Wall Street wins its bet on loss of political will for serious financial reform

The Wall Street Journal reports that U.S. financial regulators are considering relaxing, if not eliminating, the need for skin in the game by firms that originate and distribute mortgage-backed securities.

This is a clear sign that Wall Street has won its bet that 6 years after the beginning of the financial crisis there would be a loss of political will for serious financial reform.

Wall Street won its bet because it understood how to manage the legislation and subsequent writing of regulations so as to minimize the chances for any substantive financial reform.

From your humble blogger's perspective, Wall Street's winning was completely predictable.  I predicted it and cited the Dodd-Frank Act as being an impediment to reform.

The Dodd-Frank Act, with the exception of the Consumer Financial Protection Bureau and the Volcker Rule, was quite literally written by the bank lobbyists for the benefit of the banks.  It was designed to use the regulatory rule making process as a blunt instrument to kill the political will for serious financial reform.

No surprise, it succeeded.

But its very success in killing the political will for serious financial reform is also its achilles heel.  It didn't end the "lynch mob" desire to get the bankers.  The bankers made sure this desire was frequently flamed as each instance of their bad behavior behind the veil of opacity has come out.

We have seen the bankers manipulate global benchmark interest rates (Libor, Euribor,...) for personal benefit.  We have seen bankers sell interest rate swaps to unsophisticated borrowers.  We have seen bankers engage in swaps to hide the indebtedness of entire countries so they could gain admission to the EU.  We have seen bankers in the UK sell loan payment insurance products that quite literally could not be collected on.

The list goes on and on and on and with the latest being the revelations about how bankers are currently manipulating the commodity markets for aluminum, electricity, oil and ....

So if there is no political will for serious financial reform and the lynch mob desire is growing with each new report of bankers engaging in conduct that was detrimental to society for their own benefit, how is this going to play out.

What I think you are likely to see is the pressure will be put on the regulators to actually do their jobs.

You can see this with the discussion of banks being required to maintain a higher level of capital against their exposures.

You will see this as pressure is applied to the SEC to do its job and restore transparency to all the opaque corners of the financial system.

In the case of structured finance securities, the pressure will result in observable event based reporting where any activity like a payment or delinquency involving the underlying collateral is reported to all market participants before the beginning of the next business day.

In the case of banks, the pressure will result in ultra transparency where banks are required to disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

Happy Birthday Dodd-Frank: a law that was designed not to and isn't working

In his Huffington Post column, former Senator Ted Kaufman looks at how the Dodd-Frank Act was designed not to address the causes of our current financial crisis and fails to make a future financial crisis less likely.

Failure was built into Dodd-Frank from the beginning. Instead of writing laws that addressed the abuses that led to the crisis, it nearly always kicked the can down to agencies, instructing them to write new regulations.

Regular readers know that by definition Dodd-Frank could not address the causes of the financial crisis because it was completed prior to the conclusion of any inquiry into the actual causes.

Instead, Dodd-Frank, with the notable exception of the Consumer Financial Protection Bureau and the Volcker Rule, was written by the bank lobbyists for the benefit of the banks.

The US is not alone in pursuing bank friendly reform legislation.

In the UK, Parliament is just taking up financial reform legislation almost 6 years after the financial crisis began.  There have been two commissions that looked into the crisis: the Vickers Commission and the Commission on Banking Standards.  By and large, the proposed financial reform legislation either ignores or adopts a weakened version of the recommendations made by the commissions.

By and large, those regulatory agencies have been overwhelmed by a combination of congressional underfunding and a massive lobbying effort by the megabanks that increasingly seem to control Washington....

When Dodd-Frank was being drafted, the bank lobbyists knew that the regulatory rule making process favored their positions.

Regulatory rule making favors the banks for 3 reasons: money, known by regulators, and act together.

Supporters of financial reform tend not to have the same financial resources, tend not to be known by the regulators and tend to focus only on the financial reforms of interest.

So making the regulators work on a large number of rule makings was intentional.

Here are just a few examples of Dodd-Frank's failure: 

• The banks still are gambling with FDIC-insured money. The JPMorgan Chase "London Whale" fiasco was just the latest proof that there has been no change in the casino speculation of Wall Street banks. 

• There is still a giant loophole in derivatives trading. Although there are new regulations curbing the kind of derivatives trading that was a key element in the crisis, those regulations do not cover the foreign subsidiaries of megabanks. Banks can easily move trading activities into different offices. He wasn't called the "London Whale" because he worked in Philadelphia. 

• No one has gone to jail. And no one will. There are many examples of criminal behavior during the meltdown, but not one megabank executive has been jailed. Without that deterrent, white-collar crime is not just profitable but inevitable. 

• Reform of the credit-rating agencies is a long way off. "Essential cogs in the wheel of financial destruction," as the Financial Crisis Inquiry Commission described them, the credit-rating agencies still operate as they always have, bought and paid for by the entities they rate. 

• Fannie Mae and Freddy Mac have not been fixed. In fact, they weren't even mentioned in Dodd-Frank, despite the fact that everyone agrees they played a role in the meltdown.

Regular readers know that brining transparency back to the financial system would fix four of these failures.

It would end banks making proprietary bets.  JP Morgan showed with its closing out the London Whale trade when it became known to the market that transparency ends proprietary betting.

It would end concern over where derivatives are traded.  With transparency, banks must disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  So derivatives traded in London would still be disclosed and investors could adjust the cost of the bank's funding to reflect these derivatives.

It would reform the credit rating firms by making them just another voice offering their views on an investment.  When market participants have access to the same data as the credit rating firms, market participants can independently assess the risk and value an investment or hire a third party to do it for them.  They don't need to have any reliance on the credit rating firms.

It addresses the reform of Fannie and Freddie by restarting the private label mortgage securitization market.  With the private label market unfrozen, Fannie and Freddie's portfolios can be run off.

There were lots of heated debates before passage of Dodd-Frank, but no disagreement from anyone in the administration or Congress about one thing. The bill had to end the possibility that American taxpayers would ever again have to bail out a big bank because its failure would have a severe impact on the entire economy. 

You would think that by now at least that problem would have been addressed. But it hasn't been. 

Eliminating the need for taxpayer bailouts won't occur until banks are required to provide ultra transparency and disclose their exposure details.  It is only with this data that market participants can limit their exposure to each bank to what they can afford to lose given the risk of each bank.

Big banks demonstrate again why regulations won't restrain their activities

The New York Times carried an interesting article on how the big banks managed to undermine any regulation intended to restrain their risk taking.

This provides further confirmation that the combination of complex regulation and regulatory oversight doesn't work to make the financial system safer.  In fact, relying on complex regulation and regulatory oversight makes the financial system riskier and more prone to crashes.  Our current financial crisis being a case in point.

The only proven method for restraining bank risk taking is requiring the banks to disclose on an ongoing basis their current exposure details.  With access to this information, the market then exerts restraint on the banks.

Under pressure from Wall Street lobbyists, federal regulators have agreed to soften a rule intended to rein in the banking industry’s domination of a risky market. 

The changes to the rule, which will be announced on Thursday, could effectively empower a few big banks to continue controlling the derivatives market, a main culprit in the financial crisis. 

The $700 trillion market for derivatives — contracts that derive their value from an underlying asset like a bond or an interest rate — allow companies to either speculate in the markets or protect against risk. 

It is a lucrative business that, until now, has operated in the shadows of Wall Street rather than in the light of public exchanges. Just five banks hold more than 90 percent of all derivatives contracts....

Here is a prime example of why regulation fails.

Did federal regulators think that the problem posed by derivatives was a lack of price transparency?

Hello, the problem posed by derivatives is that the banks can lose a substantial amount of money on them.  Just look at JP Morgan's losses on the London Whale's CDS trade.

