Friday, May 11, 2012

Matt Taibbi: How Wall Street killed financial reform

Returning to the Opacity Protection Team theme, I thought readers might find Matt Taibbi's article on how Wall Street killed financial reform interesting.  In the following excerpt, Matt sets the stage for financial reform.

Please notice how the need for disclosure is identified, but is excluded from the Dodd-Frank Act.  As a good friend of mine says, true political power is not in the ability to block legislation, but in the ability to block the discussion in the first place by keeping the topic off the agenda.
The first advantage the banks had lay in the fact that for all Obama's bluster, Dodd-Frank was never such a badass law to begin with. 
In fact, Obama's initial response to the devastating financial events of 2008 represented a major departure from the historical precedent his own party had set during the 1930s, when President Franklin D. Roosevelt launched an audacious rewrite of the rules governing the American economy following the Great Crash of 1929. 
Upon entering office, FDR was in exactly the same position Obama found himself in after his inauguration in 2009. 
Then, as now, the American economy was in tatters after the bursting of a massive financial bubble, brought on when speculators borrowed huge sums and gambled on unregistered securities in largely unregulated exchanges. This mania for instant riches led to an explosion of Wall Street fraud and manipulation, creating a mountain of illusory growth divorced from the real-world economy: Of the $50 billion in securities sold in America in the 1920s, half turned out to be worthless. 
Roosevelt's response to all of this was to pass a number of sweeping new laws that focused on a single theme: protecting consumers by forcing the business of Wall Street into the light.
Please re-read the highlighted text as it emphasizes that the thrust of Roosevelt's response was disclosure.

This blog has expanded on the role of disclosure in the financial system in the FDR Framework.
The Securities Act of 1933 required all publicly traded companies to register themselves and offer prospectuses to investors; the Securities Exchange Act of 1934 forced publicly traded companies to make regular financial disclosures...
Prospectuses and regular financial disclosures dealt with the issue of providing market participants with access to all the useful, relevant information in an appropriate, timely manner that the participants needed to make a fully informed investment decision.

Your humble blogger refers to this as valuation transparency.

Investors need valuation transparency in order to independently value a security before making a portfolio management decision (buy, hold or sell) at the price being shown by Wall Street.
FDR also created the FDIC to protect bank depositors (through an insurance fund paid for by the banks themselves) and passed the Glass-Steagall Act to separate insurance companies, investment banks and commercial banks.
This blog has discussed that a modern banking system has two critical components:  deposit insurance and access to central bank funding.  With these two components, banks have the ability to operate for years providing loans to the real economy even if they have negative book capital levels.  As a result, banks are designed to absorb all the losses on the excesses in the financial system without requiring a bailout.
Post-New Deal, if you put money in a bank, you knew it was safe, and if you bought stock, you knew what you were buying.
 Please re-read the highlighted text as Matt makes the point far better than I do.
This reform strategy worked for more than half a century – and it offered Obama a clear outline of how to respond to the crash he faced.
What made 2008 possible was that Wall Street had moved its speculative frenzy away from the regulated exchange system created by FDR, and into darker, less-regulated markets that had coalesced around brand-new financial innovations like credit default swaps and collateralized-debt obligations. It wasn't that the old system had broken down; Wall Street had just moved the playground. 
All Obama needed to do to rescue the economy and protect consumers was to make sure that the new playground had some rules.
Rules that at a minimum should have resulted in 'if you bought any security, you knew what you were buying.'
That meant moving swaps and other derivatives onto open exchanges, making sure that federally insured banks that dabbled in those dangerous markets retained more capital, and coming up with some kind of plan to prevent the next AIG or Lehman Brothers disaster – i.e., a plan for unwinding failing companies that wouldn't require federal bailouts.
Despite having identified the importance of knowing what you are buying, Matt misses disclosure.

The strength of Wall Street's Opacity Protection Team is in its ability to refocus the discussion away from disclosure (it certainly overwhelmed the call for disclosure from Nobel prize winning economist Joseph Stiglitz and myself).

Please notice how virtually every reform in Dodd-Frank could have been better achieved by requiring ultra transparency so market participants would know what they were buying.

For example, raising capital requirements for banks.  Requiring ultra transparency would do more to change banks risk exposures than raising capital requirements.  Please note how all the capital on fortress balance sheet JP Morgan didn't stop it from taking significant risk in its synthetic credit trade.  Had there been ultra transparency, this trade is likely to never have occurred.
The initial proposal for Dodd-Frank addressed most of those concerns....
And completely avoided bringing sufficient disclosure to all the opaque corners of the financial system that market participants would know what they were buying.
Then, behind the closed doors of Congress, Wall Street lobbyists and their allies got to work.
Actually, Wall Street lobbyists and their allies had gotten to work in writing the initial Dodd-Frank proposal.

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