Bank Lawyer's Blog

Unintended Consequences And Potshots From The Peanut Gallery

It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.
---Teddy Roosevelt

A post today by John Carney at Clusterstock, and some of the comments to that post, reminded me of my preference to apply "Occam's Razor" to most of life's problems. Simply put (because I'm not bright enough to put it more complexly), Occam's Razor is a principle that states "when you have two competing theories that make exactly the same predictions, the simpler one is the better."

Carney's post discusses statements by the Federal Reserve Bank of New York's general counsel that when the Treasury Department stepped in last year to bail out AIG, the ability of negotiators to make counterparties of AIG (like Goldman Sachs, for instance) on credit default swaps take a "haircut" on what they were owed by AIG went the way of the Dodo bird. A Washington Post article elaborates.

New York Fed officials explained that the main reason creditors were willing for a time to accept less than full reimbursement was their fear of an AIG bankruptcy. The government's rescue of the company removed that threat and left the company with virtually no way to wrestle concessions from the banks.

"In its negotiations with its counterparties, AIG just didn't have the same bargaining power that it did with the Federal Reserve standing in the background," said Thomas C. Baxter, New York Fed's general counsel. "The only sensible outcome was to give them what they were legally entitled to."

Moreover, AIG's foreign creditors told the Fed that they were barred by their governments from accepting partial reimbursement unless AIG faced bankruptcy, because doing so would amount to giving a gift to a U.S. company, according to officials at the New York Fed. Because the law prohibits the central bank from favoring some banks over others, New York Fed officials said they had determined that all of the creditors, foreign and domestic, had to be paid in full. They also decided it would be improper for the Fed to use its power as the banks' regulator to pressure them into taking less money.

Baxter said that the New York Fed "engaged a couple of institutions as to whether they would contemplate a discussion of taking a couple of points less than what they were entitled to." But he said officials were also racing to prevent AIG's collapse and did not have time to get involved in protracted negotiations with each creditor.

Carney alleges that the Fed's bailout of AIG, rather than allowing AIG to go bankrupt, had the "unintended consequence" of giving the counterparties enough spine that they would settle for nothing less than 100 cents on the dollar, which AIG paid. This, according to Carney, will cost the US taxpayers much more than they would have from the AIG bailout if the US government had simply stepped out of the way and allowed AIG to file bankruptcy or, at the very least, not taken any action to bail out AIG until the crisis reached its eleventh hour, fifty-ninth minute and the screws were put to the counterparties to take less than par.

Some commenters disagree strongly with the underlying contention, arguing that the government bailouts of GM and Chrysler resulted in the government strong-arming secured and senior unsecured creditors to take much less than they'd have been entitled to under bankruptcy, and that the government could have chosen to do so in the case of AIG but chose not to do so for some undisclosed reason. Others argue a more nefarious plot, one in which Hank Paulson and Tim Geithner rewarded their Wall Street cronies with plenty of taxpayer dollars because that's what good old boys do for one another. Another commenter alleges that its premature to raise the issue because AIG might pay back its loans from the Treasury and no taxpayer will suffer a loss on AIG.

I'm not a big believer in the probability that the Treasury Department will get back its full investment in AIG, although I agree that it's too early to tell. On the other hand, I don't buy the theories about the deliberate diversion of taxpayer money into the hands of Wall Street "cronies" of Hank Paulson and Tim Geithner solely because the Wall Street firms are part of some nefarious cabal that involves government and financial "oligarchs." That smacks of a poorly written Robert Ludlum knockoff novel. Human beings simply aren't that smart.

When I look for explanations, I usually look for the simplest one available that still passes the smell test. In this case, it's that the Treasury Department decided that it had to save AIG come hell or high water and the rest of the consequences were "details." Carney's correct to cite the law of unintended consequences. I think these folks were running around like Chicken Little, convinced that the sky was falling and that they were the only ones with the money and the power to prevent it. Having been in the midst of such situations, I suspect that paying off counterparties at par was a "detail" that someone thought about for a minimal period of time, looked at what he or she thought was the "big picture" and overriding goal, and simply said "screw it; pay 'em all at par and let's get this thing done." That was about the depth of the thinking that went into that particular issue at the time.

