Still at Risk

Demos

Still at riSk A special report on the financial reform we need— but aren’t yet getting.

Featuring:

Simon Johnson Elizabeth Warren Michael Greenberger Robert Johnson Nomi Prins Robert Kuttner

contents A2 Reform and Its Obstacles

by robert Johnson

A4 Too Big for Us to Fail

by simon Johnson and James Kwak

Reform and Its Obstacles

A6 Consumer Protection

There is no mystery about how to simplify the financial system. The main obstacles are political.

By Robert Johnson

as Systemic Safety

by Elizabeth Warren

A8 Out of the Black Hole

by Michael Greenberger

A10 Watching the Watchers

by James Lardner

A12 Shadow Banking

by Nomi Prins

A14 No More Phony Accounting

by Frank Partnoy

A15 Sand in the Gears

by Robert Weissman

A17 Coalition of the Unwilling

by Heather McGhee

A18 Simplifying Securitization

by Jane D’Arista

A20 Cleansing the Temple

by Tim Fernholz

A22 Banking on Presidential Leadership

by Robert Kuttner

Illustrations by Jason Schneider

this special report appears in the June 2010 issue of The American Prospect magazine and was made possible through the generous support of the Panta Rhea Foundation, the Charles Stewart Mott Foundation, and The Nathan Cummings Foundation.

For bulk reprints, please contact Richard Boriskin at rboriskin@prospect.org. special report editor Robert Kuttner subscription customer service 1-888-MUST-READ (687-8732)

subscription rate $24.95 copyright © 2010 by the american prospect, inc.

a2 june 2010

E

ighteen months into the greatest economic crisis since the Great Depression, the United States government has not enacted significant financial reform. Nor is the legislation now pending in Congress likely to deliver the profound change we need.

When the U.S. Treasury secretary tells us that the bailouts of large complex financial institutions, however distasteful, were necessary to save the economy, he is telling us two things—one spoken and one unspoken. He explicitly states the need to give these behemoths taxpayer funds because if large institutions are allowed to fail, we will get dragged down with them into a depression. What’s not stated clearly is that these spillovers from finance to the larger economy are also grounds for very substantial financial regulation prior to the onset of a crisis— the proverbial ounce of prevention.

We need new laws and a new regulatory ethic to arrest the dominance of a financial sector that looms too large on our economic landscape. No one can argue that an industry that reaped 41 percent of all corporate profits before the crisis, and caused so much enduring damage, contributes to the economy anything on that order of magnitude. It is emblematic of the power of Wall Street that self-proclaimed deficit hawks, so keen on entitlement reform, fail to exhibit comparable zeal when it comes to preventing catastrophic events that will add at least 30 percent to the ratio of national debt to gross domestic product.

One more financial crisis and America’s public finances will resemble Italy’s. what should be done? There are a few key principles associated with proper reform. They are not hard to identify but

very difficult to legislate, given the sheer power of the financial industry.

Drastic simplification is the core need.

That means replacing complex, opaque instruments and contracts with simple and transparent ones. This will allow investors and consumers to understand what they are buying. Simplification will make it possible for top management at large financial institutions and regulators to regularly monitor the value of assets and the condition of a firm’s balance sheets.

A related imperative is to reform offbalance-sheet practices that are really just evasion schemes to increase leverage.

On the eve of the crisis, leverage ratios of 30 to one and beyond were commonplace.

When you climb up that high, it hurts more when you fall and have less cushion on which to land. We need to restore the integrity of pricing. Assets need to be marked to their market value rather than valued according to abstract models that may bear little resemblance to what they could be sold for. This reform would restore adequate capital buffers.

A third principle of financial reform is simple usury prohibition. The plain mathematics of interest rates of 30 percent cannot be sustainable at low levels of growth and inflation. Once caught in a vortex of interest rates of this magnitude, citizens have little hope of escape.

This is not a product of reckless borrowing but the unstable logic of rates moving on outstanding balances from 7.99 perw w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m cent, where finances can be managed, to 30 percent, where you cannot keep up.

Fourth, we need to align the social and private incentives of taking risk. Separating activities that are extraordinarily profitable because of inherent conflicts of interest, such as the conflict between in-house proprietary trading and executing customer business, is one example.

Risky activities must be prohibited for firms under the protective umbrella of deposit insurance.

Large, complex financial institutions must be subjected to market and regulatory discipline, rather than being indulged as “too big to fail.” Thanks to that premise, such institutions enjoy a lower cost of funds. This competitive advantage, coupled with ever-larger proportions of the nation’s balance sheet being under a protective umbrella, encourages excessive risk-taking.

The premise that an institution is too big to fail also anesthetizes creditors from the need to exercise diligence against the risk of failure. This is the “doom loop” that Andrew Haldane of the Bank of England identifies as the consequence of failure of reform, leading to an ever-larger crisis.

On this point, there is a clear consensus among experts at the Bank for International Settlements and the Financial Stability Board, though not within the U.S. Congress. Reform of “too big to fail,” at minimum, would include systems for resolution of failed financial companies that are harmonized internationally; a vast increase in the capacity of regulators to assess the real-time condition of large, complex institutions; exposure limits on cross-firm asset-holding to deter contagion; and derivatives reform so that balance sheets can be understood and monitored.

A simple menu of what we need includes: ■ Derivatives reform; ■ Off-balance-sheet reform; ■ Rating-agency reform;

of housing finance; of risky activities from the financial safety net; ■ Separation of activities that have inherent conflicts of interest within a firm; ■ Legal resolution powers for large failed institutions, with consistent crossborder standards; ■ Significant increase in resources and salaries for supervision, examination, and regulation; and ■ Consumer financial protection.

■ Restructuring ■ Separation

yet despite appearances, none of these reforms is truly included in pending legislation. Why can’t we get real financial reform? Some argue that the issues are so arcane that the public can’t comprehend the differences between real and cosmetic reform.

But there is abundant evidence that the public is not so easily deceived.

In fact, the widespread rage

unemployment and an angry electorate.

Elected officials are trying to reconcile their need to appease donors in the financial sector with recognition of the legitimate demands of an enraged public.

But they cannot do both. Public-­opinion polls such as the recent Pew Survey on reform reveal acute public concern and awareness of the issue of financial reform. Anger at the banks was clear in Massachusetts during the January special Senate election. President Barack Obama’s advisers must have recognized this, too, as they briefly trotted out Paul Volcker before quietly setting aside his proposals for financial reform. Gallup polls show that the Federal Reserve is now less popular than the Internal Revenue Service.

So with the dual needs of campaign finance from Wall Street and demands from the public, our legislators are on course to engage in a theatre of pretend reform centered on two elements: strong consumer financial protection and bold declarations that they have ended “too big to fail.” But inside the triangle of

We need a new regulatory ethic to arrest the dominance of a financial sector that looms too large on our economic landscape. at Wall Street, which pundits decry as “populism,” is really quite valid. Elected officials often disparage public intelligence when the public wants something that is in conflict with the powerful. It is their form of denial when their jobs are in peril.

Given the high cost of campaigning, many politicians follow the wishes of donors rather than pursuing strong policy. This temptation will only worsen as a result of the recent Supreme Court decision in Citizens United v. FEC, allowing unlimited corporate political spending.

We have one too many markets. The market for the purchase of rules of the game is far too strong when behemoth financial institutions have tens of billions of earnings at risk and legislation can be blocked or modified by contribution-­hungry legislators trying to survive with high

negotiation between House, Senate, and administration bills, with lobbyists working behind the scenes, there is little real reform that will accomplish these tasks.

Most of the needed reforms are either ignored or addressed only cosmetically in pending legislation. The Dodd bill would give the Federal Reserve the proposed Consumer Financial Protection Agency. This is an odd pairing to say the least. The biggest systemically significant institutions are convinced that the Fed has to court them to get proper information for supervisors and examiners; it is difficult to believe that the Fed will antagonize the large banks by enforcing laws on the consumer frontier.

These two missions are incompatible and one can only surmise that the consumer protection will be enacted in spirthe american prospect

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it more than implemented in substance.

More generally, after their failures and contributions to the crisis over the last 20 years, it is bizarre to see the Federal Reserve being given increased responsibility. It is not clear how we will inspire an “extreme makeover” of regulatory incentives inside an institution more responsive to banks than to people that has clearly failed in the eyes of the American public.

The problem now for progressive voters is not dissimilar to the situation they faced on health care. Real reform will not be produced by the White House and Congress, both controlled by the Democratic Party. Failure to pass any bill would likely lead to cries across the country that the Democrats, with both the presidency and substantial majorities in both houses of Congress and the White House, are in the pocket of Wall Street and should suffer at the voting booth. Cosmetic reform will perhaps avoid the criticism that Democrats are unable to govern, but it will not address the true structural issues and will leave the prospect of an even more violent crowding out of social expenditure after the next round of bailouts.

With the pressure to support what Ralph Nader called the “least worst” party, will progressives join the dance and pretend they have real consumer financial protection? Will they delude themselves into believing that the proposed legislation would end “too big to fail” and the risk of future taxpayer bailouts? Or will they refuse to be party to rituals of false remedy and see that crony financial bailouts and episodes like the failure of Lehman Brothers and the bailouts of American International Group, Bear Stearns, and Citigroup could all happen under this new legislation much as they did before? We deserve better, and it is not too late to demand it.

Robert Johnson, formerly the chief economist of the Senate Banking Committee, is the director of global finance and senior fellow at the Roosevelt Institute in New York and the executive director of the Institute for New Economic Thinking. a4 june 2010

Too Big for Us to Fail We need counterweights not just to Wall Street’s toxic products but to its malign influence.

By Simon Johnson and James Kwak

F

inancial regulatory reform was on few people’s minds when Barack Obama launched his presidential campaign in February 2007. But with the near collapse of the global financial system in 2008, leading to high unemployment and high government deficits for years to come, it became frighteningly obvious that something had to change.

However, in one respect—the politics of financial reform—nothing has changed.

The Obama administration has led the push to reform the financial system.

We agree with many of its proposals, including a strong Consumer Financial Protection Agency, dedicated oversight of systemic risk, and new requirements to move derivatives onto exchanges and central clearinghouses. At the same time, we do not think the administration has gone far enough to curb the behavior of “too big to fail” institutions and mitigate the risk that they pose to the financial system and the economy. But these reasonable debates over how the regulatory system should be overhauled are peripheral to a more fundamental issue: the political power of the financial sector, which determines how the regulatory system will be overhauled, if at all.

The growth of the megabanks, the rapid spread of financial “innovation,” the excessive risk-taking of the past decade, and the financial crisis were not purely economic phenomena. They had deeply political roots, in the deregulatory philosophy of the Reagan Revolution and the ideology of finance spawned by freemarket economists. And the big profits on Wall Street were made possible in the halls of power in Washington.