The way to restrain banks from exposing themselves to potentially catastrophic losses on a large derivative portfolio is to require that they disclose their current exposure details, including derivatives.

With this disclosure, banks will dramatically shrink their derivative exposures for fear that the market will trade against them.  Jamie Dimon confirmed this when he tried to hide the CDS trade.

In the aftermath of the crisis, regulators initially planned to force asset managers like Vanguard and Pimco to contact at least five banks when seeking a price for a derivatives contract, a requirement intended to bolster competition among the banks. Now, according to officials briefed on the matter, the Commodity Futures Trading Commission has agreed to lower the standard to two banks. 

About 15 months from now, the officials said, the standard will automatically rise to three banks. And under the trading commission’s new rule, wide swaths of derivatives trading must shift from privately negotiated deals to regulated trading platforms that resemble exchanges. 

But critics worry that the banks gained enough flexibility under the plan that it hews too closely to the “precrisis status.” 

“The rule is really on the edge of returning to the old, opaque way of doing business,” said Marcus Stanley, the policy director of Americans for Financial Reform, a group that supports new rules for Wall Street.

So the CFTC's rule making is all about the idea that buyers of derivatives are too lazy to call multiple banks and compare prices.

If buyers cannot be troubled to get competing quotes, they are agreeing to overpay.

Making such decisions on regulatory standards is a product of the Dodd-Frank Act of 2010, which mandated that federal agencies write hundreds of new rules. ...

It is rules like this that further confirm that Dodd-Frank should be repealed (the only worthwhile parts are the Consumer Financial Protection Bureau and the Volcker Rule).

In an interview on Wednesday, Mr. Gensler said that, even with the compromise, the rule will still push private derivatives trading onto regulated trading platforms, much like stock trading. He also argued that the agency plans to adopt two other rules on Thursday that will subject large swaths of trades to regulatory scrutiny. 

“No longer will this be a closed, dark market,” Mr. Gensler said. “I think what we’re planning to do tomorrow fulfills the Congressional mandate and the president’s commitment.”...

Unless market participants know each bank's exposure details, derivatives are a closed, dark market.

If banks are performing the role that they are suppose to, acting as middlemen as oppose to taking proprietary bets, they should have no problem making this disclosure.

While the regulator defended the derivatives rule, consumer advocates say the agency gave up too much ground. To some, the compromise illustrated the financial industry’s continued influence in Washington. 

“The banks have all these ways to reverse the rules behind the scenes,” Mr. Stanley said.... 

Too Big to Fail needs to be sorted out

The Dodd-Frank Act was suppose to eliminate the problem of Too Big to Fail.  It was suppose to achieve this wonderful result through the combination of complex regulations, regulatory oversight and Congress promising not to authorize a bailout should there ever be another systemic financial crisis.

Clearly, market participants, like investors, realize that this combination is not up to the task of eliminating the TBTF problem.

Now, Brown-Vitter is suppose to eliminate the problem of Too Big to Fail.  It is suppose to do this by making banks over $500 billion hold equity capital equal to 15% of their total on balance sheet assets plus off balance sheet exposures.

There are two ways that B-V is suppose to convince market participants, like investors, that the problem of TBTF has been eliminated.

First, the high equity level is suppose to act as an incentive so that the TBTF banks split themselves into smaller banks (21 if all the TBTF divide themselves up) that presumably can fail and be resolved by the FDIC.

Second, if a TBTF doesn't break itself up, the higher equity level presumably can absorb the losses when the FDIC steps in to resolve it.

While your humble blogger believes that B-V is a step in the right direction, it is not clear that it eliminates the problem of TBTF as it does not address the issue of interconnectedness in the financial system.

Is Congress really not going to step in with a bailout if 3 of the smaller banks fail and threaten to trigger a systemic financial collapse?

Regular readers know there is a far simpler and more direct approach to ending the TBTF problem.  Simply require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

History shows that when banks provide this level of transparency, they tend to maintain the B-V 15% equity ratio.

History also shows that when investors have the information they need to independently assess the risk of an investment, they tend to limit their exposures to what they can afford to lose.  Banks are no different and this would end the issue of interconnectedness.

Finally, history shows that when banks have to disclose their exposure details, they stop taking proprietary bets (see Jamie Dimon's efforts to withhold information on London Whale trade for fear market trade against JPM).

Bank of England's Andrew Haldane takes on combination of complex rules and regulatory oversight

Reuters reports that the Bank of England's Andrew Haldane has escalated his fight to dismantle the combination of complex rules and regulatory oversight.  

He advocates simpler rules that are harder to game.  An example of a simple rule would be that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Regular readers know that the combination of complex rules and regulatory oversight has been used unsuccessfully as a substitute for the combination of transparency and market discipline.  Examples of where the combination of complex rules and regulatory oversight failed include banks and structured finance securities.

Bank regulators need to develop much simpler rules to make it harder for large financial firms to game the supervisory system, Bank of England official Andrew Haldane said on Tuesday. 

"We need to do a radical pruning, simplifying of our regulatory apparatus (that) places much less emphasis on what are unreliable measures of risk," Haldane, the BoE's executive director for financial stability, told a conference sponsored by the Federal Reserve Bank of Atlanta....

Examples of unreliable measures of risk include, but are not limited to, bank book capital level and bank risk based capital measures.

Bank book capital levels are an easily manipulated accounting construct.  Since the beginning of the financial crisis, bank book capital levels have been manipulated by the regulators through suspension of mark to market accounting and by the banks through implementation of extend and pretend on nonperforming loans.

Bank risk based capital levels are also easily manipulated as banks simply game their internal models.

"Complex frameworks if anything are easier to arbitrage, easier to game," he said....

Too Big to Fail banks lobby for complex frameworks precisely because these frameworks are easier to arbitrage and game.

The Dodd-Frank Act, the U.S. financial reform law that Congress passed in response to the financial crisis, is some 2,300 pages long, and has been criticized for its complexity and opaqueness.

As your humble blogger noted about Dodd-Frank, it was written by the banks' lobbyists for the benefit of the banks.  Not surprisingly, it is long on complexity and short on substance that will actually make the financial system safer.

In fact, it is long on complexity so as to keep opacity in the financial system.  Opacity that allows the banks to place proprietary bets and gamble with the taxpayers' money.  Opacity that allows the bankers to engage in bad behavior (see manipulating Libor).

Bernanke gets his wish, comeback of financial system's most toxic securities

The Retirement Plan Death Spiral has been overtaken as the most toxic side effect of Fed Chairman Ben Bernanke's zero interest rate policies by the comeback of the financial system's most toxic securities: synthetic collateralized debt obligations.

Regular readers will recall that these synthetic CDOs were at the heart of the financial crisis.  These were the securities that let Wall Street ,which knew that subprime mortgages were going bust faster than was assumed in the investors' pricing models, successfully "bet" on this knowledge.

The fact that these opaque, toxic securities which the regulators and market cannot value have re-emerged is the direct result of 5 years of zero interest rate policies.

Surely, investors and the financial system will have a better experience gambling on these securities this time around.

As reported by Bloomberg,

Derivatives that pool credit- default swaps to make magnified bets on corporate debt, popularized in the last credit bubble, are making a comeback as investors search farther afield for alternatives to bonds at record-low yields....

Synthetic credit, which amplified the financial crisis five years ago, is enticing investors after corporate-bond yields dropped to less than half the 20-year average. 

By betting on the degree to which a group of companies will default, a CDO may pay relative yields of more than 5 percentage points, four times that of a typical credit-swaps transaction on similar debt.

Please note the use of the word "betting".  An opaque security cannot be valued.  Therefore, buying it is simply an exercise in betting.