Of course, that's just my opinion. I could be wrong. Not that being wrong would ever keep me from continuing to lob shells from the peanut gallery.

The Everyready Energizer Defendant

Some might think that it's hard to believe that supervisory goodwill cases arising out of bank failures that occurred in the 1980s are still working their way through the federal court system, but those faithless readers of this blog know that what Arnold & Porter partner Edward Sisson called "dancing with the bear" takes a very long time. In fact, it takes as long as is necessary for the bear to get tired enough to finally stop dancing, and this bear's "got legs."

FinCri Advisor (free registration required) profiled a shareholder derivative action that has been huffing and puffing since 1993. It arose out of the FDIC's seizure of Meritor Savings Bank, which had been given favorable accounting treatment of "supervisory goodwill" when it bailed out the former FSLIC to the tune of $696 million by buying the broke Western Savings Fund Society.

A key part of the deal, however, was a Memorandum of Understanding that the FDIC gave Meritor allowing it to treat "the differences between the liabilities assumed and the total of the market value of the Western assets, less reserves" as goodwill and amortized on a straight-line basis for up to 15 years.

Without that understanding, the merged bank would not have had enough capital to meet regulatory requirements.

To make a long story short, the regulators broke their word, refused to recognize the "supervisory goodwill" as capital, ordered Meritor to raise its capital levels, and seized it when it couldn't do so. A principal shareholder sued the government and won, to the tune of $276 million. The government appealed and argued that the FDIC was a "non-appropriated funds instrumentality (NAFI)," and, as such, should have been sued in federal district court, rather than the Federal Claims Court. A majority of a three-judge panel of the U.S. Court of Appeals for the Federal Circuit disagreed, and said that the FDIC is backed by the full faith and credit of the United States and, therefore, is not a NAFI, and that a lawsuit in the Federal Claims Court was proper.

Much of the discussion in the FinCri Advisor article focused on how the Department of Justice was shooting the FDIC behind the left ear. Rather than be paid out of the larger pot of funds appropriated by the federal government, if the argument presented by the Justice Department had prevailed, all of the judgment would have to be paid from the Deposit Insurance Fund, meaning that FDIC-insured banks might very well be stuck with the tab (through the assessments they pay to fund the DIF). More important, prejudgment interest, available in federal district court suits but not in the Federal Claims Court, might have elevated that $276 million award to $ 1 billion.

The FDIC is "operating in a manner that is against their own interests," says Thomas Buchanan, the partner in charge of litigation at Winston & Strawn in Washington, D.C., who represented the plaintiffs. "I don't think they thought it through."

Ya' think?

One of the most interesting lessons of all this is one discussed by Arnold & Porter attorney Michael Johnson, toward the end of the article.

But he cautions private parties now contracting with the government to be careful. When the crisis ends, he says, politics can come into play and "hindsight can make the deals look a little different. Government is uniquely situated to alter the terms of the deals everyone thought were good at the time. Hopefully the lesson learned here is that the government does need to keep its promises. If it chooses not to, there are consequences," he says. "Another lesson for the private parties is the wheels of justice can turn a little slowly."

That's a point I've been hammering home to banks who thought about taking TARP money (and some community banks who are still toying with that idea). Some ignored the warnings, took the TARP, and many are now having second thoughts. No small part of those second thoughts have been caused by the manner in which Congress enacted legislation after the deals were consummated that changed some of the deal terms. Those banks can't say they weren't warned, but some of the bank executives still shake their heads and ask whether the government is deliberately trying to screw up or if this is just pure incompetence. It's the latter, mixed up with cold political demagogy, in my view.

It's also a point that those who enter into "loss-sharing" and other types of agreements with the FDIC as part of the resolution of failed banks would be wise to ponder. Those agreements can be breached overnight by folks with (as a former client once put it to me) the ethical principles of an Iranian rug merchant. If a breach occurs, you may have a right to sue the government for that breach, but you may be "dancing with the bear" for 16 years or more before you see a nickel.

The government will next likely ask for a full hearing before the appeals court.

And on and on it goes...

Bad Actors For Bad Times

Bad times for banks are also bad times for their customers. Now that the body count of dead banks has zipped past 100 (with a bullet), vermin are crawling out of the sewers to take advantage of the bad news. The FDIC issued a warning yesterday of a fraudulent e-mail that purports to be from the FDIC, states that the customer's bank has failed, and attempts to get the recipient to divulge account information so that the crooks can loot the customer's account. Beware of bottom feeders.