From the Garn St.-Germain Act of 1982 (substantially deregulating savings and loan institutions) to the Gramm-LeachBliley Act of 1999 (allowing combined

commercial and investment baking) and the Commodity Futures Modernization Act of 2000 (permitting largely unrestricted trading in derivatives), Congress relaxed the regulatory constraints that had housebroken the financial industry since the 1930s, while failing to establish effective oversight of custom derivatives.

The Federal Reserve spent the 1990s relaxing constraints on commercial banks and the 2000s neglecting to enforce consumer-protection laws against predatory mortgage lenders. In 2004, the Securities and Exchange Commission relaxed capital requirements for major investment banks in exchange for the power to oversee them through the Consolidated Supervised Entity program—a program that failed spectacularly with both Bear Stearns and Lehman Brothers. the core failure of the past 30 years was not that Wall Street financial engineers thought of clever ways to make money; that is absolutely par for the course. The failure was that Wall Street was able to gain sufficient influence in Washington to win favorable policies from Congress, regulators, and both Democratic and Republican administrations. The banks earned their political power the old-fashioned way, through campaign contributions and lobbying expenditures; the financial sector was the primary source of campaign money for the past two decades, and its contributions grew disproportionately rapidly over the period. More important, the popularization and spread of the ideology of finance meant that politicians and government officials increasingly came to sincerely believe that what was good for Wall Street was good for America.

The collapse of Lehman Brothers and the near failures of Morgan Stanley and w w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m Goldman Sachs—chronicled in detail in Andrew Ross Sorkin’s Too Big to Fail— should have shaken this belief. The recent report by Anton Valukas, the examiner in the Lehman bankruptcy, revealing a history of (at best) misleading accounting and lax government oversight, should have obliterated its remains. But although Washington is more willing to regulate now than in years past, one thing has emphatically not changed: the power of the banking industry to fight back. All of the techniques honed over the past few decades have been evident in full force over the past year.

One technique is the use of complexity.

The modern financial world is complex, and most of the experts work on or for Wall Street. When it comes time to draft new legislation governing highly technical topics such as derivatives, those insiders have a clear advantage over most congressional staffers. In November, William Greider described how derivatives dealers wrote the draft legislation reforming regulation of derivatives and funneled it into Congress via conservative Democrats on the House Financial Services Committee. Administration officials such as Gary Gensler, chair of the U.S. Commodity Futures Trading Commission, have fought to close the loopholes in that draft bill, but the Senate bill introduced

by Christopher Dodd in March contains its own new exemptions.

Another technique is to hide behind “ordinary people.” During the boom years, one major argument for financial innovation was that it increased homeownership—a tenet subscribed to by both the Bill Clinton and George W. Bush administrations. Early in 2009, the American Bankers Association opposed legislation giving bankruptcy judges the power to modify the terms of mortgages on the grounds that it would “make home loans more expensive and less available for consumers.” As the legislative battle heated up in the summer and fall, the financial lobby rolled out “end users” of derivatives—corporations that use options or futures for legitimate hedging of risks— to testify against regulatory reform. The U.S. Chamber of Commerce pitched in with advertisements warning ominously

that stronger consumer-protection rules would be bad for American business.

The framing of the argument has changed. It is no longer that unrestricted finance will bring benefits to all Americans; it is now that restricting finance will actively cause harm to Americans.

In effect, the financial sector is attempting to hold the economy hostage yet again. Handcuff the banks, for example, by making it harder to increase interest rates on credit-card customers, and many people will lose access to credit.

Or so the threat goes.

Even as the ideology of deregulation has been exposed as a failure, the banks and their political allies are still invoking the bogeyman of big government to fight off financial reform. Political consultant Frank Luntz clearly spelled out the strategy to demonize reform by branding it as more bureaucracy, bailouts, and specialinterest loopholes. This has created the Orwellian specter of Republicans introducing special-interest loopholes into reform legislation (such as an exemption

finance, insurance, and real-estate sector spent over $463 million on lobbying in 2009, the most ever. (The banking and securities industries were responsible for $144 million of that total, also a record.)

Even Citigroup spent over $5 million on lobbying—although the government was its largest shareholder.

In sum, though the financial crisis hurt the megabanks’ profits (for a quarter or two, at least), it did nothing to weaken their political power. If anything, increased concentration only increased the stature and influence of the survivors, and the Supreme Court’s 2009 decision in Citizens United put politicians on notice that corporate influence over politics is likely only to grow what would it take to curb the political power of the financial sector? Grassroots campaigns, such as the Move Your Money campaign to take money out of large banks, could have a small impact.

New laws or constitutional amendments to restrict the role of money in politics

Unfortunately, government officials came to sincerely believe that what was good for Wall Street was good for America. for automobile dealers from the proposed Consumer Financial Protection Agency, introduced by Rep. John Campbell, a Republican) and then criticizing the same legislation for its loopholes.

Journalists Ryan Grim and Arthur Delaney have documented how Democrats have placed new, relatively conservative members of Congress from Republicanleaning districts on the House Financial Services Committee, because it increases their ability to raise money. Unfortunately, the effect was to create an influential bloc of banking-friendly Democrats on the committee, who allied with Republicans on certain issues to weaken financialreform legislation, against the wishes of committee Chair Barney Frank.

At the same time, lobbying by the financial sector has reached record levels. According to data collected by the Center for Responsive Politics, the

would certainly help. Restrictions on compensation, by making banking less lucrative and less alluring, would help reduce the ideological hegemony of Wall Street. Breaking up the megabanks, by increasing competition and increasing the costs of collective action, would help most of all.

Ultimately this will come down to a battle of ideas, one that will take years to win. As long as people think that finance is inherently good and big finance is inherently better, Washington will remain easily swayed by Wall Street. The political power of the banking industry is not simply a product of its deep pockets; imagine, for example, how much harder and more expensive it would be for the tobacco industry to dominate Washington. Tobacco once had far more power than it does today.

Its diminished influence shows the influthe american prospect

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ence of citizen and government efforts— a story that should give us hope that finance can also be constrained.

We should not think of finance as the pride and joy of our economy but as something like a regulated utility (an industry on which the economy depends but that should be watched over carefully) and something like big tobacco (an indus-

try that makes toxic products with huge negative externalities). Shifting the conventional wisdom in this direction will be a prerequisite for fundamental reform of both the financial system and the political system in the long term. tap Simon Johnson and James Kwak are the authors of 13 Bankers.

Consumer Protection as Systemic Safety If we safeguard consumers, we also save the entire financial system from its own excesses.

By Elizabeth Warren

T

he Senate is in the midst of a fierce battle over the future of the consumer-credit market. If you aren’t watching, you should be.

While President Barack Obama and reform advocates are pushing for the sort of meaningful rules that would fix a badly broken credit market, Wall Street is pouring millions of dollars into blocking any changes that could force the industry to change how it does business.

At the center of this fight is a proposal for a new consumer agency with the authority to write meaningful rules and with the teeth to enforce those rules.

Senate Banking Committee Chair Chris Dodd’s latest proposal, which the committee recently reported to the full Senate, would house the watchdog in the Federal Reserve System. Although the agency would not be stand-alone, as it was in the version Barney Frank led the House to approve, the Senate bill still gives it substantial authority. Sen. Jack Reed of Rhode Island is pushing for a truly independent agency, as the president proposed, while Sen. Richard Shelby of Alabama is leading the charge to put the agency more directly under the thumb of the regulators who have routinely favored banking interests.

Whether the consumer agency can sura6 june 2010

vive in meaningful form will be up to the Senate in the days ahead and then the House-Senate conference. today, nearly every product sold in America has passed basic safety standards well in advance of being put on store shelves. A focused and adaptable regulatory structure for drugs, food, cars, appliances, and other physical products has created a vibrant market in which cutting-edge innovations are aimed at attracting new consumers. Businesses can’t boost profits by substituting baking soda for antibiotics or weaker plastics in infant car seats. To grow, they need to make safe and effective products that satisfy consumers.

By contrast, credit products are regulated by a bloated, ineffective concoction of federal and state laws that have failed to adapt to changing markets. Costs have risen, and innovation has produced incomprehensible terms and sharp practices that have left families at the mercy of those who write the contracts. Profits come from tricks and traps, surprise fees, hidden risks, and sudden increases in interest rates.

While manufacturers have developed iPods and flat-screen televisions, the financial industry has perfected the

art of offering mortgages, credit cards, and check overdrafts laden with hidden terms that obscure price and risk.

Good products are mixed with dangerous products, and consumers are left on their own to sort out which is which. The consequences can be disastrous. More than half of the families that ended up with high-priced, high-risk sub-prime mortgages would have qualified for safer, cheaper prime loans. A recent Federal Trade Commission survey found that many consumers cannot understand, or even identify, key mortgage terms.

This information gap between lender and borrower exists throughout the consumer-credit market. So-called innovations in credit charges—including teaser rates, negative amortization, increased use of fees, universal default clauses, and penalty interest rates—have turned ordinary credit transactions into devilishly complex undertakings. Study after study shows that credit products are deliberately designed to obscure costs and to trick consumers. The average credit-card contract is dizzying. Credit-card contracts that were a little over a page long in 1980 have ballooned to an unreadable 30 pages today. Lenders advertise a single interest rate on the front of their direct-mail envelopes while burying costly details and hidden fees deep in the contract.

Faced with impenetrable legalese and deliberate obfuscation, consumers can’t compare offers or make clear-eyed choices about borrowing. Creditors can hire an army of lawyers and MBA s to design their programs, but families’ time and expertise have not expanded to meet the demands of a changing credit marketplace. As a result, consumers sign on to credit products focused on only one or two features—nominal interest rates or free gifts—in the hope that the fine print will not bite them. Real competition, the head-to-head comparison of total costs that results in the best products rising to the top, has disappeared.

What’s worse, the proliferation of toxic products fed enormous and unsustainable risk into the financial system. The lack of meaningful consumer-protection rules triggered an economic crisis that truly began one household at a time, w w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m eventually rocking the most storied institutions on Wall Street and wrecking the larger economy. While the explosive growth of risk and deceptive consumer products should have served as an early warning system, Washington plainly wasn’t paying attention.

The lack of meaningful oversight in Washington is the direct result of the immense political power of the financial industry and its success at heading off robust rules. The industry’s onslaught over time has left us with a sluggish, bureaucratic regulatory system that is designed to be ineffective. Today, consumer-protection authority is scattered among seven federal agencies. But not one of those agencies has real accountability for making consumer protection work, and, as a result, not one has been successful at doing so.

