More Financial Reform, Less Financial Security

If you liked Obama's takeover of health care, then you'll love the even more convoluted and poorly-understood so-called financial "reform" bill being resisted by the GOP with daily filibuster votes.

The financial reform legislation spearheaded by Senate Banking Committee chairman Christopher Dodd (D-CT) is as encompassing as the health care legislation, but we the people have been given too little time for gestation. 

While the debate rages in the Senate, most pundits and politicians tell us that "everyone knows we need financial reform," but a new Gallup poll shows that the issue is divisive. When respondents were asked on April 17 and 18 if they support giving "the federal government new powers to regulate large banks and major financial institutions," 46% were in favor and 43% were opposed (72% of Democrats were in favor while only 22% of Republicans were in favor).

What does the financial reform entail? To glean out the bullet points from the proposed 1,136-page Financial Regulation bill, we might turn to a recent speech by the president. Given on April 22 at Cooper Union in NYC, President Obama outlined the four key elements in the financial regulation bill:

1. Through the Volcker Rule, "It places some limits on the size of banks and the kinds of risks that banking institutions can take."

2."... ensure[s] that financial products like standardized derivatives are traded out in the open, in the full view of businesses, investors, and those charged with oversight."

3. "... give[s] consumers more protection and more power in our financial system. ...With a dedicated agency setting ground rules ..."


4. "The SEC [Securities and Exchange Commission] will have the authority to give shareholders more say in corporate elections."

Note the significant new responsibility that the government delegates to itself: to manage the size of banks, to regulate types of investments, to create a new government agency, and to broaden the power of the SEC. All in the name of political buzzwords like "transparency" and "oversight."

In a breath, the currently considered Financial Reform Legislation attempts to address the underlying fragility of the financial markets exposed by the recent recession. The bill suggests that the impetus of the crisis was the web of counter-party risk woven by derivative trading, but the very financial risk that this bill attempts to address was exacerbated by the government in the first place.

The financial crisis of 2008/09 was magnified by the Commodities Futures modernization act of 2000 (CFMA) (H.R. 4541) that added regulation to all derivatives save "financial," creating a now-obvious loophole. This inclusive definition created a natural exodus by investment firms from regulated to unregulated derivatives (like the Collateralized Debt Obligations, or CDOs, we've heard so much about), exposing the system to a deep, linear risk.

Not only did the government unintentionally encourage the types of derivatives trading that have been blamed for the financial crisis through this the CFMA, but it also encouraged the "subprime meltdown" by keeping mortgage rates at historic lows for much of the decade, which it accomplished by forcing banks to lend to unqualified borrowers through the Community Reinvestment Act and by feverishly buying up mortgages from those same banks through quasi-government agencies Fannie Mae and Freddie Mac. It is seldom pointed out that if not for these interventions into the housing market by the government, most of the Wall Street bets would have paid off, and derivative investments (including CDOs) would likely have been the sound investment they were billed as.

But as it stands, "derivative" has become a boogieman term that is now synonymous with Wall Street greed and danger to Main Street. This uncertainty and fear creates the means by which sweeping regulation quickly roots.

Loosely, a derivative is a contract (often highly leveraged) between two or more parties that derives its price or value from a particular asset including stocks, bonds, commodities and almost anything else that can vary in price. Derivatives traditionally hedge against risk (such as increasing oil prices) but can also be used for speculation.

President Obama's Chief Economic advisor Austan Goolsbee was asked by Politico last week how he would explain a derivative to a layperson.

It's like betting on an NBA game. You could bet on the final score, or you could take a coupon from Taco Bell offering a free taco if the home team scores more than 100 points. That offer is a derivative.

This type of dumbing down is dangerous because it over simplifies a complex multi-trillion-dollar market and gives our politicians just enough information to feel educated. But for the most part, they are not bankers or economists and likely have a minimal understanding of advanced financial instruments -- an understanding augmented only in recent weeks. What they are sure of is that more regulation, more oversight, and more bureaus (other than the existing Securities and Exchange Commission and Commodity Futures Trading Commission already charged with regulation) will solve the problem. 

Their ignorance is alarming; responding to the failed vote in the Senate to advance the bill on Monday, President Obama said that "[this financial reform] will prevent a crisis like this from happening again[.]" 

In addition to this type of ignorance, there is a deeper concern with the financial regulation bill. Under the current legislation being considered, the government will have the capacity to intervene in what they call a "bailout" whenever they see fit, meaning not only at the request of a company. Worse, instead of needing congressional approval to intervene, as was the case in 2008, under the bill, the Treasury acts unilaterally. In other words, the government will have unprecedented power over private financial companies because like health insurance companies, they are deemed too vital to the nation.   

The year 2010 is on track to become the greatest for progressive government expansion on record...and it's only April.

Brenton Stransky is co-author of  The Young Conservative's Field Guide, which is recently available. He can be contacted through the website www.aHardRight.com.
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