Another charming result of the current economic woes is one highlighted by Alain Sherter at BNet: rough tactics by collection agencies. 

Complaints about debt collection rose 34 percent from 2004 to 2008, according to a new FTC report.

The agency last year received roughly 79,000 complaints regarding those third-party debt collection services everyone loves so much. That amounted to nearly one-fifth of all consumer complaints to the FTC.

The most common complaints about debt collectors involved, in order of prevalence: (1) misrepresentation of the amount or legal status of a debt; (2) excessive telephone calls; (3) telephone calls from collectors looking for other individuals; (4) use of obscene, profane or abusive language; and (5) threatening to sue if payment was not made.

While it's always risky (although often fun) to make broad generalizations about any group, I think I'll make one: too many debt collectors are scum, and the scum are tarring the segment of the business that tries to operate within the limits of the law. A recent run-in with a national bill collection firm on behalf of a pro bono client makes me lose that warm and fuzzy feeling I used to get whenever the term "debt collector" was uttered. Some of these losers deliberately flaunt the Fair Debt Collections Practices Act and seem to believe that paying civil fines for violating it (and its state counterparts) are simply a cost of doing business. They should be slapped down and slapped down hard.

Hot Off The Wire

I've received some updated information concerning prior posts that I'll pass along.

In a recent post on de novo banks, I mentioned an interview with Commerce Street Capital's Charles Ingram and Derek Cunningham. Charlie thoughtfully provided me with a link to that interview. These folks have their thumb on the pulse of this issue, and the interview is well worth reading for those interested in the topic. I hope that both of those links lead to the correct material. I understand that last week, I inserted a link in one of my posts to a totally unrelated blog post on the blog "First Things," which deals with issues related to religion in the public square. That's why, boys and girls, you should never drink and blog. At least I didn't link to a porn site.

Another update concerns our perennial regulatory "hot ticket," Colorado Director of Real Estate, Erin Toll. When last seen on these pages, she'd been issued a temporary restraining order by a Denver judge that blocked enforcement of an administrative subpoena she'd issued for the bank records of a mortgage broker her office was investigating. Last week, the judge refused to issue a permanent injunction and upheld the Toll's power to issue such a subpoena. Toll was investigating whether the broker was steering funds to unlicensed brokers. According to Judge John Madden (not related, we assume, to the "Biff, Bam, Boom" former football coach and TV commentator of the same name), “bank records of the mortgage loan originator and his company would reveal if such funds were … distributed to unlicensed individuals in amounts indicating that such individual was being paid for originating the loan. It is possible … that methods could be utilized to mask such transactions, such as arranging for side payments by a borrower, making multiple payments to the individual in smaller amounts, or making payments to intermediaries.”

As we mentioned last time, at least one critic accused Toll of "terrorizing" licensed brokers by the use of such subpoenas. While I'm not opposed to the use of hyperbole in the service of entertainment, I don't see "the horror, the horror" in the use of a subpoena in this case. Toll's doing what she ought to be doing: following the money.

Our final bit of updating concerns PlainsCapital Corp., a Texas bank holding company that took a public relations beating administered by some of its competitors because it had the audacity to take TARP CPP money that the Treasury Department was begging banks to take. In a sign that is all too familiar at this point, PlainsCapital announced that its about to do the first bank initial public offering since 2007. It expects to raise $141.5 million and use $92 million of it to pay back all of the TARP capital. Like Ricard Nixon, PlainsCapital will soon be able to tell its critics that they won't have PlainsCapital to kick around anymore. At least, not over the issue of TARP. Texas banks kick each other around over a lot of things, so some other bank's boot is bound to be up their backside over some other manufactured marketing ploy sooner or later. However, PlainsCapital is steamed about how it was treated by some of its competitors, so when the boots start kicking, expect PlainsCapital to be wearing spurs.

This is another indication that the recently announced plan by the Obama administration to make "cheap TARP CPP" investments available to community banks is not likely to meet with open arms by all of its intended beneficiaries. Many banks who took it TARP in previous rounds and can find any way to pay it back are doing so as soon as they're able.