“That’s a valid strategy for this part of the credit cycle: Don’t stretch on credit quality, but rather leverage your exposure to better-quality credit,” Ashish Shah, the head of global credit investment at New York-based AllianceBernstein LP, which oversees $256 billion in fixed-income assets, said ....

Betting is not a valid investment strategy.  Betting is gambling.

The distinction between gambling and betting is subtle.

Gambling involves buying opaque, toxic securities and guessing what the value of their contents is.  Investing involves have transparency into all the useful, relevant information in an appropriate, timely manner so as to independently assess this information and make a fully informed decision.

“Investors are in a desperate search for yield,” said David Knutson, a credit analyst at Legal & General Investment Management America. “CDO products offer incremental yield to plain-vanilla transactions.”...

Bernanke's zero interest rate policies deliberately make investors desperate when it comes to yield.  They are designed to be coercive and force investors to take more risk.

However, there is a real difference between taking more risk while investing and simply taking risk by gambling.

Sales of bespoke synthetic CDOs are climbing after the market all but shut down during the financial crisis in 2008.

Bernanke's legacy is the revival of the synthetic CDO market that produced the following spectacular results:

After the amount of credit protection sold through CDOs in that period climbed to about $1 trillion, investors took losses of up to 90 percent on deals that bet heavily on financial firms that failed during the crisis, including Lehman Brothers Holdings Inc. and Icelandic banks. 

In the mortgage market, CDOs that packaged home-loan securities and were given top AAA ratings by S&P wiped out investors in a matter of months, according to a lawsuit by the Justice Department filed Feb. 4 in Los Angeles. 

Synthetic CDOs “enabled securitization to continue and expand even as the mortgage market dried up and provided speculators with a means of betting on the housing market,” the Financial Crisis Inquiry Committee wrote in a 2012 report. “By layering on correlated risk, they spread and amplified exposure to losses when the housing market collapsed.”

And thanks to Fed Chairman Bernanke's policies, this particularly toxic security has, like Dracula, come back to life to suck the lifeblood out of the real economy.

As the Federal Reserve holds its benchmark interest rate near zero for a fifth year, investors including pension funds and hedge funds are again seeking out more structured debt or derivatives that offer greater yields than the bonds or loans underlying them....

Your humble blogger doesn't mind if hedge funds gamble on these opaque, toxic securities.  This is what investors in hedge funds expect.

However, pension funds and insurance companies should never be allowed to invest in opaque, toxic securities.  Regulators for pension funds and insurance companies have had 5 years to adopt regulations that would prevent this from occurring.

Trading in synthetic CDOs will continue to rebound even after global bank capital rules and the U.S. Dodd-Frank Act make derivatives more expensive to trade and hold, Peter Tchir, founder of New York-based TF Market Advisors, said in a March 15 e-mail to clients. 

“There’s going to be this bigger search for yield and spread, and tranches are a natural way to do it,” he said.

As previously pointed out by your humble blogger, global capital rules do not stop gambling on opaque securities.  

As previously pointed out by your humble blogger, Dodd-Frank also did nothing to restore transparency to all the opaque corners of the financial system.  

As a result, investors have been coerced by the Fed to return to opaque areas where Wall Street can handsomely profit off of the investors inability to price the securities. 

Dodd-Frank swap data fails to catch JP Morgan's "Whale" trade

Bloomberg reports that the Dodd-Frank derivative rules are inadequate for helping regulators catch the existing JP Morgan "Whale" trade or any other similar position.

Regular readers are not surprised by this because Dodd-Frank was effectively written by and for Wall Street.  The derivative rules are an example of this as rather than use a simple direct solution they rely on the combination of complex rules and regulatory oversight.

The simple, direct solution is to have each financial institution disclose to all market participants on an ongoing basis its current global derivative exposure details.

This makes it easy for the regulators to find risky positions (at a minimum, the regulators tap the analytical expertise of the market for help in finding and assessing these positions).

Instead, Dodd-Frank proposed complex regulations where the authors knew they were creating a data nightmare.  Remember, Wall Street wants to protect opacity and they knew what they allowed to be written into Dodd-Frank and the subsequent regulations would protect opacity by creating this data nightmare.

Dodd-Frank Act derivatives rules are failing to give regulators a full picture of the swaps market and wouldn’t help them detect a loss similar to JPMorgan Chase & Co. (JPM)’s London Whale trades, according to Commodity Futures Trading Commission member Scott O’Malia. 

Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said... 

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.”... 

Dodd-Frank was enacted in part to give regulators better oversight of the $639 trillion global swaps market after largely unregulated trades help fuel the 2008 credit crisis. The CFTC and Securities and Exchange Commission were granted authority to write rules requiring trade information to be reported to so- called swap data repositories that function as central recordkeepers.

Hundreds of pages of rules governing the databases were among the first regulations completed by the five-member commission and began to take effect at the end of 2012....

Different swap dealers and trading counter-parties are using their own reporting formats because the government failed to specify standards, O’Malia said. 

“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?” 

The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said.

Dallas Fed's Fisher and Rosenblum examine how to shrink Too Big to Fail and find transparency

In their Wall Street Journal column, the Dallas Fed's Richard Fisher and Harvey Rosenblum examine why the Dodd-Frank Act does not end Too Big to Fail and they offer a proposal they think will succeed in ending TBTF.

Regular readers know that your humble blogger prefers to end the TBTF banks by requiring them to provide ultra transparency rather than rely on a solution that assumes policymakers and regulators will not bail these banks out in the future.

Ultra transparency ends TBTF because it makes the unsecured bank bond and equity investors responsible for the losses on their investment.  Investors become responsible for the losses because they have access to the information they need to independently assess the risk of an investment in the banks.

Currently, investors are protected from losses on their investment in the banks for two reasons.

First, they do not have access to the information they need to make a fully informed investment decision.  Banks are 'black boxes'.

Second, in the absence of the needed information, investors are relying on the government' investment recommendation.  This recommendation creates a moral obligation to bailout the banks and protect the investors from solvency related losses.  This investment recommendation is renewed every year through the stress tests and the subsequent statements about bank solvency.

[T]he mere 0.2% of banks deemed "too big to fail" are treated differently from the other 99.8%, and differently from other businesses. Implicit government policy has made these institutions exempt from the normal processes of bankruptcy and creative destruction. 

Without fear of failure, these banks and their counterparties can take excessive risks. 

It also emboldens a sense of immunity from the law. As Attorney General Eric Holder admitted to the Senate on March 6, when banks are considered too big to fail it is "difficult to prosecute them . . . if we do bring a criminal charge, it will have a negative impact on the national economy."... 

This is patently unfair. It makes for an uneven playing field, tilted to the advantage of Wall Street against Main Street, and it places the financial system and the economy in constant jeopardy. It also undermines citizens' faith in the rule of law and representative democracy.

This uneven playing field is the result of the policy of financial failure containment and its corollary, the Geithner Doctrine.

Under this policy, the Japanese Model for handling a bank solvency led financial crisis was adopted and bank book capital levels and banker bonuses were protected at all costs.

These costs include undermining citizens' faith in the rule of law and representative democracy (please note that this is not restricted to the US, but also applies in the EU).

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act was a well-intentioned response to the problem. Its stated promise—to end "too big to fail"—rings hollow. 

With a law that runs 849 pages and more than 9,000 pages of regulations written so far to implement it, Dodd-Frank is long on process and complexity but short on results. 

Regulators cannot enforce rules that aren't easily understood.

Please re-read the highlighted text as Mr. Fisher and Mr. Rosenblum have nicely summarized why the combination of complex rules and regulatory oversight fails and why the financial system should not be dependent on this combination working for ongoing financial stability.

Further, market discipline is still lacking for the largest dozen or so institutions, as it was during the last financial crisis. 

