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Economic outlook grim after Fin Reg passage

July 21, 2010

The Financial Regulation Bill ("Fin Reg") passed the Senate last week and President Obama said he plans to sign the bill into law today (July 21). Kudos to our President for working hard to pass another major piece of his reform agenda, after allowing for some give and take with Congress too.

After mounting a significant effort to change Fin Reg, I was saddened to see three Republican Senators — Scott Brown, Susan Collins and Olympia Snowe — break the Republican filibuster to stop this version of Fin Reg. Omitting reform of Fannie and Freddie and the rest of my grievances was unfortunate. There will probably be repercussions in the markets soon.

Now that the bill has passed, it’s time to find opportunities for the future and to avoid pitfalls wherever possible within this new law.

With the Volcker rule limiting investment-management business to 3 percent of bank tier 1 capital and not allowing proprietary trading in FDIC-covered banks, many traders may leave banks to join hedge funds and prop-trading firms. Some may start their own trading and investment-management businesses. Registration rules have been tightened, but those compliance costs are reasonable. For others, it may simply lead to the loss of their jobs and/or reduced compensation and bonuses.

Financial markets and analysts didn’t like Goldman Sachs Q2 2010 earnings reports this week. One contributing factor: Trading revenues (gains) were down by approximately 89 percent. Once Fin Reg is in full effect after a long transition period, imagine trading revenues down by 100 percent (with no trading at all). Focusing on loans only can be a risky business, especially if Fin Reg calls for more forced social lending to less-than-desirable borrowers, and demands that banks retain 5 percent ownership of securitizations. Morgan Stanley released it's earnings after I wrote this blog and they surprised on the upside due to stronger than anticipated trading gains. Taking trading gains out of these banks is like taking the iPad or iPhone out of Apple's earnings and leaving them with computers only.

There doesn’t seem to be many provisions that affect our trader clients in the first read of Fin Reg. There may be new opportunities for traders to trade derivatives which are moving to exchanges. Most stay behind at banks in the private marketplace. I didn’t notice any mention of stiffer leverage and margin requirements or access to markets.

If Fin Reg was in effect in 2008…
Before moving on to greener pastures, I wanted to vent a little more about one last big problem I have with Fin Reg. The bill’s raison d'etre was preventing “too big to fail.” I think Fin Reg may not prevent the next big bank failure, run on the bank, and/or contagion among institutions and toxic asset prices. In fact, I think it may in some cases accelerate all of the above. Let’s apply Fin Reg to the 2008 crisis that precipitated this bill, and project how it may have changed the outcome. For better or worse?

I admit that Fin Reg provisions and new regulators may have spotted and reined in unsustainable risks, abuses in mortgage underwriting, poorly packaged and rated mortgage securitizations and excesses with the GSEs. On the other hand, regulators had tools in place already to deal with these problems and they ignored them thinking the housing market juggernaut would only go up.

Here’s my biggest problem with Fin Reg. During the height of the crisis, it may have accelerated the spread of toxic asset pricing, leading to a faster run on Bear Stearns and Lehman (and other banks too).

Here’s why. This crisis brewed in two Bear Stearns real estate hedge funds, which eventually blew up and contributed to the cause of the crisis. The fund manager told Bear’s clients the fund was net short real estate and not to worry. He was lying and the funds were very long real estate and hiding large losses. Bear Stearns corporate management was not focused enough on these funds and didn’t want to bail them out with corporate monies, or close them down. They hoped real estate would turn around. Remember, Bear turned its back on the Long-Term Capital hedge fund that needed a bailout in 1998. We all know how this “House of Cards” (the book by William Cohan on Bear Stearns demise) worked out.

