Reform legislation is on the wrong path; here's how to fix it

Originally appeared February 1, 2010

Reform legislation is on the wrong path; here’s how to fix it
By Tom Bengtson

The House financial reform bill, HR 4173, is bad for banks and bad for the nation. And with Sen. Dodd’s political clout effectively neutralized, there is little hope the Senate version will be a significant improvement. The main thrust of the House bill, the administration’s recommendations, and everything we hear from the Senate is to increase the discretionary authority of regulators. On the recent record, this is a disaster. Despite the government’s frantic attempts during the past 18 months to deny its own responsibility for the late disaster, the truth remains painfully obvious: The mortgage crisis was aided, abetted and encouraged every step of the way by essentially every regulator – national and international – every central bank, and nearly every G20 government. The role of governments went far beyond pressuring banks to write mortgages for low-income buyers. Every aspect of the structured finance scam was officially encouraged. The regulators talk now about how recklessly the banks behaved but at the time, the structured finance apparatus which migrated the mortgage business away from loan officers and into public securities markets was hailed by regulators because it supposedly reduced risk. Recall that the Basel Accords explicitly favored mortgage-backed securities over traditional, bank-retained loans.

Even after it became clear that structured finance was a catastrophic mistake that had imperiled the entire banking system and the United States economy, regulators still proved miserable failures. For months before the crash in September 2008, the major regulators had field teams parked in the executive suites of every major American financial institution, monitoring and advising away, and they still did not see the crash coming much less forestall it. On the contrary, it was on the advice of those field teams that the government decided to let Lehman collapse rather than intervene. The field teams had concluded that Lehman’s fall would not unduly disturb credit markets. In July of 2008, the government declared Fannie and Freddie safe, sound and adequately capitalized. Little more than a month later, it declared the twins broke and seized them.

The last thing either American banks or America needs is more regulatory agencies empowered to make it up as they go along. Instead we need black letter law enforcing real reform on a few key issues, passed by a Congress willing to take real responsibility rather than shuffle it off onto regulators to be blamed later.

CFPA, new council flawed

The House bill, at the administration’s urging, includes a new Consumer Financial Protection Agency, which will be given enormous latitude to define abusive lending and then outlaw it. There is no requirement that “abusive” practices be fraudulent or even misleading. If the zealots at the new agency don’t like a particular product it will be banned.

Consumer advocates argue that we need the CFPA, a separate pro-consumer regulator, because traditional banking regulators focus on “safety and soundness,” slighting consumer issues. Have they been asleep since the early 1990s? That was when the Clinton administration decided to get serious about enforcing the perceived intent of the Community Reinvestment Act by pressuring banks to make more mortgages to low-income, poor-credit buyers. Bankers and regulators alike soon discovered the only way to do that was to toss the traditional 20 percent down payment. For years we listened to consumer advocates and regulators and congressmen alike condemn bankers who preferred safer loans as selfish or even bigoted.

In short, the politicians told the banks to separate safety and soundness from consumer protection. The result: millions of consumers got stuck with loans they could not afford and lost their homes. Turns out that safety and soundness are best for banks and best for consumers too. But with the CFPA in control, we’ll be right back to those Clinton years, with banks coming under enormous political pressure to make bad loans.

The House bill supposedly exempts banks with less than $10 billion in assets from direct CFPA oversight, instead allowing the banks’ traditional regulators to cover consumer issues as well. The traditional regulators, however, will be obliged to enforce substantially the same standards promulgated by the CFPA or risk being pre-empted by the consumer agency. True, Treasury makes the final call on pre-emption, but the politics of the situation will favor CFPA. It will not be possible to maintain different standards on consumer issues for small and big banks. If product A is abusive when it is offered by JP Morgan Chase, then it is abusive when offered by the smallest community bank in the state.

The House bill, in addition to creating the new consumer agency, creates a Financial Services Oversight Council, whose membership is to include the heads of just about every federal banking or securities regulator you can think of. The council’s job is to periodically assess the health and safety of the financial sector, recommend reforms, arbitrate regulatory disputes and ultimately restrict the operations of any firm it deems a threat to the system or even to force the break up of such firms. In short the council, made up of the same folks who performed so brilliantly last time around, will have almost unlimited discretionary authority to control the banking system with minimal reference to black letter law, except the law creating its vast powers.