Backpeddling on Chair Bair

FDIC Chairman Sheila Bair, who, unlike certain others in our nation's capitol who we won't name, is a master in dealing with the press, dropped some interesting tidbits last week at a Reuters Washington Summit. First, she said "she should stay out of government jobs. She said she's jinxed."

"I joke that I should stay out of government service because everything I do, something bad happens," Bair, the chairman of the Federal Deposit Insurance Corp, told the Reuters Washington Summit.

Certainly, no one blames Ms. Bair for causing the subprime meltdown, even those of us who disagree with her "what's good for the consumer is good for banks" point-of-view on dealing with its results. As someone who, at one point in his career, joined three law firms in succession, each of which imploded, I get her joke. Sometimes, bad timing and the law of averages can be humorous, if only in hindsight.

She also said her current job is not one that a person should perform for any extended period. On the other hand, she didn't indicate that she'd be leaving her Chairmanship position before her term ends in June 2011. Given her public disagreements with Timothy Geithner, Lawrence Summers, and other members of the inner circle of the administration of "The One," I'm sure her rivals would like to see her consider leaving on a fast train to Kabul tomorrow, but I'm also sure that she thinks those clowns would wreak even more havoc without her where she is, so I doubt that she'll be leaving early. Also, even though her Chairmanship is up in 2011, she'll remain a member of the FDIC's Board of Directors until 2013, and she might want to retain her board seat just to pimp the opposition and keep them "honest," as she sees it.

Whenever she exits her current role, she's dead-on with her view of what her next role should be.

"I think the day when I move on, I'll probably go back into academia or perhaps nonprofit work," she said.

I wholeheartedly agree. She'd make a great university professor (which she once was) or CEO of a nonprofit consumer advocacy group. She'd be much better at either of those roles than she has as Chairman of the FDIC.

That said, after many recent conversations with current and ex-FDIC legal counsel and "line personnel," while I still strongly disagree with her public position on systematic loan modifications as the best way to stabilize the mortgage markets, and while I'm no fan of the way the FDIC, under her watch, is treating de novo charter applicants (or industrial bank acquirers), private equity investors who want to buy failed banks, and existing community banks that are in distress, I'm not convinced that another director would make an appreciable positive difference, especially at the supervisory level. More important, I'm afraid that the Obama administration might appoint someone to fill her role who would be much worse for the future of the banking business than Sheila Bair.

Like Mao Ze Dunn, for example.

Better a self-described "populist" than someone waving a Little Red Book.

He Who Laughs Last

While much of the business press was focused on Czar Feinberg's cap on bailed-out bank executive compensation and the Federal Reserve's proposed rules to limit executive compensation at banks and bank holding companies that it supervises, the House Financial Services Committee passed (as expected) a bill to create a Consumer Financial Protection Agency. While many of the bank-hostile provisions were "watered down," enough of the original proposal passed out of committee to make the Chairman of the Congressional Oversight Committee, who claims the CFPA was her idea, almost giddy.

Elizabeth Warren, a Harvard University law professor who conceived the consumer agency, lauded the bill’s passage.

“When I first came to Washington with the idea of this agency, everyone told me the banks always win -- quit now because the banks always win,” Warren said at the news conference. “They didn’t win today.”

No, but there's always tomorrow Liz. As the linked article from Reuters notes, the "outlook was unclear in the Senate, which is moving slowly on financial regulation reform." What happens if the bill fails in the Senate? Will Liz then suffer amnesia as to her claim that she "brought it to Washington" (I hadn't heard that claim previously, but I'll accept it at face value)? Will she then "man up" and stand tall while Camden Fine of the ICBA and Edward Yingling of the ABA chest bump in front of her, then shout at her not to bring that weak-ass CFPA stuff into their house?

The fight over the CFPA is far from over. It may go through more iterations in the full House, and its certain to be slowed down in the Senate, due in part to Republican opposition, but due more, perhaps, to the fact that Chris Dodd is leading the fight on an issue that the Obama administration thinks takes precedence: health care reform. Also, let's not forget "cap and trade," an issue which can suck the brains out of the skulls of most Solons. God only knows what the CFPA piece of sausage will look like when the grinder finally spits it out. I seem to recall something about cram downs in Chapter 13 bankruptcy proceedings making it through the House but being jacked, sliced, diced, and julienned in the more deliberative body of Congress.