Why should a prospective purchaser of bank debt practice due diligence if in the end, regardless of new layers of regulation and oversight, the issuing institution won't be allowed to fail? 

The return of marketplace discipline and effective due diligence of banking behemoths is long overdue....

Please re-read the highlighted text as Mr. Fisher and Mr. Rosenblum make the case for requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Without this data, a prospective purchaser of bank debt cannot perform due diligence.

Without due diligence, there is no market discipline on the banks.

The only way to bring about the long overdue return of marketplace discipline and effective due diligence of banking behemoths is to require ultra transparency.

Your humble blogger liked how Mr. Fisher and Mr. Rosenblum described the benefits of addressing TBTF.  As a result, I have taken the liberty to replace their expression "this plan" with ultra transparency.

Had ultra transparency been in place a decade ago, it would have altered the insidious behaviors that contributed to the crisis, avoiding the bailouts and their aftermath, the cost of which our nation's citizens will bear for years to come. 

The Government Accountability Office and others estimate the cost of the financial crisis, measured in lost output and jobs, to be between $10 trillion and $20 trillion, roughly one year of U.S. output down the drain.

It is simply stunning to look at ultra transparency from a cost/benefit analysis perspective.

The cost of the banks providing ultra transparency is less than $10 billion globally per year.  The benefit is saving $10 - $20 trillion.  This is at least a 100 fold return on investment.

Most of all, adoption of ultra transparency would have avoided a crisis that undermined Americans' belief in the fairness and justice of the economic system. 

The United States was founded on the principle of economic freedom, underpinned by secure property rights and by a strong aversion to special favors and subsidies to the few. 

Those fundamental virtues were undermined by the recent financial crisis and government's response to it. 

Rescuing too-big-to-fail banks from their bad investment decisions imposed an enormous economic burden on the American people. It also perpetuated a sense that powerful banking mandarins operate above the law and prosper at the expense of the thrifty and hardworking citizenry. 

Congress should rewrite Dodd-Frank so that it actually ends the problem of banks that are too big to fail. Our proposal [ultra transparency] won't lead to bigger government. It will lead to smaller banks governed by the market discipline of creditors who are at real risk of losses, and by laws that apply equally to all.

With passing grades on their stress tests assured, big banks look to make mockery of capital regulations with big payout

Bloomberg reports that the Too Big to Fail US banks are preparing to unleash a tsunami of dividends and stock buybacks with the announcement by the Fed that they have once again passed a meaningless stress test.

The Dodd-Frank Act mandates annual stress tests to reassure the market that the moral obligation to bailout the banks is still in place.

Each year, the Fed recognizes that the safety and soundness of the financial system requires that it say the banks are adequately capitalized.  Naturally, the Fed sticks to this script even if the reality of the losses hidden on and off the bank balance sheet suggests otherwise.

By sticking to the script, the Fed obligates the US Treasury to bailout the banks should they encounter any solvency problems.  This obligation occurs because it is hard to stick investors with solvency related losses after the Fed has effectively recommended the banks as an investment.

Regular readers know that FDR specifically pointed out that the role of government is to never make an investment recommendation as doing so creates a moral obligation to bailout the investor.  Rather, it is the role of government to ensure that all the useful, relevant information is made available in an appropriate, timely manner.  Investors have an incentive to use this information as they are responsible for all losses on their investments.

Naturally, under the Geithner Doctrine (nothing should be done that would hurt the profits or reputation of a big or politically connected bank), the US government adopted incurring the moral obligation.  With this obligation, the government improves the profitability and reputation of the banks.

This year, the banks are turning their guns on making a mockery of bank capital regulations.  Having gamed the system to show high levels of capital, the banks are set to engage in massive payouts to shareholders.

The six largest U.S. banks may return almost $41 billion to investors in the next 12 months, the most since 2007, as regulators conclude firms have amassed enough capital to withstand another economic shock.....

The highlighted text nicely summarizes one of the most important failures in the response to the financial crisis.

Regulators are offering their opinion on whether the banks have enough capital or not to withstand another economic shock.

Please recall that these are the same regulators who missed the financial crisis.

Were it not for the moral obligation, actually it is more than that since then Treasury Secretary Tim Geithner pledged the full faith and credit of the US to supply the banks with all the capital they need, there would be no reason to bet on what is inside the black box banks.

However, with the downside eliminated by the US government, no reason not to gamble....

“You’ve gone from a few years ago, when the industry as a whole didn’t have enough capital, to the point where in the not- too-distant future, it’s going to have too much,” Jason Goldberg, a New York-based banking analyst at Barclays Plc, said in a telephone interview. The Fed’s endorsement is “a Good Housekeeping seal of approval.”

A seal of approval that FDR would say should never under any circumstances be provided by the government as it creates the obligation for the government to absorb the investors' losses.

Senator Warren grills Ben Bernanke over policy of financial failure containment

Senator Elizabeth Warren used Fed Chairman Ben Bernanke's semi-annual visit to the Senate Banking Committee as an opportunity to expose the fundamental flaws in the policy of financial failure containment and its corollary, the Geithner Doctrine.

• the policy directly leads to the creation of Too Big to Fail.  

• the policy directly leads to the Too Big to Fail banks receiving a sizable subsidy because market participants think the financial institutions will be bailed out.  No market participant believes that orderly liquidation authority under the Dodd-Frank Act will ever be imposed.

As reported by the Huffington Post,

Warren pressed the Fed chairman about whether the government would bail out the largest banks again, as it did during the financial crisis. 

"We've now understood this problem for nearly five years," she said. "So when are we gonna get rid of 'too big to fail?'" 

Regular readers know that we won't be rid of Too Big to Fail until banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is needed to make investors in the banks responsible for any losses on their investments.  When an investor can independently assess the risk of an investment, they can adjust both the amount and price of their exposures to reflect this risk.

So long as banks continue to be 'black boxes', there is a moral obligation to bailout the investors as they are investing based on a reliance on what the bank regulators have to say about the risk and solvency of each bank.

Warren also asked whether big banks should repay taxpayers for the billions of dollars they save in borrowing costs because of the credit market's belief that they won't be allowed to fail, repeatedly citing a recent Bloomberg study estimating that the biggest banks essentially get a government subsidy of $83 billion a year, nearly matching their annual profits....

One way for the big banks to repay taxpayers for the subsidy would be for the banks to hold their excess reserves at the Federal Reserve in an account that doesn't pay them interest.  These reserves would be used to fund the portfolio of securities the Fed purchased as a result of pursuing quantitative easing.  The earnings on these securities would flow through to the US Treasury.

he said the market was wrong to give banks any subsidy at all (in the form of lower borrowing costs), insisting that the government will in fact let banks fail. 

The 2010 Dodd-Frank financial reform law has given policymakers the tools to safely shut down big, failing banks, he claimed. 

But when repeatedly pressed by Warren, Bernanke's confidence seemed to waver. 

"The subsidy is coming because of market expectations that the government would bail out these firms if they failed," Bernanke said. "Those expectations are incorrect. We have an orderly liquidation authority. Even in the crisis, we -- uh, uh -- in the cases of AIG, for example, we wiped out the shareholders..." 

"Excuse me, though, Mr. Chairman," Warren said. "You did not wipe out the shareholders of the largest financial institutions, did you, the big banks? 

"Because we didn't have the tools," Bernanke replied. "Now we could -- now we have the tools." 

Of course, the policy of financial failure containment relies on these tools and that they work.  A really, really big "if" surrounds these tools as they apply to the Too Big to Fail.

Regular readers know that your humble blogger prefers the policy of financial failure prevention upon which our financial system is based.  It is far better to prevent a bank's failure by subjecting it to market discipline made possible by ultra transparency than to deal with a failed bank.