The seven agencies with a piece of consumer protection have failed to create effective rules for two structural reasons. The first is that financial institutions can currently shop around for the regulator that provides the least oversight. Bank-holding companies can shift their business from their regulated subsidiaries to those with no regulation­—and no single regulator can stop them. The problem is exacerbated by the funding structure: Regulators’ budgets come in large part from the institutions they regulate. To maintain their size, these regulators compete to attract financial institutions, with each agency offering more bank-friendly regulations than the next. The result has been a race to the bottom in consumer protection.

The second structural flaw is cultural: Consumer-protection staffs at existing agencies are small, are low priorities for funding, and invariably play second fiddle to the primary mission of the agencies.

At the Federal Reserve, senior officers and staff focus on monetary policy, not protecting consumers. At the Office of the Comptroller of the Currency and the Office of Thrift Supervision, agency heads worry about bank profitability and capital adequacy requirements. As the current

crisis demonstrates, even when they have had the legal tools to protect families, existing agencies have shown little interest in meaningful consumer protection.

The new consumer agency is designed to fix these structural problems by consolidating the scattered authorities, reducing bureaucracy, and ensuring an agency in Washington is on the side of families to counterbalance the industry’s enormous political power. By giving this agency a clear mission and making it answerable directly to Congress and the American people, we can begin to reverse decades of regulatory capture. By staffing it with people who believe in the importance of family economic security—not just banking profits—we can allow the agency to develop the expertise to fix the broken consumercredit market and give families a fighting chance against the resources of Wall Street banks.

American Enterprise Institute. Shorter, clearer contracts will allow consumers to begin making real comparisons among products and to protect themselves.

Better transparency will mean a better­f unctioning market, more competition, more efficiencies, and, ultimately, lower prices for the families that use them.

A century ago, anyone with a bathtub and some chemicals could mix and sell drugs—and claim fantastic cures. These “innovators” raked in profits by skillfully marketing lousy products because customers weren’t equipped to analyze and compare treatments. In the decades following, the Food and Drug Administration developed a few basic rules about safety and disclosure, and everything changed. Companies had greater incentives to invest in research and to develop safer, more effective drugs. Eliminating bad remedies made room for creating good ones.

The FDA cannot prevent drug over­ doses, and the new consumer agency cannot stop overspending. Nothing will

Today, nearly every product sold in America has passed basic safety standards. Yet dangerous credit products lack real oversight.

The consumer agency would be able to revolutionize consumer credit by promoting simple, straightforward contracts that allow consumers to make betterinformed choices. For decades, policymakers mistakenly followed the principle that more disclosure promotes product competition. What they missed is that more disclosure is not necessarily better disclosure. The extra fine print has given creditors pages of opportunity to trick unsuspecting customers. Comparison shopping has become impossible.

The new agency would cut through the fragmented, cumbersome, and complex consumer-protection laws, replacing them with a coherent set of smarter rules that will bring more competition into the market. These rules will drive toward shorter, easier to understand agreements, like the one-page mortgage agreement promoted by the

ever replace the role of personal responsibility. A credit-card holder who goes on an unaffordable shopping spree should bear the consequences, as should someone who buys an oversize house or a budget-­busting new car. Instead, creating safer marketplaces is about making certain that the products themselves don’t become the source of trouble.

Most consumers—those willing to act responsibly—would thrive in a credit marketplace that makes costs clear up front. And for the vast majority of financial institutions that would rather win business by offering better service or prices than by hiding “revenue enhancers” in fine print, the consumer agency would point the way to a more efficient and competitive financial system. tap Elizabeth Warren is the Leo Gottlieb Professor of Law at Harvard University. the american prospect

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Out of the Black Hole Reining in the reckless market in over-the-counter derivatives

By Michael Greenberger

I

n September 2008, the United States faced what President Barack Obama called the “most profound economic emergency since the Great Depression.”

A mortgage crisis begat a credit crisis, shaking the entire financial system and sending the U.S. economy into what has been called the Great Recession.

This crisis was caused in large part by the opaque and unregulated over-thecounter (OTC) derivatives, or “swaps,” market, which was then estimated to have a value of almost $600 trillion, or 10 times the world’s gross domestic product.

Approximately one-tenth of the unregulated OTC market was made up of the nowinfamous credit-default swaps, a product that Wall Street sold to “insure” sub-prime mortgage investments but which lacked regulation and, therefore, the capital required to support these “guarantees.”

When sub-prime investments failed, the “insurance” payments were triggered.

Only the multitrillion-dollar U.S. taxpayer interventions to save Wall Street prevented a worldwide depression.

This crisis was the direct result of the deliberate dismantling of regulatory safeguards. After the collapse of the equity markets and then the banking system between 1929 and 1933, the Roosevelt administration drove the passage of the Securities Acts of 1933 and 1934 to regulate securities, and the Commodity Exchange Act of 1936 to regulate futures transactions. These landmark legislative efforts established eight classic regulatory norms to prevent systemic financial collapse in financial markets, including transparency of prices, recordkeeping, capital adequacy, full disclosure, anti-fraud and anti-manipulation prohibitions, regulation of intermediaries, private enforcement through litigation, and the federally supervised self-regulation of financial exchanges. a8 june 2010

These eight guidelines still govern ordinary stock markets today, and it is noteworthy that malpractices in conventional securities played no role in the 2008 systemic worldwide collapse. These norms had governed the futures markets until 1993 when Wall Street insisted that OTC derivatives be exempt from those traditional regulations. In that year, an accommodating Commodity Futures Trading Commission (CFTC) created an exemption for a limited class of OTC derivatives from classic market regulation.

However, Wall Street almost immediately became dissatisfied with the constraints of the 1993 exemption. Wall Street wanted to sell a far broader range of profitable swaps that could not meet the 1993 restrictions. By 1998, the market grew to over $80 trillion, with swaps dealers conducting most of that business in complete disregard of controlling law.

As a result, in May 1998, the CFTC, under the leadership of then-Chair Brooksley Born, issued a “concept release” inviting public comment on how this multitrilliondollar unsupervised and opaque market should be regulated. The release was premised on several systemically destabilizing events that had been caused by unregulated OTC swaps.

At the behest of Wall Street, a Republican-­controlled Congress passed legislation enjoining Born from this work and then, on the recommendation of the senior Clinton economic team including among others then–Secretary of the Treasury Larry Summers and Fed Chair Alan Greenspan, rushed through a 262page rider to an 11,000-page omnibus appropriations bill on Dec. 15, 2000— the last day of a lame-duck session. The rider, the Commodity Futures Modernization Act (CFMA), removed what was by then the $94 trillion OTC–­derivative market from all federal regulation.

In one fell swoop, the OTC market was exempt from the traditional market regulatory controls, including capitaladequacy requirements; reporting and disclosure; regulation of intermediaries; supervised self-regulation; and bars on fraud and manipulation. Overnight, the entire OTC market was legitimized as a private market, wholly opaque to financial regulators and market observers.

To understand the central role played by OTC derivatives in the recent meltdown, a review of sub-prime securitization is necessary. In brief, the securitization of sub-prime mortgage loans evolved to include simple mortgage-backed securities within highly complex collateralizeddebt obligations. CDOs packaged huge numbers of mortgage-backed securities, then sliced up those instruments sorted by supposed degree of risk for sale to investors, the so-called tranches. This process, in theory, would offer diversified and graduated risk options to sub-prime mortgage investors.

However, investors became unmoored from the essential risk underlying loans to noncredit-worthy individuals by the continuous reframing of the form of risk (from sub-prime mortgages to mortgage-backed securities to CDOs); the misleading assurances given by creditrating agencies; and, most important, the undercapitalized “insurance” offered on CDOs in the form of credit-default swaps—the poster child for unregulated OTC derivatives.

That “swap” was the exchange by one counter party of a “premium” for the other counterparty’s “guarantee” of the financial viability of a CDO. While creditdefault swaps have all the hallmarks of insurance, issuers of these swaps in the insurance industry were urged not to call it “insurance,” because the transactions would be subject to state insurance law, which would have required, among other protections, adequate capital underpinning the guarantees. Swaps fell into the regulatory black hole created by the CFMA . Federal regulators had no knowledge of, or control over, the multitrillion-dollar world of swaps.

Because a credit-default swap was deemed neither insurance nor a transacw w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m tion otherwise regulated by the federal government, issuers were not required to set aside adequate capital reserves to stand behind the guarantee of CDOs. The issuers of the swaps were beguiled by the utopian view (supported by ill-considered mathematical algorithms) that housing prices would always go up. They believed that even a borrower who could not afford a mortgage at initial closing would soon be able to extract the appreciating value in the residence to refinance and pay mortgage obligations. Under this utopian view, the writing of a credit-default swap was deemed to be risk-free. The issuers had as their goal the writing of as many swaps as possible to develop the huge cash flow from the “premiums.”

To make matters worse, the swaps were deemed to be so free of risk (and so much in demand) that financial institutions began to write “naked” credit-default swaps, offering the guarantee to investors who had no risk in any underlying mortgage-backed instruments. (Under state insurance law, if this had been deemed insurance, rather than a swap, it would be considered insuring someone else’s risk, which is flatly banned.)

Naked credit-default swaps provided a method to “short” the mortgage-lending market, allowing speculators to place low-cost bets that those who could not afford mortgages would default.

Because both naked swaps and synthetic CDOs were nothing more than bets on the viability of the sub-prime market, at Wall Street’s behest, the CFMA banned application of state gambling laws to these transactions.

It is now well established that: ■ Issuers of credit-default swaps did not have adequate capital to pay off guarantees as housing prices plummeted, thereby defying the supposedly “risk free” nature of issuing huge guarantees for relatively small premiums.

■ Because credit-default swaps are private and bilateral arrangements unknown to federal regulators or market observers, the triggering of such swaps often came as a surprise to both the financial community and regulators.

■ As the housing market worsened, new swap obligations were unexpectedly triggered, creating heightened uncertainty about the viability of financial institutions that had, or may have, issued these instruments, thereby leading to the tightening of credit generally.

■ The issuance of “naked” credit-default swaps increased exponentially the obligations of swap underwriters, since every time a subprime mortgage defaults

This economic crisis was the direct result of the deliberate dismantling of key financial regulatory safeguards.

The problem was further aggravated by the development of “synthetic” CDOs. Again, these synthetics were mirror images of “real” obligations, thereby allowing an investor to play “fantasy” securitization: The purchaser of a synthetic CDO did not “own” any of the underlying mortgages or securitized instruments but was simply placing a “bet” on the financial value of a real CDO being mimicked. Synthetic CDOs are also OTC derivatives and therefore not subject to federal regulation. Synthetic CDOs were also “insured” by unregulated swaps.

there is both the real financial loss and the additional loss derived from failed bets.