Now let’s apply Fin Reg to this situation. Under Fin Reg’s Resolution Authority and wind-down provisions, regulators would have seized the Bear Stearns hedge funds quickly and probably sold off the toxic assets at fire-sale prices. That government takeover would have spooked the markets more than what happened in the crisis. Yes, it brings more transparency, but in this case, it would have spread more fear. If you think the new accounting rules for mark-to-market accounting caused havoc on bank balance sheets and accelerated the crisis, then this would have been far worse. Also, bank-sponsored funds of this size wouldn't be allowed with the Volcker Rule but that rule is phased in over many years, so we could have this problem sooner rather than later. Big banks are increasing their investments into hedge funds since Fin Reg was agreed-to and they are not downsizing those departments yet.

Fin Reg doesn’t allow a bank to bailout its own hedge funds. So, Bear would not have had that option. Bear should have bailed out its funds, as it sold them on its good name, not the character manager’s name. That may have stopped the crisis from spreading and not caused a run on real estate prices and fear. Prices had gone up with market sentiment and confidence.

Now we get to even more serious problems. Fin Reg grants the government the ability to modify and even rescind financial, employment and other business contracts executed by an institution during the wind-down procedure. Remember the President, Congress, public and media were inflamed by AIG using TARP-funds to honor 100 percent of its swap contracts with Goldman Sachs and other banks (and their employment contracts as well). Many thought the government should pay for (at a discount) what amounted to a pre-packaged bankruptcy. Treasury Secretary Paulson thought discounts would cause chaos in the financial markets and he was right.

Banks now understand that under Fin Reg, if a counterparty bank runs into trouble, and the government steps in very fast to wind them down, their contracts can be modified or rescinded. Therefore, all financial institutions are only as strong as their weakest link in counterparty transactions. It’s ironic that Fin Reg is intended to prevent contagion, but this linking of losses actually spreads contagion.

After a wind-down, the government is entitled under Fin Reg to send the final bill for all losses to the rest of the big banks in the form of bank taxes or levies. Fin Reg may have dropped $19 billion of upfront bank taxes, but these bank taxes remain on the back-end. It was an accounting gimmick only to drop them and win curry for passage.

Spreading losses from the failed to the strong fundamentally changes capitalism in America and weakens our marketplace. No wonder banks and corporations are on a capital strike now. Who can they trust? Make a deal with a weak player and it can come back to haunt you.

Back to the Bear Stearns saga. If the government took control of the Bear Stearns hedge funds because Bear Stearns wasn’t allowed to, that would have started the contagion and spread of toxic asset prices. All counter parties would then avoid Bear Stearns like the plague thinking the losses could be passed to Bear Stearns and the government might take it over next and rescind its contracts. Banks would start questioning each other and inter-bank lending would seize up. That is the recipe for this type of crisis.

What would management do during these difficult times under Fin Reg? New provisions in Fin Reg allow the government to claw back compensation from managers and that’s just the least of it. The government can also charge managers with a share of the losses. After I read these new provisions, I realized that someone would have to be crazy to work for a bank subject to Fin Reg without knowing their true risks and the bank’s full situation. It reminds me of working for a private partnership in the old days of Wall Street, except now managers don’t see all the cards and they have less say than old time partners in these firms. Certainly, bank managers should take precautions such as seeking their own legal counsel and obtaining sufficient insurance just like directors were forced to do years ago with Sarbanes Oxley regulations.

Some Fin Reg provisions like prop trading and hedge funds phase in over many years, but resolution authority containing these wind-down provisions starts immediately.

Auto bailout results
How did the government do with its decisions on the last bailout? Neil Barofsky, the Treasury special inspector general responsible for TARP, reported not so well. His report released on Monday stated “Treasury made a series of decisions that may have substantially contributed to the accelerated shuttering of thousands of small businesses and thereby potentially adding tens of thousands of workers to the already lengthy unemployment rolls -- all based on a theory and without sufficient consideration of the decisions' broader economic impact." This is not surprising to me as regulators and politicians don’t know business as well as industry pros do. They often make big mistakes in business decisions.

With this Fin Reg bill, we went from “heads: business wins” to “tails: taxpayers lose” to the reverse. Now the government holds the purse strings for business in health care and banking and they can heap huge losses onto industry participants. With this type of anti-business over-reach regulation, I expect the capital strike and lackluster job market to continue.

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