Later, when pressed again by Warren, Bernanke suggested that the government's tools to wind down a big bank that is failing were still a work in progress -- or at least that financial markets have not yet been convinced of their power. 

"Some of these rules take time to develop -- um, uh, the orderly liquidation authority, I think we've made progress on that," he said. "We've got the living wills -- I think we're moving in the right direction ... We do have a plan, and I think it's moving in the right direction." 

"Any idea about when we're gonna arrive in the right direction?" Warren said. 

"It's not a zero-one kind of thing," Bernanke stammered in response. "Over time we will see increasing, uh, increasing market expectations that these institutions can fail."

Until the banks are required to provide ultra transparency, we will never see increasing market expectations that these institutions can fail.

Market participants know that in the absence of ultra transparency regulators will not use the ordinary liquidation authority because it is an admission that they failed to properly oversee the banks.

Regulators will always play for time and hope that the bank can generate enough earnings to cover the hole in its balance sheet (this policy has been in effect since the 1980s and covered the savings & loans, Security Pacific and now the Too Big to Fail).

He later added, "As somebody who's spent a lot of late nights dealing with these problems, I would very much like to have confidence we can close down a large institution without causing damage to the economy."

The only way you can close down a large institution without causing damage to the economy is if there is ultra transparency.

With ultra transparency, market participants adjust their exposure to what they can afford to lose as the financial institution gets closer to needing to be liquidated.

Without this ability to adjust their exposures, there is no way to close a large institution without causing damage to the economy (this is the basis for financial contagion).

Bernanke suggested that banks would eventually lose some of the benefits of size and would shrink themselves voluntarily -- news that might surprise JPMorgan Chase CEO Jamie Dimon, who was again extolling the benefits of his bank's size even as Bernanke spoke.

If banks were required to provide ultra transparency, they would most certainly shrink themselves.  It wouldn't be voluntary, but rather as a result of market discipline as market participants raise the cost of funds to these banks to reflect their actual risk levels.

Elizabeth Warren: CFPB, Dodd-Frank and a trade with the Republicans

Bloomberg ran an article on how the Republicans are united in their efforts to restrict the independence of the Consumer Financial Protection Bureau and Senator Warren has the opportunity to forge a compromise.

Your humble blogger would like to suggest that Senator Warren take the Republicans up on their offer and propose the following compromise:

In exchange for ensuring accountability and transparency at the CFPB, the rest of the Dodd-Frank Act is repealed and replaced with a law requiring transparency, specifically valuation transparency, be brought to all the opaque corners of the financial system.  Under this law,

• Banks would be required to provide ultra transparency under which they disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
• Structured finance securities would be required to provide observable event based reporting on all activities like a payment or delinquency involving the underlying collateral before the beginning of the next business day.

How can the Republicans possibly decline the opportunity to let the market function properly?  After all, it is well known that the necessary condition for the invisible hand of the market to actually work is valuation transparency.  Specifically, that market participants have access to all the useful, relevant information so they can independently assess this information and make a fully informed decision.

How can the Republicans possibly decline the opportunity to get rid of the explosion in complex rules and regulatory oversight like the Volcker Rule that make up Dodd-Frank?  In an era of endless budget deficits, here is an opportunity to save substantial sums of money.

How can the Republicans possibly decline the opportunity to get rid of the Office of Financial Research (aka, the government agency where transparency goes to die)?  The whole point of bringing transparency to all the opaque corners of the financial system is not to have agencies like OFR having a monopoly on information that market participants need if they are to have all the useful, relevant information.

How can the Republicans possibly decline the opportunity to end the market's reliance on supervision by bank regulators and the related taxpayer funded bank bailouts when supervision fails? With ultra transparency, the market can exert discipline on each bank to reduce its risk of failure.  If it does fail, market participants can absorb the loss because they could assess what was happening at the bank and have limited their exposure to what they can afford to lose.

Failure of financial regulatory system repeated in Dodd-Frank implementation

One of the critical lessons from the current financial crisis is that a financial system dependent upon the combination of complex rules and regulatory oversight is prone to catastrophic failure.

Despite this lesson, the Obama Administration, led by Tim Geithner, decided that we should double down and bet the financial system again on this combination.  The result of their bet was the Dodd-Frank Act.

Reuters reports that the very features that make financial systems dependent on this combination prone to catastrophic failure have bogged down implementation of the Dodd-Frank Act.

The U.S. financial regulatory system remains fragmented two and a half years after Congress passed the Dodd-Frank law, and time-consuming coordination among regulators has stalled its biggest reforms, a government watchdog said in a report on Wednesday.... 

The Dodd-Frank law gave regulators new oversight of the $650 trillion over-the-counter swaps market, called for tough new rules to prevent banks from speculating with their own money, and sought to end "too big to fail" by creating a path for regulators to wind down giant, failing banks. 

The complexity and interconnected nature of some required rules has caused regulators to get behind, as has the coordination required for multiple agencies to agree on joint rules. 

Also, Dodd-Frank did little to streamline the overlapping organizational chart of financial regulation, which includes numerous federal and state supervisors, the GAO observed. 

"The implementation of many of these reforms remains ongoing and the effectiveness of some remains an open question," the GAO said....

Bottom-line:  we have agencies with overlapping authority trying to protect their turf while writing rules that are so complex that the rules will be impossible to enforce.

Hmmm...wasn't it the failure of the overlapping agencies to enforce the existing rules that resulted in our current financial crisis?

In particular, all the agencies had the responsibility for ensuring that there was transparency throughout the financial system and that there were no opaque corners.  Clearly, given that the financial crisis struck each of the opaque areas of the financial system (think banks and structured finance securities), the agencies didn't enforce transparency.

Financial regulators have pushed out dozens of new rules called for by Dodd-Frank, but they are behind on some of the biggest changes. 

A controversial ban on proprietary trading known as the "Volcker rule" was supposed to take effect in July 2012. 

The five agencies responsible for the rule -- the Securities and Exchange Commission, Federal Reserve, Commodity Futures Trading Commission, Federal Deposit Insurance Corp and Office of the Comptroller of the Currency -- have not finished writing it....

Regular readers know that your humble blogger "wrote" what should be the Volcker Rule in less than five minutes.

Paragraph one is a restatement of the Volcker Rule:  banks shall not take proprietary bets.

Paragraph two is enforcement of the rule:  banks shall provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, market participants, including regulators, can assess each of the bank's exposures to see if it is in compliance with the rule stated in paragraph one and exert discipline on the bank if the exposures are not in compliance.

Please note, the complicated Volcker Rule that the five regulatory agencies are producing was almost 300 pages long when last seen.

There is absolutely no chance that this 300 pages long rule can or will be enforced.

Some rules have been held up while regulators waited for other agencies to craft similar rules. And the GAO said other regulations require coordination among agencies and with international regulators, which can be time-consuming. 

"Although regulators have established mechanisms to facilitate coordination and believe coordination efforts have improved the quality of the rulemakings, several regulators indicated that coordination increased the amount of time needed to finalize rulemakings," the report said. 

Translation, we are creating millions of pages of rules and regulations that will make the financial system more prone to catastrophic failure.

Elisse Walter, chairman of the Securities and Exchange Commission, said in response to the report that implementing Dodd-Frank has been a "major undertaking" but that the SEC has made considerable progress implementing the law.

Everyone knows that the SEC completely abandoned its responsibility for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they could independently assess this information and make a fully informed investment decision (the SEC staff abandoned pursuing the SEC's responsibility because it interfered with their becoming high paid partners at law firms after leaving the SEC).

Given that the staff was willing to abandon the SEC's reason for existence, everyone should be nervous when the SEC says it has made considerable progress implementing Dodd-Frank.

