Are Obama's proposed financial reforms a disaster in the making?

Dr Charles Lieberman explains why President Obama’s pledge to iron out the flaws in the US financial system is somewhat short-sighted.

President Obama announced last month that he wanted to prevent banks from engaging in proprietary trading activities, private equity transactions and hedge fund activities.

In effect, he wants risk-taking completely separated from banking, and the size of financial institutions to be limited.

His objective is to prevent banks from engaging in risky activities to prevent any reoccurrence of the credit crisis that damaged the financial system and contributed to a severe recession.

While his objective is laudable and the financial system is in need of new regulations to protect it more effectively, the proposed approach is naïve and unlikely to be ineffective.

In addition, it fails to reflect what actually happened, is unlikely to be implemented as proposed, panders to the financially unsophisticated public and will contribute to more turmoil in the markets.

The proposals fail to understand how the financial system descended into crisis. Neither Fannie Mae nor Freddie Mac is a bank. Bear Stearns and Lehman Brothers were not banks. AIG was not a bank. J.P. Morgan Chase is a bank, but it engages in proprietary trading and banking and was not damaged by the crisis.

Countrywide engaged in some proprietary trading activities that Obama would no longer permit, but those trading activities had nothing to do with the enormous damage Countrywide inflicted on the financial system by making large numbers of poorly documented sub-prime loans to people who could not afford the homes being purchased or refinanced.

New Century did not engage in proprietary trading activities and was not a bank, but that did not prevent it from making fraudulent or inappropriate sub-prime loans.

Washington Mutual was a bank uninvolved in proprietary trading, but it blew up because of poor mortgage underwriting.

CIT’s bank was uninvolved in its entry into activities that incurred huge losses and forced its restructuring. Hartford Insurance nearly collapsed, but it engaged in no banking activities. I could go on.

The idea of separating risk taking trading operations from banking is also hard to understand. Banks make loans, such as mortgage loans. If they are not permitted to trade these mortgages, they must hold them until maturity.

This has one nice benefit: banks will be more careful about their lending if they are forced to own the loans.

But such a rule also destroys the ability of banks to get liquidity if they need it. If the objective is to have banks retain exposure to loans so that they will underwrite more carefully, then this can be accomplished by setting a minimum retention rate on underwritten loans so banks can sell off the remainder.

The President’s proposal would preclude any bank from owning a hedge fund or proprietary trading activity. How would such a rule be applied to a foreign bank, such as Deutsche Bank, UBS or Barclays?

It is highly doubtful US rules could be applied to such firms. What would prevent any US bank from setting up its trading activity offshore?

All our largest banks already have such trading operations in the world’s premier financial markets, including London and Tokyo. Typically, they even have such operations in secondary financial centres including Singapore, Hong Kong, Paris, Frankfurt and Toronto.

US hedge funds may trade with the operations in New York, but they also trade with the US bank’s trading desks located in the other financial centres. So it is doubtful that any rules could be applied to our own firms.

It is a safe bet that all these points will be made by bank lobbyists.

Obama might blame the lobbyists for obstructing approval for his proposals, but these proposals are likely to fail because financially sophisticated individuals understand how totally irrelevant and inappropriate the proposals would be.

Obama would preclude any firm from proprietary trading and running a bank.

Goldman Sachs would easily circumvent this proposal by giving up its bank charter, a charter it took on only after the crisis broke out.

In fact, that charter gave the Federal Reserve a channel through which it could have extended credit to Goldman.

One of the claims that was made by Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Henry Paulson was they could not extend credit to Lehman because it was not a bank. So they had no choice but to allow it to fail.

Looking back, one of the most serious mistakes made during the crisis was Paulson’s decision to allow Lehman to fail, which rippled through the financial system and provoked the meltdown of the markets.

Government actions unquestionably worsened the credit crisis, and a case can be made that the actions of the government instigated the crisis.

Government actions failed to prevent risky activity even when bank regulators and supervisors were aware of it.

Fannie Mae and Freddie Mac were both compelled by legislation to make risky mortgage loans to low-income borrowers (Barney Frank publicly threatened them for not making enough such loans).

When Paulson took over Fannie and Freddie, he immediately suspended the dividends on their preferred shares, which severely impaired many banks that owned such shares in their portfolios on the recommendation of the Office of the Comptroller of the Currency.

Several banks were destroyed as a result. But this action also rendered it impossible for other banks to raise fresh capital by issuing preferred shares, since investors were afraid to buy such stock after seeing what Treasury had done to the Fannie and Freddie preferred shares.

And as mentioned, the handling of Lehman was a total disgrace that precipitated a collapse in many financial markets.

It led directly to losses at The Reserve money fund, which triggered a run against all money funds, as just one example.

Obama declared that a few large firms will not be permitted to run the financial system. Will the British break up Barclays?

Will the Japanese break up Bank of Tokyo Mitsubishi?

Will the French break up BNP Paribas?

Will the Germans break up Deutsche Bank?

Good luck! So, do we really want to turn our top tier banks into pygmies to compete against these formidable foreign institutions?

Obama’s proposals suggest that the Federal government is engaging in blaming the banks for the financial crisis to divert attention from its own role, as well as to divert attention from other issues.

The proposals are unlikely to pass as proposed, because they are such bad policy it is hard to understand how objective individuals would approve such folly if given the time to understand what is on the table.

Should some version of Obama’s proposals actually pass, very little will have been accomplished in preventing a future financial crisis — and the financial system will get around the proposals quite easily.

So, what should be done?

First, government regulators and supervisors must become significantly more effective. If a firm is engaged in risky activity, regulators must halt that activity before it becomes large enough to sink the organisation.

Higher compensation should be offered to attract better regulators, and the focus should be on risk taking — not just mindlessly checking boxes to confirm that regulations have been adhered to.

The people at the regulatory agencies must also be held responsible for their failures. Inappropriate behaviour should be prosecuted.

Few people been prosecuted so far — even though the cracks in the system began to appear in March 2007.

Second, government agencies need to be combined into efficient regulatory bodies that are aligned with the firms being regulated.

Instead, agency heads have been jockeying to preserve their own turf and responsibility and Congress appears to have backed off from what needs to be done.

Third, capital requirements need to be aligned with risk taking activities. Firms that engage in proprietary trading need to hold more capital than firms that don’t engage in such activity.

Note that this recommendation will not be applied very easily to firms with international operations unless other nations implement the identical capital requirements.

This has been done in the past, so it should not be a major hurdle.

Fourth, politicians need to stop pandering to the masses and manage the technical details associated with a complex financial system.

Populist pandering to the masses hurts, as has been demonstrated by the recent selloff in the market.

In fact, very few firms would actually be affected by Obama’s proposals. Firms like Goldman and Morgan Stanley could simply drop their bank charters and continue with business as usual.

Regional banks that have no proprietary trading activities (which is almost all of them) would find the new rules irrelevant to them. J.P. Morgan Chase, Citigroup and Bank of America would be most adversely affected, but would simply relocate certain activities offshore.

So, why did the stock market sell off so sharply? Investors were appalled at the populism and inability of the government to manage the financial system.

If this is the best they can do after all this time, how do we gain confidence that the government would do a better job of avoiding another financial crisis at some time in the future?

Obama’s financial proposals, if implemented, would be an unmitigated disaster.

Dr Charles Lieberman is chief investment officer at Advisors Capital Management, LLC in New Jersey. This article originally appeared in Advisor Perspectives in the US.