■ This securitization structure is present not only in the sub-prime mortgage market but in the prime mortgage market, as well as in commercial real estate, credit-card debt, and automobile and student loans. As of this writing, the financial media is filled with concerns that forfeitures in many of these markets will worsen substantially, thereby triggering many more swaps for which there will almost certainly be insufficient capital to pay the guarantees,

thereby restarting the downward cycle that drove the country into recession.

In June 2009, in response to the catastrophic systemic failure caused by unregulated derivatives, the Obama administration issued a white paper proposing that all standardized OTC derivatives be subject to clearing and exchange trading. It proposed that they be overseen in accordance with the traditional dictates of market regulation that had been in place since the New Deal but were abandoned under the CFMA .

The administration also recommended that “all OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation,” including the imposition of increased capital requirements, business conduct standards, and auditing requirements.

However, on Aug. 11, 2009, the Treasury Department submitted to Congress a specific legislative proposal that substantially undermined the Obama administration’s June 2009 stated goal of “bring[ing] the markets for all OTC derivatives … into a coherent and coordinated regulatory framework that requires transparency and improves market discipline.”

On Aug. 17, 2009, CFTC Chair Gary Gensler, in a letter to Congress, critiqued the Treasury’s proposed loopholes as being so broad that they could “swallow up the regulation.” While key legislative supporters of the Treasury proposal maintain that its loopholes only exempt 20 percent to 30 percent of the $600 trillion market, respected experts both within and outside of the Obama administration have estimated that almost 60 percent of that market will be unregulated by virtue of only one of the two major loopholes supported by Treasury with state gaming laws unable to stifle any of the rampant “betting” permitted within the unregulated part of the OTC market.

On Dec. 11, 2009, the House passed HR 4173, which contains derivatives language that generally follows the August the american prospect

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2009 Treasury proposal. As of this writing, Sen. Blanche Lincoln has, to the surprise of many observers, just circulated a bill that either eliminates or substantially limits the Treasury loopholes. The Democratic Senate majority now appears to support her effort, and President Obama has just warned wary Republicans that any financial-reform bill that does not strictly regulate the OTC market will be vetoed.

Unregulated OTC derivatives have been at the heart of systemic or near systemic collapses—from the 1994 bankruptcy of Orange County, California; to the collapse of Long Term Capital Management in 1998; to the bankruptcy of Enron in 2001–2002; to the 2008 subprime meltdown; and now to an emerging European sovereign-debt crisis in which derivatives were used to disguise the extent of debts taken by nations such as Greece. After each crisis, governments worldwide proclaim that the OTC market must be regulated in the same manner as equity markets, which are dwarfed in value by OTC derivatives. However, Wall Street always deflates those aspirations with aggressive lobbying and campaign contributions. The present financial-reform regulatory effort may be the last chance to prevent the kind of crisis that was dodged in 2008—a worldwide depression. Wall Street and its allies must be stopped now.

To avoid further systemic and irreparable meltdowns, legislation must be enacted that requires all standardized derivatives to be guaranteed by well-capitalized clearing facilities and traded on fully transparent and well­regulated exchanges. This is what the Obama administration’s June 2009 white paper promised. The president and Congress should be made to stick to that promise, or the world economy will devolve into a black hole with far greater pull than the regulatory black hole that exists for swaps. tap Michael Greenberger is a professor at the University of Maryland School of Law and a former division director at the U.S. Commodity Futures Trading Commission. a 10 j u n e 2 0 1 0

Watching the Watchers The corruption of credit-rating agencies was at the heart of the financial collapse. So far, Congress has not had the nerve to pursue fundamental reform.

By James Lardner

C

redit-rating agencies exist to evaluate the safety of debt securities. Imagine for a moment that they had done their job when financial go-getters began churning out bonds backed by sketchy loans and the dream of endlessly rising home prices. Properly labeled as junk, those bonds would have found few buyers. Denied access to the vast reservoirs of capital held in mutual, money-market, and pension funds, the go-getters would have ended up as minor players. And millions of Americans might still have the jobs, homes, retirement savings, and economic security they lost.

Now imagine what it would take to get the rating agencies to do their job properly. The problem is one of glaring, undisputed, inescapable conflict of interest. Why did the rating agencies gloss over the huge risks of mortgagebacked bonds and collateralized debt obligations? Because that was the way to attract business from the securities issuers who paid them, picked them, and, in many cases, had their help structuring securities to achieve the desired rating.

The first imperative of reform, then, is to align the incentives of these badly corrupted entities with their mission.

The most promising proposal, outlined in a policy paper by David Raboy, an economic consultant to the congressional panel overseeing the bailout, envisions an independent clearinghouse to collect fees from securities issuers and assign bond offerings to ratings agencies at random. This would be a game changer: The rating agencies, which have lately become Wall Street players in their own right, would go back to being the cautious, green-eyeshade types they once

were—and the cool observers of the bond market that we need. Their executives and lobbyists would holler in protest; that, too, would be a plus.

But, sadly, the rating agencies have not had to do any hollering. Under the terms of the financial-reform measure pending in the Senate Banking Committee (and of the similar set of reforms approved by the House of Representatives in December), these important gatekeepers will go right on being paid by those seeking to go through the gate. the rating agencies started out selling information, in printed form, to large investors. That was still their line of business—a good and useful one—in the 1930s, when federal regulators told the nation’s banks to invest only in “investment grade” bonds as determined by the Big Three, composed then as now of Moody’s, Standard & Poor’s, and Fitch.

In subsequent decades, federal and state watchdogs handed down many similar rules, requiring brokerage houses, insurance companies, and pension funds to base their investment decisions on credit ratings and giving official recognition to the established firms.

In the 1970s, modern photocopying machines undermined the original business model of the rating agencies by allowing investors to obtain ratings materials without paying for them. One by one, the rating agencies sought and obtained the approval of the relevant regulators to move from an investorpays to an issuer-pays model.

The perils of the new arrangement were not fully revealed until the late 1990s, when the balance of the rating business began to shift away from w w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m straightforward bonds issued by corporations and public agencies toward mortgage-backed securities and the other complex products of modern “structured finance.” The governmentsponsored housing agencies Fannie Mae and Freddie Mac had been securitizing mortgages for decades. Wall Street firms put a new spin on the practice, however, by bundling thousands of loans together, carving out repayment rights in the form of “tranches” of bonds (each representing a different place on line in the event of repayment trouble) and claiming that this alchemy could transform high-risk loans into low-risk bonds.

Because most of the underlying mortgages involved teaser interest rates and other short-term lures, millions of borrowers faced payments they would have no way of making a few years down the road, unless continued increases in housing prices allowed them to refinance into lower-cost loans or pull out cash to buy time. Like sidewalk shell-game artists, the mortgage companies and their Wall Street partners used the razzle-dazzle of tranches and other fancy forms of “risk management” to divert attention from

to go around. While the quality of their work deteriorated, the combined profits of the rating agencies swelled from $3 billion in 2002 to over $6 billion in 2007; their CEOs meanwhile earned a collective $80 million. Moody’s, whose profits quadrupled between 2000 and 2007, had during five of those years the highest profit margins of any company in the S&P 500. The secret of that fabulous success was the power to dispense something precious—an investment-grade rating—without any sense of duty to properly investigate, or even fully understand, the bonds in question.

The mission that these companies so thoroughly betrayed is a crucial one.

Even if regulators take steps to reduce investor reliance on ratings, as both the House and Senate reform measures urge, rating agencies are needed to help investors accurately price risk and to allow issuers of bonds—from small municipalities to large corporations—to compete for credit in a national market.

Some have called for the creation of a public rating agency. That would hardly be a radical step. We expect our government to safeguard us against crash-

Why did the rating agencies gloss over the huge risks of mortgage-backed bonds and collateralized-debt obligations? what really mattered—any significant downturn in the housing market was bound to bring massive defaults and foreclosures. And the rating agencies went along, bestowing triple-A ratings (equivalent to the rating of U.S. Treasury bonds) on the vast majority of the roughly $3.2 trillion in mortgage-backed securities sold between 2002 and 2007.

In 2004 and 2005, Standard & Poor’s and Moody’s lowered standards again and again, as each sought to avoid the perception that it might be even marginally less accommodating. “I knew it was wrong at the time,” S&P director Richard Gugliada testified later, adding that “it was either that or skip the business.”

There turned out to be plenty of loot

prone cars and airplanes; why not against crash-prone financial instruments?

But a case can also be made for multiple voices and competitive forces, and Raboy made it well in his January 2009 policy paper commissioned by the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP).

Raboy’s ingenious plan calls for the creation of an independent clearinghouse— most likely within the Securities and Exchange Commission—to receive rating applications from securities issuers and then farm out assignments in a random or unpredictable way The funding, which could come from a financial-transaction fee, would need to cover the operations of the clearinghouse as well as the ratings process itself.

The performance of the rating agencies would periodically be compared on the basis of simple, transparent criteria, such as the number of times that investmentgrade bonds defaulted or lost significant value. The most accurate rating agencies could be rewarded with additional assignments. Those with the poorest records could, in extreme cases, be suspended or removed from the pool.

The clearinghouse idea would solve the perverse-incentives problem with one blow. It could have other advantages as well. Under the current system, rating agencies get paid, as a rule, only if they come through with a rating; the clearinghouse could compensate them even for concluding that a particular set of securities was just too complicated to rate. Up to now, that healthy possibility has not been considered. “We rate every deal,” a Standard & Poor’s analyst grumbled in an instant message to a colleague. An offering “could be structured by cows,” the analyst added, “and we’d rate it.” in the wake of the financial meltdown, a tidal wave of rage briefly overran the usual lines of ideology and political calculation. “We’ve got to deal with the conflicts,” Sen. Richard Shelby, a Republican from Alabama and the ranking minority member of the Senate Banking Committee, declared in a January 2009 exchange with Mary Schapiro, the Obama administration’s choice to head the Securities and Exchange Commission. Schapiro earnestly agreed and so did the committee chair, Chris Dodd of Connecticut.

Shelby, Schapiro, and Dodd were three of many influential figures who initially had no trouble diagnosing what ailed the rating agencies but who have since been unable to convert their own logic into tough-minded remedial action.

Dodd’s version of financial reform, like that of his House counterpart, Barney Frank of Massachusetts, comes at the rating-agency question from every angle except head-on.