Price transparency brought to opaque swaps markets

Financial regulators, particularly the CFTC, are calling bringing price transparency to the opaque swaps markets a pivotal moment in the regulation of Wall Street.

Regular readers know that that there are two types of transparency:  valuation and price.  It is valuation transparency that is the important form of transparency.

As everyone knows, the investment cycle has three steps:  value the security; solicit a price for the security from Wall Street; and then make an investment management decision to buy, hold or sell the security.

Without valuation transparency, it is impossible to value the security and go through the investment process.

Without valuation transparency, the act of buying or selling the security is simply blindly betting.

So the question is, is there any reason to get excited about bringing price transparency to the opaque swaps market?

No.  In fact, price transparency makes the problems in this market worse.  Price transparency by itself suggests that the casino is somehow not just for gambling.

As discussed by Ben Protess in a NY Times Dealbook article,

After spending two years and millions of dollars to temper a regulatory crackdown, the world's biggest banks are now resigned to a wave of new oversight.

This assumes that the banks did not get exactly what they wanted.  Price transparency has not been the problem in the swaps market as buyers and sellers could always call multiple banks for quotes.

By New Year's Eve, 65 banks had registered their derivatives business with regulators and turned over heaps of real-time trading data to outside warehouses, fulfilling a central rule of the Obama administration's financial regulatory overhaul. 

Late on Wednesday, a warehouse also posted an early batch of data online, shining a rare spotlight on an opaque business that blew up in the 2008 financial crisis. 

The changes, regulators say, signal a pivotal moment in the fight over Wall Street regulation. 

Until now, regulators had little authority and little information to scrutinize the minutiae of derivatives trading, a vast market that totals more than $600 trillion.

Actually, the regulators have always had access to reams of information.  They simply had to ask for it from the banks as the regulators are entitled to know each bank's exposures.

"They are an historic change for the markets that will benefit the public and the economy at large," Gary Gensler, chairman of the Commodity Futures Trading Commission, the architect behind the derivatives overhaul, said in a statement....

Why?  What data will the public get that is useful for valuing these securities?

The new oversight is a major component of the Dodd-Frank Act, the Wall Street regulatory overhaul passed after the financial crisis. The law took particular aim at derivatives, which proved pernicious in the crisis. 

Banks had bought billions of dollars in derivatives as dubious insurance on mortgage-backed investments. 

When the investments soured, the American International Group lacked the capital to honor agreements with the banks, prompting a $180 billion government bailout of the giant insurance company.

So the important data is what each firm's exposure is.  After all, who cares what price the derivatives that blew up AIG were purchased/sold at.  What was relevant was AIG's exposure to losses if the sub-prime mortgage market blew up.

Does the data being disclosed to the market allow market participants to know what is currently on JP Morgan's or Goldman Sach's balance sheet and who their counter-parties are?

Hoping to prevent such calamities, lawmakers spelled out a plan in Dodd-Frank to require derivatives dealers to register with Mr. Gensler's agency. Under the law, the banks and hedge funds must also open up their trading books to regulators and the broader public.

So all market participants are going to be able to see each bank and hedge fund's trading book?

The oversight, carried out through new rules written at Mr. Gensler's agency, developed in fits and starts. At times, a plan that was supposed to kick in during 2011 seemed like it might never take effect. 

The delay was in part a result of an aggressive lobbying campaign on Wall Street, which dispatched lawyers and lobbyists to temper the overhaul. In turn, Mr. Gensler's agency conceded modest changes and postponed the oversight for several months.... 

Wall Street has been aggressively lobbying since before the Dodd-Frank Act was passed.  With the exception of the Volcker Rule and the Consumer Financial Protection Bureau, the act appears to have been written by the industry for the industry.

The banks must also turn over in real-time the data from their trading book.

 And what data from their trading book must be disclosed?

The disclosures, posted on the Web site of the Depository Trust and Clearing Corporation, a data warehouse, include the volume, time and price of each derivatives trade....

Data that is focused on price transparency and not valuation transparency.  Remember, part of valuation transparency is knowing what the exposure to losses is for the counter-party.

The spreadsheet, regulators say, presents the public with its first window into the swaps market. While the public is blocked from viewing the identity of the trader, regulators have access to that information.

This is a classic example of Wall Street protecting the opacity that it profits from.

The data that is being made available relates to price only.  This is of limited benefit as the last price could represent the price that the biggest fool was willing to buy or sell at.

To a buyer or seller who is willing to pick up the phone and call several firms, they can get all the price quotes they want.  Price disclosure simply saves them the hassle of making several calls.

The only market participants who have access to the identity of the trader, which is data needed for valuation, are the regulators.

Wall Street has nicely protected opacity in the swaps market by making it impossible for the market participants who need the valuation data to have access to the data they need by giving the regulators an information monopoly.  A monopoly that the regulators will be very reluctant to give up.

"Real-time reporting brings transparency to the formerly opaque swaps market," Mr. Gensler noted.

As currently being implemented, it only brings price transparency.  The regulators with their information monopoly are helping to keep the swaps market opaque from the perspective of valuation transparency.

France moving forward to separate investment and commercial banking

The Wall Street Journal reports that French bank reform is focusing on separating investment from retail and commercial banking.

France's banks are lobbying against this saying the separation will hurt economic growth.

I can clearly see how it will hurt banker bonuses, but I fail to see the direct connection between separating the two businesses and hurting economic growth.  The reason I don't see a direct connection is that the two businesses still exist after they have been separated.

Regular readers know that your humble blogger sees reform efforts focused on separating investment from retail and commercial banking as a best a distraction and at worst a barrier to real reform of the financial system.

The starting point for real reform of the financial system is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Not only does ultra transparency address the issue of reducing the riskiness of the investment and retail/commercial banks, but it also ushers in cultural change as sunlight is the best disinfectant for bad behavior.

The French government-planned reform of the banking industry, which seeks to separate speculative and highly risky activities from retail and commercial operations, is ill-timed, the head of the French Banking Federation said Saturday. 

Implementing the reform, which was an electoral pledge of socialist president Francois Hollande while the country is facing strong economic headwinds could further limit banks' profitability and ability to help foster growth, Jean-Paul Chifflet said in an interview with France Inter radio. 

In the U.S., banking reforms have been put on the back-burner because of the economic slowdown, Mr. Chifflet said.

Actually, in the US, bank reform was put on the back-burner by the Obama administration and the passage of the Dodd-Frank Act.  The administration didn't want to reform the banks and Dodd-Frank was written by and for the banks by their lobbyists.

The French government last week presented a bill forcing French banks to create specific units to house risky speculative operations, in a bid to address one of the causes of the financial and economic crisis that started in 2007 and to protect retail activities and customers' savings. 

The project, however, has been watered down from Mr. Hollande's original plan to split the banks into two and end the combined model of commercial and investment bank.

Office of Financial Research: looks for advice in all the wrong places

In his ProPublica article, Jesse Eisinger confirms your humble blogger's observation that the Office of Financial Research is a tool of the financial services industry to bury transparency.

Regular readers know that there are two pillars underlying the FDR Framework:

• The philosophy of disclosure; and
• The Principle of Caveat Emptor (buyer beware).

OFR was designed under the Dodd-Frank Act to bring as much opacity to the financial system as possible.  Specifically, OFR can collect data, but it cannot share this data with market participants.  It can only provide summary analyses.

As a result, the ability of the market to analyze the data collected by OFR is never brought to bear on the data.

As Mr. Eisinger observed,

But hardly anyone is paying much attention to the Office of Financial Research. 

This entity was created by the Dodd-Frank Act to conduct independent research on the sweeping risks to the financial system. Ah, right, another group of Washington wonks who will issue reports carrying vague warnings of risks looming sometime in the uncertain future. Yawn. I hadn't paid much attention either. 

