Thursday, September 12, 2013

Senator Warren: "How much longer should Congress wait for regulators to fix this problem"

In her speech on state of financial reform on the fifth anniversary of Lehman Brothers' collapse, Senator Elizabeth Warren asked: "how much longer should Congress wait for regulators to fix this problem?"

While she was referring to Too Big to Fail banks, this question applies equally well when "the financial system" replaces the more limited "this problem". [How much longer should Congress wait for regulators to fix the financial system?]

Senator Warren suggested and then rejected some potential time periods for waiting: 3 months, 3 years or until another big bank comes crashing down.

Instead, Senator Warren suggested that Congress should act.

Below, your humble blogger has laid out Senator Warren's case for why Congress should act.  I have inserted the words "the financial system" where appropriate as her case can be applied more generally.
In April 2011, after a two-year bipartisan enquiry, the Senate Permanent Subcommittee on
Investigations released a 635-page report that identified the primary factors that led to the crisis. 
The list included high-risk mortgage lending, inaccurate credit ratings, exotic financial products, and, to top it all off, the repeated failure of regulators to stop the madness.  
As Senator Tom Coburn, the Subcommittee’s ranking member, said: “Blame for this mess lies everywhere from federal regulators who cast a blind eye, Wall Street bankers who let greed run wild, and members of Congress who failed to provide oversight.”...
Not on Senator Warren's list is transparency, however, transparency is at the very heart of her argument for why Congress should act.

The crash happened quickly and dramatically, and it caught our nation and apparently even our regulators by surprise. 
But don’t let that fool you. The causes of the crisis were years in the making, and the warning signs were everywhere.... 
I’ve also studied the financial services industry and how it has developed over time. 
A generation ago, the price of financial services—credit cards, checking accounts, mortgages, and signature loans—was pretty easy to see. Both borrowers and lenders understood the basic terms of the deal. 
But by the time the financial crisis hit, a different form of pricing had emerged. Lenders began to use a low advertised price on the front end to entice customers, and then made their real money with fees and charges and penalties and re-pricing in the fine print. Buyers became less and less able to evaluate the risks of a financial product, comparison shopping became almost impossible, and the market became less efficient....
This movement from transparent products to opaque products was not limited to the consumers, but also occurred with investors (think structured finance).  As Yves Smith observed, no one on Wall Street was compensated for creating low margin, transparent products.

As a result, investors became less and less able to evaluate the risks of an investment and instead relied on the risk assessments conveyed by rating firms and regulators.  This lead to the market becoming more and more fragile, until....

There are many who say, “Sure, Too Big to Fail [fixing the financial system] isn’t over yet, but Congress should wait to act further because the agencies still have to issue a bunch of Dodd-Frank’s required rules.” 
True, there are rules left to be written, but that’s because the agencies have missed more than 60 percent of Dodd-Frank’s rulemaking deadlines. 
I don’t understand the logic. Since when does Congress set deadlines, watch regulators miss most of them, and then take that failure as a reason not to act? 
I thought that if the regulators failed, it was time for Congress to step in. That’s what oversight means. And that’s certainly a principle that would have served our country well prior to the crisis....
Ironically, Dodd-Frank puts such a huge burden on the regulators to write new rules that it appears to have limited their ability to rewrite existing rules based on what has been learned as a result of the financial crisis.

For example, the financial crisis showed that Regulation AB covering disclosure requirements for structured finance securities was fundamentally flawed.  It allowed Wall Street to create opaque securities that hid their toxicity (think opaque, toxic sub-prime mortgage-backed securities).

Five years later, Reg AB still hasn't been rewritten when all it would have taken is a simple one page addition.  This one page would have required all structured finance securities to a) disclose all the data fields tracked by originators and servicers (while protecting borrower privacy) and b) report on all observable events, like payments or delinquencies, involving the underlying collateral before the beginning of the next business day.

For example, the financial crisis show that banks are 'black boxes'.  Clearly, being a black box allows Wall Street to make proprietary bets where they keep the winners and taxpayers get the losers.

Five years later, the SEC still hasn't rewritten the disclosure rules for banks.  Again, all it would have taken is a simple one page addition that said banks must disclose at the end of each business day, their current global asset, liability and off-balance sheet exposure details.
But if the regulators won’t end Too Big to Fail [fix the financial system], then Congress must act to protect our economy and prevent future crises. 
We should not accept a financial system that allows the biggest banks to emerge from a crisis in record-setting shape while ordinary Americans continue to struggle. And we should not accept a regulatory system that is so besieged by lobbyists for the big banks that it takes years to deliver rules and then the rules that are delivered are often watered-down and ineffective. 
What we need is a system that puts an end to the boom and bust cycle. A system that recognizes we don’t grow this country from the financial sector; we grow this country from the middle class. 
This is the system that was designed and implemented as a result of the Great Depression.  This financial system is based on what your humble blogger refers to as the FDR Framework.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  

It is adherence to this framework which allows for market discipline to restrain risk taking by banks and puts an end to the boom or bust cycle.

This framework does this because each market participants knows they are responsible for all losses on their exposures.  As a result, they have an incentive to independently assess risk and limit their exposures to what they can afford to lose.

It is the act of limiting their exposures through which investors exert market discipline.

This framework also changes the behavior of bankers.  It ends practices like manipulating Libor.  It does this because sunlight is the best disinfectant.
Powerful interests will fight to hang on to every benefit and subsidy they now enjoy. 
Even after exploiting consumers, larding their books with excessive risk, and making bad bets that brought down the economy and forced taxpayer bailouts, the big Wall Street banks are not chastened. 
They have fought to delay and hamstring the implementation of financial reform, and they will continue to fight every inch of the way. 
That’s the battlefield. That’s what we’re up against.
Transparency is a make or break issue for the banks.  They know that if they are required to provide exposure detail transparency their days of taking excessive risk are over.

Banks have been lobbying very aggressively to protect their opacity.

For example, bank lobbyists helped to write the Office of Financial Research in Dodd-Frank Act in such a way that they could hope that OFR was the place where transparency would go to die.  OFR allows the banks to claim not only can the regulators see their exposure details, but so to can a regulatory entity that is suppose to worry about risk.

What they won't say is that this regulatory entity cannot share this data with other market participants who might be far more skilled at assessing the data (do you think OFR or JP Morgan would do a better job of assessing the risk of Citi?).
But David beat Goliath with the establishment of CFPB and, just a couple months ago, with the confirmation of Rich Cordray.... 
And I am confident David can beat Goliath on Too Big to Fail [fixing the financial system]. 
We just have to pick up the slingshot again.

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