Both call for stronger SEC oversight, more ratings transparency, and greater even-handedness in the treatment of municipal and corporate bonds; both the american prospect

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require each rating agency to have a clearly stated methodology and appropriate compliance machinery; and both would give new legal recourse to investors. (This is the gutsiest component of the Dodd and Frank plans: The ratings agencies would no longer be allowed to make heaps of money from their quasi-official role as guardians of the line between speculation and investment, and then, when their ratings turn out to be worthless, pose as mere publishers of “opinions” enjoying the unlimited protection of the First Amendment.) But both leave the basic, thoroughly corrupt business model of the rating agencies untouched.

That is a failure of vision as well as

nerve. The goal of financial reform, as Dodd, Frank, and too many others in Washington seem to conceive it, is merely to reduce the likelihood of another disaster. They must aim higher, toward a financial economy that is truly an instrument of the real economy. At the moment, America needs nothing from the financial sector more than fully functioning, trustworthy credit markets. No step could do more to achieve that result than the kind of wholesale reform of the rating agencies that is, tragically, not yet on the table. tap James Lardner is a journalist and a senior policy analyst at De¯mos.

Shadow Banking Reforms pending in Congress would not touch the abuses of hedge funds and private equity.

By Nomi Prins

D

espite all the noise about financial reform, the shadow banking system that helped create the financial crisis would remain fundamentally unaltered by the legislation now pending in Congress. Indeed, leveraged entities such as private-equity, venture-capital, and hedge funds get only minor regulatory attention.

These barely regulated, nontransparent bastions of speculation propagated systemic risks beyond any that could be created by the banks themselves. Whether housed at banks, created by banks, or freestanding, they exist to enable speculative risk-taking hidden from either regulatory or market scrutiny while camouflaging layers of debt and enabling the complex-securitization deals that caused the financial collapse.

Yet, neither the House bill passed last December nor the most recent Senate bill submitted by Sen. Chris Dodd does more than impose marginal adjustments on the shadow banking system.

Even those measures contain loopholes a 12 j u n e 2 0 1 0

so inviting that JPMorgan Chase, the largest hedge-fund manager by assets worldwide, scoffs at the notion it will be adversely affected.

Leaving Shadow Banks Intact. Under the most recent Senate bill, hedge funds managing more than $100 million worth of assets would have to register with the Securities and Exchange Commission as investment advisers. But private-equity and venture-capital funds would not.

Dodd’s bill leaves it up to the SEC to construct a definition for private-equity and venture-capital funds as differentiated from hedge funds. (There’s no standardized definition of hedge fund yet.) Cue industry lawyers.

Loophole No. 1: Private-equity funds are financial-pyramid bottom-feeders; they buy distressed companies or assets, load them up with debt, extract nearterm profit, and are gone before any collapse occurs. And since private-equity funds can both invest in hedge funds and do anything a hedge fund does (it’s all a matter of how they pitch what they do to

their investors), hedge funds could just change their name to avoid registration or information sharing. Dodd’s bill would charge banks and any non-bank financial company supervised by the Fed holding $50 billion or more in assets to pay into an “orderly liquidation fund.” But hedge, private-equity, and venture-capital funds wouldn’t have to contribute.

Loophole No. 2: Neither the Senate nor the House bill alters the way in which hedge and private-equity funds do business. They only minimally alter where a fraction of the funds’ business can’t be done. A collapse of all or part of the banking system due to hedge-fund or private-equity abuses would necessitate use of a resolution fund—into which shadow bankers have made no payment.

They pile on the risk but don’t pay for the fallout.

The Volcker Rule Minus Teeth. The latest Senate bill ostensibly adopts the so-called Volcker Rule restrictions prohibiting depository institutions and bankholding companies from sponsoring or investing in a hedge or private-equity fund (it makes no explicit mention of venture-capital funds). A new Financial Stability Oversight Council would decide how to implement and interpret this regulation. Additionally, the comptroller general is required to conduct a feasibility study regarding a self-­regulatory private-equity and venture-capital fund oversight and submit a report to the House Financial Services and Senate Banking committees within a year after enactment. Of course, a year gives lobbyists plenty of time to figure out ways to circumvent any form of regulation.

Loophole No. 3: Under the Senate bill, foreign-based firms that aren’t directly or indirectly controlled by a firm organized under U.S. laws are exempted. European banks could thus expand their privateequity and hedge-fund game on our soil, thereby spreading globalized risk.

Loophole No. 4: Though large banks like JPMorgan Chase and Goldman Sachs run hedge funds, the language in Dodd’s bill doesn’t prohibit a bank from managing the portfolio of a client who chooses to invest in hedge funds.

Since banks aren’t required to delinw w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m eate or disclose exactly what’s proprietary and what’s client-oriented (a major deficiency of the Volcker Rule itself), there’s nothing to keep them from calling nearly every hedge-fund activity client-­oriented, thereby getting around this rule.

Missing the Problem: Hedge Funds.

Despite lobbyist claims to the contrary, the hedge-fund industry played a key role in the runup to the banking crisis.

It was an eager buyer and trader of the equity in toxic collateralizeddebt obligations (CDOs) and other complex high-risk securities while heavily leveraging the higher-rated pieces of these securities. In other words, the industry provided the seed money to create these securities and a market for them while excessively borrowing money from the banks creating them. By doing so, the industry inflated the perceived value and demand for these securities, as well as systemic risk and leverage.

Indeed, the hedge-fund industry tripled to an estimated $1.8 trillion business between 2002 and 2008, just as the sub-prime loan and complex­securitization market was expanding.

Not a coincidence.

Bear Stearns’ infamous credit hedge funds were designed to leverage structured credit securities by as much as 35 to 1, enticing “hot money” investors who ultimately ran for the hills when they smelled potential losses, creating chaos in their wake. Current proposals might prohibit banks from outright owning such funds (and only if they aren’t “client oriented”), but they don’t constrain how the funds operate.

Private-Equity Firms Weren’t Innocent Bystanders. Private-equity funds financed both mortgage-lending and real-estate-development companies, both directly and by purchasing equity in commercial CDOs. Now, they are picking up the broken pieces of those endeavors by buying failed banks and lenders on the cheap (as hedge funds go about

buying cheap bank stocks in bulk).

Major private-equity firms like Fortress and the Carlyle Group are busy raising capital to buy chunks of more than $1 trillion of distressed commercial realestate debt that lies underwater on the books of banks, insurance companies, and other lenders. Much of that original debt had been securitized in complex assets with high leverage, just like subprime loans were—and could ignite another crisis when defaults cumulate.

Between 2002 and early 2008, roughly $1.4 trillion worth of sub-prime loans were originated by now-fallen lenders like

cial engineering, investing, and inflation of values upon which leveraged funds thrive. Right now, Wall Street funds are inhaling a host of new distressed security concoctions (a k a toxic assets part II) that scoop up all the junk out there and regift it to the markets. This all operates under the radar screen.

Thus it is imperative that banks with any form of leveraged fund, even if it belongs to a client, must provide detailed information to the SEC, no exceptions.

Every hedge fund, private-equity firm, and venture-capital company, no matter what its size, should be required to register with the SEC and be subject to stringent reporting requirements and limits on leverage.

Private-equity firms should have to confer with regulators and make public all steps of their actions when buy-

Right now, Wall Street is scooping up all the junk out there—toxic assets part II—and regifting it to the market.

New Century Financial. If such loans were our only problem, the theoretical solution would have involved the government subsidizing these mortgages for the maximum cost of $1.4 trillion. However, according to Thomson Reuters, nearly $14 trillion worth of complex-securitized products were created, predominantly on top of them, precisely because leveraged funds abetted every step of their production and dispersion. Thus, at the height of federal payouts in July 2009, the government had put up $17.5 trillion to support Wall Street’s pyramid Ponzi system, not $1.4 trillion. The destruction in the commercial lending market could spur the next implosion.

As long as leveraged funds bolster these markets (whether inside or outside of banks), the true value of complex securities will be unknowable and subject to extreme cycles of bubble and collapse. This time it was sub-prime; next time it could be commercial real estate, oil, or food.

The Reforms We Need. Current reforms won’t deter the reckless finan-

ing and operating failed banks whose deposits are government-insured; otherwise we will maintain this unbalanced situation where banks can’t own privateequity funds, but private-equity funds can manage banks.

Hedge funds should have restrictions on the percentage of securitized assets they can buy and the percentage of federally backed banks or financial firms they can own. Hedge funds currently own 6 percent of Citigroup, for example; if they dump their stock, the ripple effect could generate a need for more federal aid.

Without addressing these structural issues, shining a high-beam of transparency, and dramatically restraining the leverage and risk that these funds can take or enable, we are doomed to crash again. tap Nomi Prins is a journalist and a senior fellow at De¯mos. Her books include It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street and Other People’s Money. the american prospect

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No More Phony Accounting Cooked books helped produce the collapse— and the fakery continues.

By Frank Partnoy

P

hony books played a central role in the financial crisis, but recent financial-reform proposals say virtually nothing about accounting. This omission is shocking. Simply put, the balance sheets of major banks were, and still are, fiction. Financial institutions did not, and still do not, disclose their true liabilities and true risks. If they had, we might have averted this crisis. Until Congress adds accounting to its agenda, and until financial statements reflect reality, financial reform will not work.

Accounting can be boring, so let me begin with a startling illustration. Below is a balance sheet, a real balance sheet, of a real company. Look at the numbers and try to guess which company it might be.

While you are doing so, remember that the market declined sharply in 2007, crashed in 2008, and recovered by more than half in 2009. For most companies, the previous four years were a roller-coaster ride in which they soared, plunged, collapsed, and finally recovered (some). Now here’s that actual balance sheet:

2006

2007

2008

2009

Assets

$1,884

$2,188

$1,938

$1,857

Liabilities

$1,765

$2,074

$1,797

$1,702

$120

$114

$142

$155

Equity

These numbers look rock solid. Assets declined a bit since 2007, but so did liabilities. Overall, the net equity of this company has been rising steadily, apart from a minor blip in 2007. If these numbers are accurate, they represent a conservative and steady company, one that miraculously weathered the recent financial storm. Who might it be? Perhaps Starbucks? Or Wal-Mart?

In fact, this is the balance sheet of Citigroup. Yes, Citigroup. These numbers do not even hint that the value of Citigroup’s business went from a quarter of a trillion a 14 j u n e 2 0 1 0

dollars to nearly zero during this time.

There is no indication that Citigroup suffered massive losses in 2007 and 2008 and then a major post-rescue recovery in 2009. There is no suggestion that Citigroup was insolvent, or close to insolvent, until the federal government promised to guarantee more than $300 billion of its debts. Instead, this balance sheet depicts an illusion of Citigroup as consistently healthy for all four years. The accuracy hasn’t improved recently, either: The latest numbers in the chart are from a financial filing dated Feb. 26, 2010, just a few weeks ago.