But then I spoke to Ross Levine, an economist and specialist in regulation at Haas School of Business at the University of California, Berkeley, and I finally got it. The Office of Financial Research is a great idea.

Indeed it is as it is based on my call since the beginning of the financial crisis to create the "Mother of all financial databases".

And as I grasped it, I felt a minor sense of horror, as when you see a precious ring slip off a finger in slow motion and go down the drain while you are powerless to stop it. 

This was exactly how I felt when I saw the supporters of the National Institute of Finance come bumbling into the space I had defined with the call for the "Mother of all financial databases".

The office is looking as if it will be a tool of the financial services industry, instead of a check on it. 

Which is exactly what the National Institute of Finance and its supporters managed to achieve because they had not the slightest clue about what they were doing.

Its main role is to serve the Financial Stability Oversight Council, providing the systemic risk overseer with data and analysis of where the nukes are buried.

This is where they made there first mistake.  OFR should never have been in the research business.  It should solely have been in the business of overseeing a data warehouse run by a third party that collected, standardized and disseminate data to all market participants.

Everyone knows except the ego maniacs who were part of the National Institute of Finance that the market is better collectively at doing analysis than a handful of economists.

By insisting on doing analysis, the supporters of the National Institute of Finance opened the door for the Wall Street lobbyists to both neuter OFR and protect opacity in the financial system by burying transparency in the form of the "Mother of all financial databases".

But the Office of Financial Research was hobbled from the get-go by a poor design. It is housed in the Treasury Department, while ostensibly being independent of it. It has a small budget. And it has to report to the very regulators it is supposed to report on. 

This month, it announced its advisory committee. Thirty big names charged with giving the fledgling operation direction and gravitas. But these same people have also compromised it. 

A committee that by design substitutes for the market if OFR had been a tool to bring transparency to all the opaque corners of the financial system like I intended that it should be.  Instead...

By my count, 19 of the 30 committee members work directly in financial services or for private sector entities that are dependent on the industry. There are academics, but many of them have lucrative ties to the financial services industry. I noted only one financial industry critic: Damon A. Silvers, the policy director for the A.F.L.-C.I.O.... 

The Treasury Department sees it differently. 

"We were not looking for critics or proponents. That wasn't the goal," said Neal S. Wolin, the Treasury deputy secretary. "We were looking for people with a range of perspectives who understand keenly the systemic risks in the financial system."... 

The world is teeming with expert critics of Big Banking; they just aren't heard from much in the halls of Washington. 

The Federal Reserve Banks of Kansas City and Dallas have candidates. The economist Joseph Stiglitz would make a good choice. The Bank of England houses two prominent banking critics, Andy Haldane and Robert Jenkins. Outfits like Better Markets or Demos could nominate people who would give Jamie Dimon some indigestion. 

Certainly, financiers are not a monolithic lot. Investors often have differing interests from those of banks, and investment banks from commercial banks, and the small from the large. Even in big institutions, there are secret sharers of anti-Wall Street sentiment. ...

Clearly, there is a place for finance professionals. But shouldn't the balance of the committee be tilted in the opposite direction and give greater voice to the critics and the banking skeptics? This is a panel that is supposed to identify giant risks in the system that bankers ignore in their pursuit of profit and bonuses and to spot flaws in regulations that could cost the public and economy trillions....

Imagine how all of these market participants could have been utilized to identify problems in the financial system if OFR were there to foster transparency rather than create opacity by monopolizing information. 

So why does yet another Washington advisory panel of worthies matter? Mr. Levine has a subtle and fascinating answer. He starts by pointing to the mystery of the home-team advantage in sports, which has long puzzled researchers.

It turns out that umpires are biased toward the home team not out of conscious or recognizable bias. Rather, they subconsciously gravitate toward their immediate "community" — in this case, the home-field crowd, especially at crucial moments in a game. (Researchers will next study how this appears to have no effect whatsoever on the New York Jets.) 

To minimize the bias, you can tell the umpires that they are being monitored. Introduce instant replay. With that, you have expanded the community that is watching the umpires to an audience far beyond the home crowd....

Which is exactly what happens when the data is made available to all market participants.

The Office of Financial Research is well on its way to barring the gate. 

Before the crisis, the consensus was that the Office of Thrift Supervision was the regulator most in the pocket of Big Banking. For its efforts, it got shut down as part of the postcrisis regulatory overhaul. 

"Now, the title of ‘Most Captured' is up for grabs," Mr. Johnson said. "And I think we have a contender." 

Washington and the financial regulators are not about to crack down on Wall Street

In a Propublica article, Jesse Eisinger looks at the ongoing implementation of the Dodd-Frank Act and concludes that Washington and the financial regulators are not about to crack down on Wall Street.

Regular readers know that with limited exceptions, the Consumer Financial Protection Bureau and the Volcker Rule, the Dodd-Frank Act was written by lobbyists for Wall Street's benefit.  The act was never designed to crack down on Wall Street.  It was designed to protect Wall Street and the opacity that Wall Street thrives on.

For example, the act created the Office of Financial Research.  The idea behind OFR is that it will operate like the National Weather Service and collect all the useful, relevant information about the financial system.

Unlike the National Weather Service which makes its data available to anyone who asks, by law, OFR must keep its data confidential.  All it can share is the results of analyses conducted by its in-house analytical team.

Hence, OFR is nothing short of the black hole in the financial system where transparency goes to die as the reason that transparency works is that it lets every market participant independently assess the information and come to their own conclusion.  A conclusion that they then act on when determining both the amount and price of any exposure.

Surely, reformers can now ride in and save the day, right? 

Alas, no. While the rule making will speed up, the core problems with the financial system and its regulators are deeper than personnel and sadly impervious to which party occupies the White House. They are bipartisan and structural.... 

The structural issues go deeper. The Commodity Futures Trading Commission and the Securities and Exchange Commission still exist as two separate agencies, a huge missed opportunity for Dodd-Frank and one borne of politics. 

The C.F.T.C. is protected (and bashed) by the Senate Agriculture Committee, the S.E.C. by the Senate Banking Committee. Merging the agencies would mean that one of those committees would lose power, so forget about that. ... And, anyway, these agencies are still run by commissions, not single heads, and they rely on Congress for their financing. It's little surprise that such a structure creates plodding impotence. 

"One of the biggest weaknesses of Dodd Frank is that we failed to look long and hard at true independence of regulators," a frustrated and regretful Senate staff member, who worked on the legislation, told me the other day....

 Did the Senate staff member expect Wall Street and its lobbyists to say this was a problem?

Or take the Volcker Rule, one of the most prominent symbols of the financial overhaul. The rule, which was intended to prevent banks from speculating with money backed by taxpayers, still has not been finalized almost two and a half years after Dodd Frank passed. 

It's the subject of multiple-agency negotiations, which are going about as well as that phrase would suggest. Representative Barney Frank, Democrat of Massachusetts, had called on the regulators to finish up by Labor Day. That came and went. Senators Carl Levin, Democrat of Michigan, and Jeff Merkley, Democrat of Oregon, the authors of the provision, fired off a letter a few weeks ago, urging the regulators to finish their work. 

Now, it would be good if regulators were assiduously working to radically simplify the rule, which is a bloated monstrosity filled with loopholes and exemptions. But they aren't. Instead, they're squabbling over petty turf issues....

Regular readers will recall that the Volcker Rule could be written in 2 pages.  Page one would repeat the Volcker Rule and its prohibition on proprietary trading.  Page two would require banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

As Mr. Volcker said, you know proprietary trading when you see it.  With ultra transparency, all the market participants could see if a bank engaged in proprietary trading.  This would make it easy for regulators to enforce the rule.

