promulgated regulation and integrating it into daily operations. I admit to reading regulations and thinking, "Have the persons who wrote this EVER been in an actual business?" I admit to seeing the regulatory pendulum swing wildly back and forth, and hating the tendency to over-regulate after a crisis. I predict that this legislation will be analogous to affirmative action, where administrations will use it as a political symbol as "pro-consumer" and "pro-business" stands that will result in its being more or less consumer friendly. It will undoubtedly, however, be expensive. Read on.

It Will Make Financial Institutions Less Profitable

Absolutely right. Between the increase in capital and liquidity requirements discussed in the prior post and the increase in regulation that will require new forms, new procedures, new training, etc., etc., banks will definitely be less profitable. And, since one of the stated goals of this new agency is to give access to traditionally underserved markets, i.e., the poor, non-English speaking residents, etc., the expenses inherent in this proposal will likely result in higher fees paid by the rest of us. Speaking for myself, I will pay higher fees in order that the most vulnerable of us not be subjected to the usurious rates charged by "payday loan" and "rent to own" firms, but I am speaking only for myself. Banking is going to cost more, just as health care will cost more as we insure the uninsured. This is a social, as opposed to business issue. If you think that the poor should not have access to basic financial services, this is not the time to voice your opinion. You're not in the majority

Non-Binding Executive Compensaton Shareholder Votes

Non-binding means that you are not bound by what I say. Non-binding votes by shareholders about executive compensation is a paper tiger. By this, the Administration seeks to let shareholders tell executives that they think they're getting paid too much, but stops before giving them any power to do anything about it. In some ways, I like this, as "capping compensation" is basically wage controls, and anyone who lived through the 1970's will tell you how well that worked out. Also, imagine the press you'll get if you're one of those executives. The 24-hour business channels will be all over you, forcing you to justify your compensation, and making you say why you should have your job. It's an interesting solution. I'm on the fence on this aspect of the proposal, but think public outcry a far superior recommendation than salary caps. We shall see.

That said, this part of the financial proposal has some potential land mines, and I'll be watching it very closely. Hopefully, we won't over regulate and make a bad situation worse.

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.