This balance sheet is fiction.

And Citigroup is not alone. The balance sheets of every major Wall Street bank are just as fictitious. They do not reflect trillions of dollars of swaps. They do not include many subsidiaries, which banks use to avoid recording risks. Instead, the banks’ exposure is off-balance sheet. Their financial statements do not show many of their actual liabilities. The dirty secret of the markets is that the financial statements of major Wall Street banks are false.

Consider the recent revelations about Lehman Brothers. Before its collapse, Lehman not only hid its derivatives liabilities from view but also used a scheme known as “Repo 105” to remove tens of billions of dollars of debt from its balance sheet.

In March, after the Lehman bankruptcy examiner revealed some details about the scheme, members of Congress finally promised hearings into these false financial statements. Yet the legislative financial­reform proposals still do not require that balance sheets reflect reality. Indeed, they do not address balance sheets at all.

Some industry insiders will tell you that a formal balance sheet is no big deal.

Supposedly, sophisticated analysts can uncover the data that is missing from the balance sheet, in footnotes to the financial statements. But even an investor who waded through the hundreds of pages of footnotes in a corporate filing would not have found deals like Repo 105 or the real exposure of swap liabilities at any major bank.

More important, the balance sheet remains a crucial document for financial regulation. Fools or not, regulators rely on financial statements. The balance sheet is the basis for numerous legal rules, including a bank’s core (“Tier 1 and Tier 2”) capital requirements. Investors look to balance-sheet numbers for a range of purposes.

Until financial statements reflect something closer to the actual assets and liabilities of our major financial institutions, regulators will not be able to assess the risks of these institutions, the markets will not properly function, and another crisis will be just around the corner. abusive off-balance-sheet accounting triggered the daisy chain of dysfunctional decision-making by misleading investors, markets, and regulators. False accounting facilitated the spread of the bad loans, securitizations, and derivative transactions that brought the financial system to the brink of collapse. Bankers became predisposed to narrow the size of their balance sheets, because they knew investors and regulators use the balance sheet as an anchor in their assessment of risk. Bankers used financial engineering to make it appear they were better capitalized and less risky than they really were—and still are.

Wall Street lobbyists argue that fixing off-balance-sheet transactions would be too complicated. But these accounting problems are neither new nor complex.

Indeed, Congress confronted similar problems in 1933, when it investigated the accounting shenanigans of the 1920s, such as the far-flung schemes perpetratw w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m ed by Ivar Kreuger, known as “The Match King,” whose securities were the most widely held in the world. During the New Deal, Congress’ straightforward remedy was to require ample disclosures and to enforce stiff penalties when companies failed to accurately disclose their risks.

That approach cleaned up the financial system back then, and we need to adapt the same core principles now.

Transparency and enforcement are simple but crucial reforms, and most people understand their importance. If the balance sheets of Citigroup or Lehman or American International Group or Bear Stearns had been accurate, they would have shown massive exposures to opaque financial instruments and securities and derivatives based on sub-prime mortgages. But they did not. The details are complex, but the problems posed by off-balance-sheet accounting are quite obvious to ordinary Americans. What if the next time you wanted to borrow money, you didn’t have to list most of your debts? What if Congress let you keep your credit-card bills and mortgage liabilities hidden from view? How much would you borrow? How would you spend or invest that borrowed money? How much risk would you take? The answers do not require an MBA . Common sense tells us that if we let people hide their debts, they will borrow more than they should, at the wrong times, for the wrong reasons.

Lynn Turner, the former chief accountant at the Securities and Exchange Commission, and I recently proposed a straightforward fix to the off-balancesheet problem: Require that balance sheets reflect reality. We even included proposed language for Congress to adopt. It is just one paragraph (with a second paragraph anticipating some of the objections Wall Street might raise). It wouldn’t take long for Congress to add this language: “The Securities and Exchange Commission, or a standard setter designated by and under the oversight of the Commission, shall, within one year from the enactment of this bill, enact a standard requiring that all reporting companies record all of their assets and liabilities on their balance sheets. The recorded amount of assets and liabilities shall

reflect a company’s reasonable assessment of the most likely outcomes given currently available information. Companies shall record all financings of assets for which the company has more than minimal economic risks or rewards.”

That’s it. With this simple reform, Congress could mandate that companies report all of their assets and liabilities. Companies that omitted material assets and liabilities from their balance sheets would be subject to civil liability in the same way companies generally have been exposed to private rights of action for material misstatements. This is not a radical proposition: It is precisely what Congress did in 1933 and 1934, in response to that era’s financial crisis.

Accounting reform is absent from today’s debate, not because it is partisan but because concentrated Wall Street powers wield more influence than the diffuse interests of Main Street. In principle, Democrats and Republicans agree

that market capitalism requires transparency, or it will not function properly.

But it also is clear that transparency reduces the profits of Wall Street banks.

They do better operating in the dark, in shadow derivative markets that are hidden from public view. Accounting reform is a test of whether members of Congress will respond to hundreds of millions of dollars of campaign and lobbying expenditures by banks or to the needs of most investors and taxpayers.

Average Americans understand what can happen if people are permitted to lie about their debts. The rest of us include all of their liabilities on our financial statements. Banks should, too. tap Frank Partnoy is the George E. Barrett Professor of Law and Finance at the University of San Diego. His most recent book is The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals.

Sand in the Gears The case for a tax on financial speculation

By Robert Weissman

B

uy a cup of coffee in Manhattan, and the sales tax is 8.875 percent.

Buy a share of Exxon on the New York Stock Exchange, and the tax rate is just a hair more than zero. Like other double standards that benefit high finance, the zero tax rate on financial transactions both reveals and reinforces Wall Street’s massive power and privilege.

But now a growing movement is coalescing around the idea of a financial­speculation tax, as an opportunity to confront Wall Street politically, shrink the bloated financial sector, diminish dangerous speculation, and raise significant sums of money to meet priority needs. The movement is drawing support among consumer, labor, and financial-reform groups associated with Americans for Financial Reform and

also among climate-change and globalhealth campaigners, who hope a speculation tax can generate revenues for targeted purposes. The idea is attracting interest among congressional leaders and has the affirmative support of British Prime Minister Gordon Brown, French President Nicolas Sarkozy, and other European leaders.

There are numerous possible variants of a financial-transaction tax. Nobel economist James Tobin famously proposed a tax on currency transactions, and some advocates focus on currency trades. Even Larry Summers, as a young economist, wrote a scholarly paper supporting a Tobin tax as salutary “sand in the gears”—and that was before the explosion of derivatives trading. Today’s leading proposals envision a sales tax the american prospect

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applied to stocks, derivatives, and other financial instruments, scaled to prevent investors from circumventing the tax simply by switching from, say, stocks to derivatives. a speculation tax has several distinct benefits. First, it can slow down the ever faster pace of buying and selling financial instruments. Far too many of Wall Street’s transactions take the form of short-term trades intended to aggregate tiny margins. This insider business does little to promote efficient allocation of capital— Wall Street’s purported service to the real economy. But it creates major risks because it uses very high leverage that endangers individual financial institutions and our whole financial system.

Vanguard founder John Bogle says he “loves” the speculation tax because it will curb the worst trading excesses. Bogle campaigns against high-turnover, speculative trading as an investor-consumer rip-off. Altogether, he points out, investors by definition can only do as well as the overall market return. The aggregate impact of frequent trading by mutual funds doesn’t change this, but it does provide the rationale for high fund fees—the “croupiers’” cut, Bogle says. A speculation

problem, of course; a bigger Wall Street is able to exert more political power.

Third, a speculation tax can raise serious money. Assuming a quarter-percent tax on stock trades, and a commensurate rate tax on other instruments, Baker and Robert Pollin of the University of Massachusetts, Amherst, estimate that a speculation tax could raise more than $100 billion a year.

Despite Wall Street’s intense opposition to a speculation tax, such a measure remains politically viable because of its revenue-raising potential. A diverse set of interests are hoping to tap some of the revenue from a speculation tax. The AFL-CIO hopes a speculation tax can finance job creation and infrastructure investment.

Climate campaigners want a speculation tax that could generate monies to transfer to developing countries to assist their transition to a post-carbon economy and help them adapt to a changed climate; the World Bank estimates developingcountry energy-transition costs at hundreds of billions a year. Global-health and anti-poverty advocates are seeking tens of billions annually to provide basic health care in poor countries and meet the modest targets of the United Nations Millennium Development Goals, which aim to

An oversized financial sector is not just an economic problem; a bigger Wall Street is able to exert more political power. tax would encourage longer-term investing and give investors more incentive to urge for better management.

Second, by reducing trading volume, a speculation tax can also help shrink the bloated financial sector generally. Finance is an “intermediate good”—something that is supposed to help produce the goods and services we ultimately care about, not just be an end in itself. Dean Baker of the Washington, D.C.–based Center for Economic and Policy Research asks how we would react if trucking had tripled in size relative to the economy over the last three decades, as finance has by some measures. An oversized financial sector is not just an economic a 16 j u n e 2 0 1 0

cut severe poverty in half by 2015.

Fourth, and making the tax even more attractive, it is extremely progressive. The rich own most stocks and bonds—with the top 1 percent holding 40 percent of the nation’s financial assets, and the top decile controlling roughly 80 percent— and they would pay most of the tax. A speculation levy is eminently feasible.

A tax of less than two-thousandths of a penny on stock trades presently funds the Securities and Exchange Commission.

Opponents and skeptics of the speculation tax offer two primary arguments.

First, they contend, if done only domestically, the tax would drive financial business overseas. But this is Wall Street’s

standard response to any national regulatory moves and is no more plausible in this instance than others. A stock tax in the United Kingdom has not driven business from the London Stock Exchange, which has grown rapidly over the last decade.

Prior to the financial crash, Wall Street firms complained untruthfully that the Sarbanes-Oxley accounting standards— the extremely modest reform resulting from the last financial crash—were driving new stock offerings to the UK. And while Wall Street traders may disapprove of a speculation tax, listed companies or offerors may look more kindly on a modest tax aiming to reduce turnover.

While international agreement should not be a prerequisite for action on a speculation tax, a global approach would certainly be a good thing. Given European support, U.S. embrace of a speculation tax would likely result in an international accord.