Crowing about how "the banks lost today" might bring an ecstatic blood rush to the nether regions, but those feelings never last (or, if they last more than four hours, you should call your doctor). Even if you were the one who brought this big idea to Washington.

UPDATE 10/23/09: Updated to correct the link to the Bloomberg.com article and corresponding quote.

Son of TARP Takes Flight

I suppose that it's too soon to have more than a knee-jerk reaction today's announcement by President Obama that he'll propose legislation to "goose" lending to small businesses and to help community banks with what's left of the TARP money. Inasmuch as I have a knee (two of them, to be precise) and I'm certainly a jerk, I'll offer one up.

An SBA lending boost was first proposed seven months ago and the federal government is just now getting around to helping small business borrowers and their lenders. As has been the case throughout the bailout, small fry are the red-haired stepchildren of the family of folks who are "entitled" to a government handout. To me, this is all too little, too late. If it helps some businesses and some community banks, that's great. Yet, if, as the president correctly states, "there is too little credit flowing to our small businesses," what's changed in the last year in that regard? Why are we just now getting around to dealing with small businesses and their community bank lenders? If these steps "will lead to more jobs, more growth, and a stronger economic recovery,” why weren't they taken much, much sooner?

[I hope that this criticism of the administration doesn't cause the Anita ("I Wanna Be Mao's Girl") Dunn and Robert ("Glenn Beck Is Not Objective") Gibbs to go on a "Funnell hunt" like the "Fox hunt" they've been conducting recently. On the other hand, that might be kind of fun.]

As to this latest "Son of TARP," it may be true that a 3% (as opposed to 5%) dividend rate on preferred stock, and a waiver of warrants for small fry, will attract some community banks to jump in bed with the government. Nevertheless, I think that the hurdles to taking TARP that we've discussed in the past, including the negative public perception of "TARP Babies" (used by some non-TARP takers to publicly castigate TARP recipients in public advertising) and the fact that the government has changed the rules of the game after the fact, will deter many potential recipients from seeking to jump in bed with the government. Many banks who previously took TARP capital infusions have been lining up to pay them back, and some of those recipients have not been happy with the Treasury Department trying to "stick it to them" with the valuation of the warrants that the banks must repurchase. Likely the most enthusiastic applicants will be those banks desperate for a capital infusion, who are also likely to be in such bad shape that they'll not qualify for approval by their federal primary regulator.

Time will tell. Until I see concrete evidence to the contrary, I'm reserving a "healthy skepticism" about how successful this latest round of government largess will be.

You know, if the TARP trickle down continues, sooner or later we're all going to get a little taste of TARP. That will make people like Bill Zucker very happy.

It's Good To Be Too Big To Fail

Sheila Bair offered a sharp observation yesterday, one with which community banks are certain to agree.

As the Federal Deposit Insurance Corp. braces for the 100th bank failure this year — the most since 1992 — Bair warned that small community banks are struggling to compete against behemoths such as Citigroup and Bank of America: Last year's $700 billion bank bailout proved that the federal government is willing to spend whatever it takes to keep the biggest banks from going under.

" 'Too big to fail' has become worse," Bair told USA TODAY. "It's become explicit when it was implicit before. It creates competitive disparities between large and small institutions, because everybody knows small institutions can fail. So it's more expensive for them to raise capital and secure funding."

A study cited in the USA Today article contends that the cost of funds for banks with over $100 billion in assets was an average of 78 basis points less than for all other banks, which constitutes a $34.1 billion advantage for the giants. As ICBA president Camden Fine puts it, that’s not fair in light of the fact that the “too-small-to-save” community banks “didn’t cause this train wreck.” You can’t say the same for many of the bailed out “too-big-to-fail” behemoths. Well, you could say it, but not with a straight face.

Bair also mentioned continuing downward pressure on commercial real estate values as a “continued source of stress” for community banks. That’s like saying that a predator drone-launched Hellfire missile is a “continued source of stress” for its intended terrorist target. Many of us fear that when it comes to the intersection of commercial real estate and community banks, we’re watching an approaching train wreck that we simply can’t tear our eyes away from, and we aren’t quite certain what we can do to avert it.