Dodd Frank is so sweeping in scope yet so picayune in application that it will be close to impossible for the public to tell whether it's making a difference.

Dodd Frank is designed not to make a difference.

Any effort to truly crack down on Wall Street will start with transparency and providing market participants with access to all the useful, relevant information so they can independently assess the risk and make a fully informed investment decision.

Dodd Frank is designed to protect opacity.  As a result, it calls providing pricing information transparency.

Everyone knows that pricing information is not transparency.

The first step of the investment cycle is for the market participant to independently assess a security.  Transparency is focused on providing all the useful, relevant information for this assessment.

The second step of the investment cycle is to look at the prices shown by Wall Street.

The last step of the investment cycle is to compare the independent assessment of the security against the prices shown by Wall Street in order to make an buy, hold or sell decision.

The lesson that investors relearned at the beginning of the Great Recession is that if you cannot do the first step, stop.  Buying and selling based on price is simply blindly betting.

Election winner must re-establish proper relationship with Wall Street

In his Bloomberg column, William Cohan argues that the winner of the presidential election must repair the "rift" between Washington and Wall Street as America functions best when they have a "symbiotic, rather than adversarial, relationship".

This argument is flawed as history has shown that America functions best when Washington requires

• Wall Street to provide transparency in all of the opaque corners of the financial system and
• Investors use this transparency knowing they are responsible for all gains and losses on their exposures under the principal of caveat emptor.

By definition, Washington's requirement of Wall Street creates an adversarial relationship.  The reason that it is an adversarial relationship is that Wall Street likes opacity as opacity allows Wall Street to make a lot of money off of the inability of investors to properly value the risk of a security.

Yves Smith confirmed this on NakedCapitalism with her observation that nobody on Wall Street was ever highly compensated for creating transparent, low margin products.

On Wall Street, opacity is a winner.

For America, transparency is a winner.

Therefore, it is up to Washington to act in America's best interest and make sure that there is transparency is every corner of the financial system.

History has shown that America functions worse when Washington tries to 'befriend or make a client of' Wall Street.

First the Great Depression and now the Great Recession show how America and its capital markets function at their worse when Washington pursues a 'symbiotic' relationship and does not ensure that there is transparency in every corner of the financial system.  

Each part of the financial system that broke down in the Great Recession is characterized by its opacity:  including, but not limited to, structured finance securities and banks.

Regardless of whether Mitt Romney or Barack Obama wins the presidential election Tuesday night, one of the first orders of business will be to repair the deep rift between Washington and Wall Street. 

Plenty of Americans may feel that the antagonism between the two is useful -- and lord knows there have been times in recent history when the relationship between the power centers in Washington and New York City has been unbearably cozy. Yet the truth is that America functions best when Wall Street and Washington have a symbiotic -- rather than adversarial -- relationship....

The financial system is dependent on antagonism between the two as transparency is the casualty of a friendly relationship.

Please recall that FDR welcomed the bankers' enmity when he set up the FDR Framework as the foundation for our financial system.  He knew full well that requiring transparency would dramatically reduce the profitability of Wall Street.  He saw this as a good thing because the profits came at the expense of America's real economy.

So, whichever man wins, he should get to work immediately on improving the vibes between Washington and Wall Street. Here’s how to do it, in three simple steps: 

First, don’t pretend the problem doesn’t exist. Yes, it is true that during the past four years Wall Street has benefited enormously under President Barack Obama -- from the trillions of dollars used to bail out failed firms to the doubling of the Standard & Poor’s 500 Index (SPX) since its 2009 nadir to the failure to put in place meaningful regulatory reform to the Federal Reserve’s decision to keep interest rates low. ... 

The Dodd-Frank reform act remains the law of the land, banks remain under the (often heavy-lidded) eye of the watchdog agencies, and uber-capitalist Romney, one hopes, understands that markets won’t function unless the people have faith in them being fair.

What a litany of doing Wall Street's bidding and not re-establishing the right relationship between Washington and Wall Street.

Rather than focus on bringing transparency to every corner of the financial system, the focus has been on promoting opacity with complex rules/regulations and regulatory oversight.

To put things on a new footing, I suggest a weekend retreat ... to figure out how to salve feelings bruised by the endless battles over how the new regulation of Wall Street will work. 

History shows that FDR did not care about Wall Street's bruised feelings.  He understood that Wall Street is filled with big boys who understand, even if they don't like it, that forcing them to provide transparency is nothing personal.  It is simply stripping them of an information advantage that undermines the financial markets by making them unfair.

What would they discuss at such a retreat? The other two items on my agenda. 

One of which is that, while federal agencies need to quickly wrap up writing the rules called for under Dodd-Frank, the government should actually let Wall Street banks take more risk with their capital than Dodd-Frank law implies they should.

Your humble blogger has argued for the repeal of Dodd-Frank with the exception of the Consumer Financial Protection Bureau and the Volcker Rule.  In its place, Washington needs to bring back transparency to all the opaque corners of the financial system.

For banks, this will require that they provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, banks will be subject to market discipline in addition to regulatory discipline as a restraint on their risk taking.

For structured finance securities ranging from covered bonds to securitizations this will require they provide observable event based reporting on all activities like payments or delinquencies involving the underlying collateral before the beginning of the next business day.

Time to rethink regulatory reform and replace it with ultra transparency

The American Banker ran an interesting article on all the complex rules that are being implemented as a result of the Dodd-Frank Act and Basel III and asking if there is a better solution.

Regular readers know that all these complex rules and increases in regulatory oversight are a substitute for the simple solution of transparency and market discipline.

As I have said numerous times, with the exception of the Consumer Financial Protection Bureau and the Volcker Rule, Dodd-Frank should be repealed.

It should be replaced with an Act that brings transparency to all the opaque corners of the financial system.  At a minimum, this Act should

• Require that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This is the data market participants need to independently assess the risk of the banks and exert discipline to restrain risk taking.

• Require that structured finance securities provide observable event based reporting on all activities like a payment or default involving the underlying collateral before the beginning of the next business day.  This is the data that investors need to know what they own.

Utilizing 21st century information technology, all of this disclosure can be centralized in the 'Mother of All Financial Databases' and made available to all market participants.

Market participants have an incentive to use this data because there is money to be made from using it.

• For example, banks with deposits to lend can use this data to assess the risk of banks looking to borrow.  With this assessment, the interbank lending market can reopen.

• For example, market participants can calculate Libor because they have access to all of the interbank transactions.

Regular readers know that unlike complex rules and regulatory oversight, transparency and market discipline have pass the test of time.

How ripe is the moment? Even lawmakers who voted for the 2010 reform law are open to improving it. 

"Congress never gets it right, when you're looking at massive reform legislation, the first time through," Sen. Mark Warner, D-Va., told The Hill newspaper last week. "You directionally head in an area and then you come back, two years, three years hence to do a corrections legislation."...

Ammunition for anyone seeking change arrived Monday from Karen Shaw Petrou of Federal Financial Analytics.... 

Her stark conclusion: even if regulators did everything called for in Dodd-Frank, and did it perfectly, financial services supervision would still be a mess. Throw Basel III in the mix and it just gets worse. 

The end-result of numerous agencies pumping out massive rules to meet statutory deadlines will be a tangle of contradictory mandates that will be tough to enforce and impossible to comply with....

Please re-read the highlighted text as Ms. Petrou makes the case for restarting financial reform with a simple focus on bringing transparency to all the opaque corners of the financial system.

As I have documented on this blog, simply bringing transparency back to the opaque corners of the financial system will go a long way towards fixing all of the problems that financial reform is suppose to address.

Transparency has one more advantage over loophole ridden complicated regulations that the industry will render irrelevant.  Transparency has been shown to prevent a financial crisis in the first place.