The most common excuse for empowering regulators to make the same mistakes all over again, rather than actually solving the problem, is that the issues are too complex and dynamic to be resolved by an inflexible statute. This is exactly wrong. The entire crisis can be reduced to two problems, each of which could be dealt with in a single sentence of legislation.

A better approach

One: Junk mortgages. This barn door is probably nailed shut by now; not in our lifetime or probably our children’s are there going to be a lot of no-money down, no-documentation mortgages written in this country, regulators or no. You can take it to the bank that if even Congress has recognized a problem, the rest of America has figured it out as well. Still, if the alternative is to erect a whole new agency to impose its opinions on mortgage lenders and borrowers, instead let’s pass a federal statute forbidding mortgages on residential property with less than a 20 percent down payment, or 15 if you want some wriggle room. Stock market investors have been required since 1933 to put 50 percent down on margin purchases and that little piece of black letter law has served the nation well. For good measure add in a provision forbidding teaser interest rates and we’re done.

Two: Too big to fail. The House bill deals with too big to fail by erecting a vast and unpersuasive mechanism for dealing with “fail.” Addressing “too big” is a lot easier and more likely to work.

How did today’s behemoth banks get so big? Simple; long before they really were too big to fail, they were perceived to be under the government’s protection. That perception dramatically reduced their cost of capital. Without that subsidy, none of the great banks would have grown to their current size; without it many of them would not be profitable.

Although GSEs, Fannie and Freddie are the best examples. With their debt “implicitly” guaranteed by the U.S. government, those institutions could borrow almost as cheaply as the Treasury. Certainly they could borrow much more cheaply than a couple of perilously undercapitalized banks — which is what they were — should have been able to. Andrew Redleaf and Richard Vigilante, Minneapolis-based authors of a very interesting, about-to-be-published book called “Panic,” argue this interest rate subsidy for the twins easily allowed them to borrow at rates between 75 to 150 basis points cheaper than merited by an objective review of their balance sheets. As Redleaf and Vigilante point out “On roughly $1.5 trillion in combined average debt during the last five years before the 2008 crack-up a 100 bps interest rate subsidy amounts to some $15 billion a year, double the twins combined net income for most of those years. If the subsidy actually amounted to at least 150 bps, which it surely did in the late stages, the annual too-big-to-fail subsidy to the twins amounted to more than one-fifth of their total shareholders’ equity.”

“The rest of the too-big-to-fail banks,” they go on to argue, also “enjoyed effective credit ratings, as measured by their bond yields, far better than justified by their actual behavior. Though the too-big-to-fail subsidy for the banks was not as great as the twins’, it accounted for much or most of their net profit in most of those years.”

The only way to resolve too-big-to-fail is to take that subsidy away, by statute. Some argue that the current bill would do that because the bill’s new “rapid resolution” procedure for shutting down banks that pose a systemic risk would be largely supported by fees on the biggest banks. This solution actually perpetuates the problem: it would institutionalize too-big-to-fail and the interest rate subsidy to the big banks. Only if the fees charged to the banks fully offset that subsidy would the scheme take away the current incentive to grow at all costs. Under a discretionary regulatory scheme and considering the mega banks huge political power, there is no reason to believe that will be the case.

Instead of continuing to collectivize risk, the government should force the mega banks to self-insure. The way to do that is to dramatically increase capital requirements, by statute, enough to fully offset the too-big-to-fail subsidy. Currently, to be rated as well-capitalized, banks must hold Tier 1 capital amounting to about 6 percent of assets. For banks (including all the shadow banks and quasi-banks as well) managing more than $100 billion, that figure should be raised certainly to 10 percent and more likely to 12 percent. And all such institutions should be required to be well-capitalized all the time.

Could the big banks ever support such a move? Ironically, the half-dozen biggest banks in the nation, which face the threat of being broken up by the Supreme Almighty Banking Council under the House bill, might see in such a requirement a legitimate way to avoid that fate. A bank required to hold a 12 percent capital reserve might choose to shrink. But even if it did not, it would be very unlikely to fail. Raising capital requirements allows the mega banks to go at the problem from either direction: they can cease to be too big, or they can cease to be at risk of failure. Isn’t it better to have the choice rather than standing in the corner waiting for the regulators to decide your fate?

Tom Bengtson is publisher/editor of NorthWestern Financial Review.