Opponents’ second main argument is that a speculation tax will in fact prove harmful to small investors who rely on mutual funds. Investors in high-turnover mutual funds will suffer high costs, argues George Sauter, managing director and chief investment officer at Vanguard Group (yes, the same Vanguard founded

by John Bogle), with significant impact on returns over time due to compounding. Not only will the tax impose costs, he argues, but eliminating high-volume traders from the market will raise bidask spreads and thus impose additional costs on mutual funds. these claims are not groundless, but they are overblown. The direct impact of the tax on small investors can be avoided by providing an exemption for retirement accounts and under some threshold in trades, as the leading congressional proposals do. Dean Baker concedes that a rise in the bid-ask spread will occur but contends it will be far smaller than Sauter suggests. And increased transaction costs, to the extent they occur, will have a beneficial effect for smaller investors: It will encourage them to switch to investment in broad index funds and to pursue longer-term investments generally. Also, importantly, increased costs per trade w w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m will be offset by reduced trading volume.

In Congress, Rep. Peter DeFazio of Oregon has introduced the Let Wall Street Pay for the Restoration of Main Street Act, which would impose a .25 percent tax on buying and selling a stock and a corresponding amount on other financial transactions. DeFazio’s bill has 29 cosponsors. On the Senate side, Sen. Tom Harkin of Iowa has introduced a similar measure, The Wall Street Fair Share Act, with three co-sponsors. But the interest on the Hill goes far beyond the numbers co-sponsoring the proposals. Nancy Pelosi has spoken positively of the idea, and other Congress members consistently raise it as a potential funding source for jobs and transportation initiatives.

In the United Kingdom, the idea of a speculation tax has caught the public’s imagination thanks to a cleverly branded “Robin Hood” campaign and a humorous Internet video featuring actor Bill Nighy.

U.S. campaigners hope that importing the verve of the Robin Hood campaign will enable the speculation tax to break through the clutter of confusion around seemingly technical and arcane financialreform proposals. With public anger at Wall Street still boiling hot, and massive domestic and global needs remaining unfunded, this is the right political moment to win a speculation tax. tap Robert Weissman is president of Public Citizen.

Coalition of the Unwilling Diverse individuals and businesses are hurt by the financial system. Can they coalesce?

By Heather McGhee

I

n theory, financial reform should dismantle the same deregulated system that produced toxic credit-default swaps and toxic credit cards. But on every aspect of financial reform except perhaps for basic consumer protection, the necessary structural reforms won’t be passed in 2010. If the greatest financial-market meltdown in history couldn’t spur deep, structural reform, what will?

The battle-within-a-battle for consumer protection offers some clues. A new federal regulator dedicated solely to keeping unfair and deceptive financial products out of Americans’ hands was what the advocacy community wanted and, more or less, got. What advocates didn’t get has filled the pages of this special report.

Why was consumer protection so different? Partly, it’s not quite as opaque as Wall Street’s insider stock-in-trade. Derivatives, proprietary trading, off-­balancesheet reporting, hedge-fund regulation, and the like aren’t exactly the stuff of kitchen-table conversations. Even so,

when polled about the shadowy “casino economy,” likely voters in swing districts responded viscerally, with four to one in favor of more regulation. Yet consumer protection hasn’t just fared better because it is simpler. It has benefited from a simple truth: Taking down the system requires a revolt from within—a revolt of customers.

And we need more such revolts.

With trillions of dollars in economic power lined up to protect the deregulated status quo, the best dissidents have turned out to be the purported beneficiaries of the system. On consumer finance, the revolt happened years ago when middle-class borrowers broke up with their lenders over credit-card abuses, deceptive mortgages, and ridiculous overdraft fees.

Of course, the banking industry quickly learned the lesson. To make the case against regulation of derivatives, the bankers didn’t show their faces, even though the big five mega-banks control 97 percent of the market and have $78 in derivatives exposure for every $1 held by

actual businesses. Instead, they lined up the corporate buyers of traditional and defensible derivatives such as options and futures to hedge against changes in the price of supplies. These so-called end users from Apple to John Deere fronted for bankers and lobbyists and argued that aggressive reform would hurt ordinary corporations. Suddenly, the reformers’ argument that exchange trading would bring price transparency and benefit the real economy had nowhere to go.

Americans for Financial Reform, the umbrella advocacy coalition established to promote real reform, quickly organized an impressive array of other end users who had been burned by speculative price spikes in commodities like food and energy. But it was nearly impossible to break through in the media or Congress once other corporations had presented a united front with bankers. achieving financial reform that’s more than just tinkering around the edges will require a revolt of many more unsatisfied customers. One unorganized potential base: the dozens of state and local governments who bought aggressively marketed interest-rate swaps on bonds during the boom and are now being hammered on both ends by Wall Street. On the one end, the Street caused the Great Recession, which is decimating tax receipts and community budgets. On the other, the same bankers have refused to renegotiate outrageous interest-rate spreads even though, as a result of the crisis they created and due to taxpayer largess, their borrowing costs are next to zero.

Banks like Goldman Sachs and JPMorgan Chase will collect over $1.25 billion from cash-strapped school systems, towns, and states over the deals in 2010. The insult of having to pay an investment bank money for nothing while it cuts city services stirred the Los Angeles City Council into action in March. Faced with a $19 million annual payment to Wall Street, the council voted to move nearly $30 billion in city business away from any company that refused to renegotiate a derivative deal. A number of states are even considering their own “public option”—cutting out the private sector the american prospect

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altogether and opening their own banks to fund infrastructure and lend to citizens. This is exactly the type of “end user” revolt that, once organized, could pave the way to a real financial-reform agenda.

Though largely focused on health care and the Employee Free Choice Act for the past year, organized labor is beginning to tell a broader story about how productive, jobs- and goods-producing American businesses have suffered in an economy dominated by finance. (Finance overtook manufacturing as America’s largest sector by profits in the 1990s.)

“We want real growth in America, not just growth in the debt markets,” says Heather Slavkin, a senior policy adviser at the AFL-CIO. With Wall Street’s current business model, those two are increasingly incompatible. Unregulated hedge funds and private-equity funds bought up over 3,000 American companies during the leveraged buyout boom. The buyout model—use Wall Street–financed debt to purchase companies, extract equity, and leave companies highly vulnerable to loan defaults—has put millions of American jobs at risk. Experts estimate that half of the bought-out companies will go bust in the coming years. Such a reckoning could add the executives and workers of America’s private-equity-owned companies to the ranks of Wall Street’s dissatisfied customers.

Pitting the banking business against the rest of American business could create just the opening progressives need, as the U.S. Chamber of Commerce understands perfectly. That’s why it insists that financial reform isn’t aimed at big banks—it’s aimed at “businesses that have little to do with consumer finance,” such as the local butcher who lets customers buy ground chuck on a tab.

Besides proving how out of touch the chamber is with modern life, its multimillion-dollar “local butcher” ad campaign showed how toxic the real targets of financial reform are—even within their own trade group. Fortunately, health-care reform has battle-tested new progressive groups to represent the actual butchers of America (who may not extend credit anymore, but they certainly need it, and fairly priced). Small a 18 j u n e 2 0 1 0

businesses that are priced out of affordable health care did not join big businesses in opposing health reform, and organizations like Business for Shared Prosperity, the MainStreet Alliance, and Small Business Majority will be essential to dismantling the business case for predatory finance.

Another improbable ally in the structural critique of the banking system is the Independent Community Bankers of America, which supports breaking up the large banks and reinstating the Glass-Steagall Act. True, the ICBA lobbied hard to exempt their members from the proposed Consumer Financial Protection Agency, but when the agenda moves on to truly dismantling “too big to fail,” count on them to be there.

In sum, there is a huge, majority coalition of unhappy customers of Wall Street.

This is the prime constituency for real reform. The trillion-dollar question, of course, is where the White House will be.

President Barack Obama got a taste of the fruits of progressive leadership when he won health reform. But on banking, at least for now, the Bush administration’s mission to preserve the system in 2008 has ended up being the same mission of the Obama administration’s reform plans in 2010. But the system—highly leveraged, opaque, overconcentrated, and dominated by shadow market players and practices that didn’t exist even a decade ago—is fundamentally not worth saving. In the years ahead, we will need many more voices to convince the powers that be of that truth. tap Heather McGhee is the director of De¯mos’ Washington office.

Simplifying Securitization With a better system, the economy can have plenty of credit without the outlandish risks and excess banker profits.

By Jane D’Arista

T

he packaging of loans into securities is one of the financial innovations most deeply implicated in the financial crisis. It is not only closely associated with the explosive growth of sub-prime mortgages and credit derivatives but responsible for transforming the U.S. financial structure from a system based on prudent bank lending to one based on highly speculative securities markets.

The creation of a market for mortgage­b acked securities came about as a response to the banking crisis of the inf lationary 1970s. Lending institutions were making 30-year fixed-rate mortgage loans but financing them with short-term deposits at newly deregulated market interest rates. As inflation increased, banks lost money on their mortgage portfolios. In response, Congress called on the government-

sponsored secondary mortgage-market enterprises (known as GSE s)—Ginnie Mae, Fannie Mae, and Freddie Mac—to support savings institutions and small banks by buying their low-interest-rate mortgages. At that time, the GSEs were the only entities converting loans into bonds, which were fairly straightforward and not divided into securities with different degrees of risk, known as “tranches.”

By the close of the 1970s, however, a second and larger inflationary spike overwhelmed the safety valve provided by the GSEs. And in the 1980s, private competitors to Fannie, Freddie, and Ginnie began offering far more complex securitized products. In principle, this innovation allowed a lender to go on making fixed-rate mortgages, shedding risks to third-party investors willing to bet on the future movement of interest w w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m rates and housing prices. But in practice, securitization without regulation sowed the seeds of the great collapse three decades later.

In the mid-1980s, Congress explicitly authorized private financial institutions to market securitized products, but without the most basic safeguards that apply to other securities markets. Mortgage-backed securities were exempt from registration and disclosure. Congress authorized a “safeguard” in the form of required ratings by government-­recognized creditrating agencies as a substitute for due diligence, but these ratings were soon corrupted as securitized packages of highly risky mortgages were nonetheless awarded triple-A ratings. Moreover, mortgage-backed securities were not traded on organized exchanges, so information on the volume and price of transactions was not available to investors. In addition, capital backing along the chain from loan origination to issuance of securities was minimal or nonexistent.

Attracted by the laissez faire nature of the market, new, unregulated loan originators such as mortgage brokers became major players. Banks and savings institutions increased their lending for housing because they could earn fees for originating and servicing mortgages without having to raise the capital required had they held the loans in their portfolios. In the 1990s, securitization expanded to include car loans and consumer receivables and, together with mortgage-backed securities, issuance and trading of asset-based securities came to dominate capital markets and credit flows. Between 1977 and 2007, the share of total credit-market assets accounted for by GSEs, mortgage pools, and asset-backed securities issuers rose from 5.3 percent to 20.5 percent while banks’ share shrank from 56.3 percent to 23.7 percent. The result was a transformation in the traditional U.S. bank-based system and an erosion of the protections so carefully crafted in the 1930s.