As we discussed yesterday, the clobbering of commercial real estate values as a result of the economic meltdown isn’t keeping the big banks up at night. CRE loans, described by the linked article as community banks’ “bread and butter,” is merely an appetizer for the big boys. Most of them are too busy screwing servicing consumers to pay much attention to what a local widget manufacturer, or a strip mall owner, needs in order to keep food on the tables of its employees. That’s the job of community bankers, and it’s only fitting that in a world where, if you screw up on a grand scale, you don’t have to pay the piper, that small lenders who stuck to their knitting are, once again, left out in the cold.

It’s almost enough to make a populist out of a running dog lackey of the capitalist oppressors.

The Big Get Bigger

There's a bit of good news and bad news for commercial banks. The good news, according to the CRE-beat blog, is that commercial real estate loans shouldn't bring down the nation's largest banks (in excess of $1 billion in assets). That's because CRE loans account for only 18% of their loan portfolios. The bad news is that for small banks (under $1 billion in assets), CRE loans account for 40% of their loans, which means that community banks are much more vulnerable to continuing CRE woes.

A commenter asks an interesting question which, as of the time this post was written, had not been answered: "Does your calculation of an institution’s CRE loan portfolio include only loans or does it also include CMBS/CDO positions?" If it doesn't include CMBS positions, then bad banks, too, might in for a bad time as CRE values continue to take hits.

FinCriAdvisor has related news, again good for large banks and not good for community banks. 

Despite hand-wringing over the dearth of bank lending, the amount of loans held by financial institutions has dropped only slightly since the crisis unfolded a year ago, a FinCri Advisor analysis shows. Total loans are about the same as two years ago, amid steady increases of commercial real estate, multifamily and farm loans.

Total loans and leases at all financial institutions - the line item FDIC Senior Banking Analyst Ross Waldrop cites to FinCri Advisor as the key data point to explore - is down just 1% since Sept. 2007, standing at $7.63 trillion at end-June. Since the crisis began, loans have fallen steadily 1.4%-1.8% per quarter and 4.5% overall. But 90% of that decline is from banks with $10 billion or more in assets.

[...]

Now the bad news for community banks: Money center banks have seen sudden increases in lending, whereas the rate of decline is accelerating at smaller institutions, FDIC data show. While mortgage lending surged 3.6% last quarter at big banks, for community banks whose bread and butter is mortgage loans, they fell 1%.

"The statistics you present show the creeping seriousness of the problems at banks," says former bank CEO John Mason, now a finance professor at Penn State University. "One of the problems at banks is that they tend to postpone writing off loans. They always think things are going to get better. Even when regulators come along, they have their stories."

That tendency ultimately shows up in dire new figures, Mason says. Over the past five weeks, the absolute (not percentage) decline in loans made by non-money center banks (a decline of $69 billion) has for the first time outstripped that of the top 25 banks ($66 billion), speeding a pattern that emerged over the past quarter, according to Federal Reserve data. The differences are most acute in real estate loans, which fell $48 billion in the last five weeks, of which $38 billion was shed by non-money center banks.

"Here we find the startling difference," Mason notes: Most of the drop for the smaller banks was in commercial real estate loans, with CRE accounting for $24 billion of the $38 billion decline during the 5-week decline. "CRE lending really tanked in the last four weeks in the small banks. You hadn't seen this before," he says. "The economic difficulties in commercial real estate could continue to paralyze the smaller commercial banks for quite some time."

The FinCriAdvisor post contains additional grim statistics and warnings by Sheila Bair, Mason, and others that confirm what those of us in the trenches have been seeing for some time now: CRE problems are bad and they're going to get worse, especially for community banks. For too many of the little guys, it's not a question of having enough capital to lend, it's a question of having enough capital to survive. On the other hand, their big brothers, flush with capital (some of it TARP CPP capital), are grabbing, and will continue to grab, "market share." Thus, while the ranks of community banks will continue to be thinned, too-big-to-fail banks will get bigger. 

What's wrong with this picture?

"Prudent" Financial Regulation

Over at the Financial Post, Jagadeesh Gokhale and Peter Van Doren meet calls for tighter regulation of financial institutions with the argument that tighter regulation won't make things better, it will make things worse. I've heard many argue that financial institution deregulation following adoption of the Gramm-Leach-Bliley Act a decade ago, coupled with the Federal Reserve Board's policy of keeping interest rates low, caused the current crisis or at the very least, were the major fuels that caused it to burn as fiercely as it has. Gokhale and Van Doren disagree.

