Three Financial Industry Reforms We Should Demand

The House recently passed a major financial reform bill, and the Senate will vote on it as soon as there’s enough Republican support to push it through. By most accounts, the Republicans are mostly on board, which is probably why we’re not hearing a whole lot about it from the media. There’s not enough conflict and hysteria to make it television fodder.

18 months ago we were told we were teetering at a precipice. We felt anxiety, which subsided into anger as we learned more about how the firms we paid to rescue had precipitated the crisis. Now we’re no longer feeling the acute fear, and the anger at Wall Street has fizzled somewhat, so I’ve been a bit worried that the final reform bill won’t have any teeth.

This inspired me to do some digging. I’m not a financial whiz, but having devoured many accounts of the crisis, I feel like I have a pretty good handle on what needs to change.

Too Big To Fail is a maddening phrase we heard a lot, and we’ll never know what would have happened if the federal government had rejected the premise outright – meaning we’ll never know what would have happened if the government didn’t bail out the banks. There are lots of smart people on both sides of the debate around the bailouts, but ultimately hindsight is blind.

Given this fact, too big to fail is one of the key things that Congress has vowed to fix in the financial reform bill. Specifically, they want to be empowered to break up companies before they become too big to fail. I for one have little confidence in the government’s ability to define big in a way that would lead to action down the road. The truth is, the government will never be able to know exactly when or how they should intervene, so I don’t think this will really be a meaningful part of the final reform bill.

Another piece of needed financial reform has to do with incentives. Up and down the whole chain of cause and effect, from home buyers in the suburbs to folks on Wall Street assembling mortgage-backed securities – people had good incentives to make really bad decisions. But this is something the companies themselves need to fix.

That makes one thing the government can’t fix, and one thing they shouldn’t fix, so what should we expect from a reform bill? I think there are three obvious things:

1. Create independent ratings agencies – Agencies like Moody’s and S & P are paid by the firms whose bonds they are responsible for rating. This is the only reason a CDO made up of hundreds of garbage loans put together by Goldman Sachs was able to get a triple-A rating, and it’s obviously insane. Either the government should put together its own truly independent ratings entity, or it should require the existing agencies to operate independently. Either way this is easier said than done, but it’s pure common sense.

2. Eliminate huge private transactions – Wall Street firms routinely make multi-billion-dollar deals with each other that are not reported on anyone’s balance sheet or visible on any index. If the larger financial market is exposed to the risk inherent in these transactions – which it obviously is – then the larger market needs to know about them. The financial industry will fight this tooth and nail, and we’ll certainly hear lots of manufactured reasons why it’s a bad idea. Look for the “trickle-down” attack – you know, the one that says that any restraint imposed on big business is bad for the economy because that’s where the jobs come from.

3. Regulate “hedging” – This is a tough one, because it’s subjective. A few firms made a lot of money from the deals that led to the financial crisis by aggressively touting certain investments to customers while simultaneously making big bets that those same investments would fail. Executives from Goldman Sachs were questioned about this by Congress, and a series of deals engineered by a firm called Magnetar makes a perfect case study. Companies call this “hedging” and claim it’s just a prudent part of doing business – you make a bet, and you “hedge” it with a side bet, as insurance.

There are two problems with this argument. First, the side bets they refer to as hedging were mostly secret, back-channel deals, whereas the affected investments they promoted were very much the opposite. In other words, they aggressively sold certain investments that they secretly bet would fail, and the more of these bad investments they sold, the more money they stood to make from their failure. Secondly, many indications suggest the so-called hedges were often bigger than the bets (which means they’re the real bets and not hedges at all). This is hard to prove, given the secrecy around these “hedges,” which is its own problem.

Again, this is something the financial industry will fight tooth and nail, but we should all demand transparency. We have the right to know about both the hedges and the bets, so we – meaning not only ourselves, but our banks, mutual funds, etc. – can make informed investment decisions

One proposal put forward in the financial reform bill is to establish a new government entity called the Consumer Financial Protection Agency to alert us to red flags in potential investments (like giant side bets), and this is what the Republicans are opposed to, because they see it as unnecessary government bureaucracy. This is a valid point, but I’m not sure what else they’re offering. Alternatives suggested by Democrats in an effort to gain Republican support include beefing up  the consumer protection power within one or more existing agencies.

In any case, consumer protection should give us more freedom, serving to illuminate risks in complicated financial products without prohibiting those products. It’s transparency we need, and that’s what we should look for in the financial reform bill.

[UPDATE] The good news is that items 1 and 2 are in the bill that passed the House. Item 3 is fuzzier, although there are a number of provisions in the bill that might have some impact on the way that firms will be allowed to make bets vs. side bets. Maybe worthy of another post.