First, they don't believe that economists can detect coming bubbles (like the housing price bubble) even when the indicators run up and bite them in the backside.

Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy.

Yes, but current day arm chair quarterbacks claim they could have seen it all coming and would have turned the tide. You don't believe that? Well, you aren't reading the comment boxes of blogs, are you? No, neither am I.

As to tighter regulation, Gokhale and Van Doren believe that simply would not have helped avert disaster.

Concerning regulation, we find that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.

Among the points they make to support that contention are:

• Hybrid subprime loans (and "teaser rates") didn't sucker people into loans they couldn't afford. "[T]he majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans." In other words, no matter what the loan terms, many people were taking out loans they couldn't afford to repay regardless of the exotic or vanilla features involved.
• Tighter regulation of swaps wouldn't "have avoided the mispricing of risks in underlying contracts." In other words, regardless of the market used to price and sell and swaps, if the underlying contracts are toxic, the swaps will be toxic.
• The previous (and ongoing) bailouts of large financial institutions will encourage the same, and similar, institutions in the future to do everything they can to skirt whatever regulatory restrictions are put upon them. They know that no matter what regulatory screws are tightened on them, they'll hire the best legal minds to figure a way out of or around the traps, and if those avenues lead to financial failure, Uncle Sam ultimately will save their bacon by stripping it from the hides of the American taxpayer.
• At the same time that the big boys are figuring how to avoid the trap and grab the cheese, the rest of the industry will become a wasteland of financial product innovation. After all, nothing says "cutting edge" and "entrepreneurial spirit" quite like the phrase "we're the federal government and we're here to help you."
• "prudential regulation" sounds nice in theory, but the problem isn't necessarily the inherent prudence of regulators, but the fact that they swim in a sea filled with bottom feeders called "professional politicians." "[A]s recent experience with fiscal stimulus packages shows, political pressures prevent politicians from leaving such systems well enough alone. Any whiff of financial-sector problems will incite Congress and Treasury bureaucrats to tinker with the rules. Which institutions and officials are likely to be sufficiently prescient to correctly calibrate such regulations each time the financial sector hiccups? And would politicians be able to resist calls for regulatory relief when financial sector lobbyists flood their offices as profit opportunities surge? Even more likely, any new regulatory attempt to globally control profit-driven risk-taking will spur new attempts to circumvent regulations." Amen, brothers.

A couple of months ago, I listened to economist David Kotok talk about past banking crises in the United States. He reminded his audience that the banking panic of 1907 spurred Congress to create the Federal Reserve Board to ensure that no such crisis ever occurred again. When it did as a result of the Great Depression, Congress again enacted sweeping legislative and regulatory changes, including the creation of the FDIC and the FSLIC, to, once again, ensure that no more banking crises would occur. Inasmuch as I'm now working on the second banking crisis of my career (the first one having cratered the FSLIC), color me as skeptical as the authors Gokhale, Van Doren, and Kotok of the power of the federal government to prevent human nature from taking its course and to perfect life as we know it through better central planning and control by flawed human beings.

So what's the alternative? How about exercising restraint and actually thinking long and hard before you act to change the world "for the better"? How about letting the losers lose and quit trying to rig the rules of the game to predetermine an outcome that can never be achieved without a lot of the mess and pain that is the natural order of things in a world where freedom means the freedom to hit the ball out of the park or, conversely, to hit into a triple play? How about recognizing both the limitations of federal legislation and regulation to achieve lofty goals and the always present danger  of unintended consequences?

The key lesson from the current financial crisis and recession is that a government-imposed financial architecture is unlikely to persist for any significant length of time. Global market developments, and the need to channel resources toward opportunities perceived to be the least risky and most profitable, will continue to modify institutional financial arrangements. Imposing onerous financial regulations will only impede the reconstitution of financial institutions, delay the recovery, and dampen the pace of long-term economic growth.

Makes sense to me. However, if someone put a gun to my head and forced me to place a bet, I'd bet that this country will opt for "imposing onerous financial regulations." These days, that's just the way we roll.