The role of securitization in the crisis

The sub-prime scandal is a major and well-recognized outcome of this massive experiment in deregulation. The laxity and conflicts of interest inherent in the role of rating agencies is another.

The diversion of so large a share of credit flows into the market for mortgagebacked securities facilitated the buildup of the housing bubble. It also ensured that mortgage-backed securities were held and traded by all financial sectors, all of which inevitably experienced distress when loss of confidence caused trading to dry up and prices to fall.

As the bubble inflated, large profits were made by financial institutions, and rising house prices gave a boost to the savings of households.

When the bubble burst, homeowners experienced a double whammy: Their net

more disclosure about the underlying assets in the pool.

But these reforms are far from sufficient. It is likely that pressure for securitizing mortgages, car loans, and other forms of consumer credit will continue.

For banks, ongoing exposure to a volatile interest-rate environment means that holding long-term mortgages and even medium-term car loans in portfolio presents a level of uncertainty and an ongoing threat of insolvency that even increased capital requirements cannot alleviate. At some point, the larger concerns raised by this innovative financial technique will have to be addressed.

What kinds of reforms are needed?

Capital Requirements. In the aftermath of the crisis, the seriously undercapitalized status of the U.S. financial system was glaringly apparent. As a result, higher capital requirements have become the one-size-fits-all solution for any area that has been identified as needing reform. In the case of securi■ Higher

The rise of securitized products marked a shift away from the traditional bank-based system with its carefully crafted protections. worth fell because of the drop in the value of their homes and dropped further as the value of mortgage-backed securities in their pension and mutual funds declined.

In a third blow to households, damaged financial institutions grew more resistant than in the past to negotiate loan workouts—a factor that exacerbated the rate of foreclosures. As the International Monetary Fund noted as early as 2005, households became the shock absorbers in a market-based system.

The bill passed by the House last December and the one introduced by Sen. Christopher Dodd this March address only some of the abuses. Both provide for more oversight of the creditrating agencies and create an agency to protect consumers from harmful financial products. The Dodd bill requires that sellers of securitized products retain 5 percent of the credit risk and provide

tized exposures, given the widespread distribution of asset-based securities throughout the system, all institutions that originate, underwrite, or hold such securities must have even higher capital requirements.

■ Adequate Disclosure. Capital alone will not address all the problems that caused damage to financial markets and households. The Financial Stability Board—a multinational organization of central bankers and regulators—­proposes reforms that require greater disclosure and transparency at each stage of the securitization process. The losses experienced by pension funds and other pools of household savings were attributable in part to incomplete information. Many believe the issuance of mortgage-backed securities should not be permitted going forward without the same requirements for disclosure that apply to the issuance the american prospect

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of all other securities. As spelled out in the Dodd bill and a recent Bank of England report, this must also include disclosure about the underlying assets in the pool so that the risk of each underlying mortgage can be evaluated. That level of disclosure is also needed both for investors and to ensure that mortgage borrowers can be identified to facilitate workouts if needed.

■ Standardizing Contracts and Reporting Trades. The fact that there was no real-time information about prices and the volume of trading in what had become the dominant credit market in the U.S. was another structural failure that contributed to the crisis by destroying confidence in securitized products and the institutions that held them. Many analysts have proposed that these products be simplified and standardized and that transactions be documented. But real reform will require that mortgage-­backed securities be traded on an exchange so that trading arrangements do not obscure what is happening in the market for a given product.

■ Improved Lending Standards. Allowing lenders to relax (or even ignore) loanto-value ratios and borrowers’ ability to pay ensured that securitized assets would develop into the toxic assets they became. The systemic threat posed by securitization will not be lessened unless more stringent and prudent loan­origination standards are reinstated and enforced. Comprehensive regulation of all institutions that make loans—bank and nonbank—and the creation of a Consumer Financial Protection Agency are needed.

■ “Skin in the Game.” As reflected in the Dodd bill, there is substantial agreement that mortgage originators should be required to retain a meaningful share of the credit risk they are packaging into securities as a way to improve due diligence. But there is a better way: using socalled covered bonds as a complement or replacement for securitized products.

■ Covered Bonds. This strategy, used

by Europe’s large “universal” banks, would give banks access to capital markets and help solve the liquidity and other risks they face when holding longer-term a 20 j u n e 2 0 1 0

assets. Loans and other assets backing bonds issued by the banks would be segregated (“ring fenced”) to protect investors against the credit risk taken by the bank. Issuing long-term bonds to finance those assets would protect the banks against the interest-rate risks of having to roll over short-term deposits or borrowings while holding loans with longer maturities that can’t be sold or traded.

The investors take on the interest rate and price risk while the bank remains fully exposed if one or more of the loans defaults. This would encourage both the lending banks and the buyers of the bonds to screen the credit risks they are assuming. It would also make it easier for banks to do the workouts needed to prevent foreclosure when loans become nonperforming.

Covered bonds would accomplish the objectives of those who advocate reforming securitization by simplifying and standardizing the mechanism for funding longer-term credits like mortgages and ensuring improved due dili-

gence and disclosure. It is possible that, like securitization itself in its early years, such a change in funding strategies would require public-sector encouragement.

But it would make possible a needed structural change that could help rebalance the U.S. financial system by reinstating a larger role for traditional portfolio lending. This would revive previous protections to homeowners and consumers by reducing the exposure to the credit, interest-rate, and market risks they were forced to assume both as borrowers and savers when securitization took hold.

All of these reforms are needed if innovation in credit markets is to serve its advertised purpose of improving liquidity and accurate pricing of assets rather than just increasing speculation and risk. tap Jane D’Arista is a research associate and co-coordinator of the SAFER Project at the Political Economy Research Institute, University of Massachusetts, Amherst.

Cleansing the Temple Can financial reforms straighten out one of America’s most byzantine institutions, the Federal Reserve?

By Tim Fernholz

I

n 2008, many Americans were surprised to discover that they live in what an earlier article in these pages called the “Republic of the Central Banker.” The Federal Reserve, an institution whose opacity rivals only its reach, was forced by crisis to exercise its powers more publicly and more broadly than it had in a generation.

Under the current chair, Ben Bernanke, and before him, Chair Alan Greenspan, the Fed failed in nearly all its responsibilities. It did nothing to pop a burgeoning asset bubble in the housing markets and related derivatives. It refused to prevent that bubble by restricting pernicious lending practices despite ample regulatory

authority on the books. The banks under the Fed’s supervision took extraordinary risks and blew themselves up.

When the crisis came, though, the Fed acted quickly to stabilize the financial system with a massive leveraging of its balance sheet, deploying loan guarantees and discounts to keep lending alive even as it dropped interest rates to zero. In the face of pressure from Congress, it even belatedly enacted consumer protections on the mortgage and credit-card markets.

Do these actions demonstrate that the Fed has learned from its mistakes?

Should the Fed’s more recent behavior mitigate the need for reform?

Not at all. It is clear that without the w w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m pressure of a crisis, the Fed would not act to preempt disaster. It is time to rethink what we expect from our central bank and how its different functions work in concert and in tension. Unfortunately, present congressional efforts to overhaul the bank could leave the institution even more convoluted as reformers clash with moderate Democrats who are skeptical of more regulation, Republicans who oppose it outright, and the Fed’s own attempts to defend its turf.

dent audit. An audit bill passed in the House’s financial committee by a bipartisan vote of 43–26, but it is vehemently opposed by the Fed and isn’t included in the Senate’s discussions of financial reform. It’s hard to explain, though, how knowledge of what the Fed is doing is a detriment to its independence.

Similarly, there’s no clear reason why the Fed should be responsible for both regulatory supervision and monetary policy. In fact, the central banks of the Unit-

Monetary policy requires independence from politics; regulation requires independence from industry. Clearly the Fed has neither. the problems start with the basics of the Fed’s outmoded and undemocratic structure. Just consider the geographic spectrum of the Fed’s regional branches: five banks east of the Appalachian Mountains—including one in Richmond, Virginia, barely 100 miles from Washington—and only one bank west of the Rockies. Each of those banks is run by a president and board of directors selected largely by the private banks they are meant to regulate. At its most absurd, this involved a Goldman Sachs banker being tapped to represent the public interest at the New York Federal Reserve.

Reformers want to change the structure of those boards, but legislation proposed by Senate Banking Committee Chair Chris Dodd allows the president of the United States to select only the head of the New York Fed (other regional Fed presidents would still be appointed by boards selected by bankers). The bill bars bankers from serving on the boards but not from picking who does. Mandating real public representation on these boards and limiting conflicts of interest is the only way to ensure that the Fed has the independence it needs from the political process and financial interests.

The Fed also lacks transparency, keeping its ledgers secret from the public eye.

With the central bank’s balance sheet rapidly expanding due to its rescue efforts, critics in Congress have demanded more accountability in the form of an indepen-

ed Kingdom and the European Union have no regulatory role at all. While monetary policy requires independence from politics, regulation requires independence from industry—but at the Fed, banks have essentially been picking their own supervisors. An equally salient point is that consolidation in prudential regulation is critical to avoid the kind of race-tothe-bottom regulatory arbitrage we saw in the run-up to the financial crisis.

Richard Carnell, a Fordham Law professor who has worked at both the Fed and the Treasury Department, notes that even now the majority of banks aren’t regulated by the Fed at all. Greenspan, a staunch defender of the Fed’s prerogatives, has recognized that giving even more regulatory authority in the Fed would be unwise.

But legislators are taking half measures. There is general agreement that the supervision of bank-holding companies should end up in a consolidated regulator. Policy-makers also recognize that the overhaul requires increasing supervision of both systemic risk and of non-bank financial institutions. But, strangely, they’ve decided that the Federal Reserve is the right place to house those responsibilities. (Broader systemic risk oversight will likely rest in a council of regulators that includes the Treasury secretary.)

There is some logic to the plan; the Fed is powerful, and as the economist Tyler Cowen writes, its independence makes it

uniquely suited to responding to crises: It “is the fireman with the awesome power to print money, move markets, lend to the banking system on a large scale, and now even conduct fiscal policy, all without Congressional approval.”

But Dodd’s bill significantly limits the Fed’s emergency-response powers, barring the bank from lending to individual companies during emergencies, putting new checks on its role as an emergency liquidity provider, and transferring the task of dealing with failure to the Federal Deposit Insurance Corporation and the proposed regulatory council. New authority for systemic risk and nonbank institutions shouldn’t be in the Fed, either, but in a consolidated regulator.

The Fed has protested every effort to strip it of its powers, saying that it needs to retain oversight of the banking system to augment its monetary policy-setting powers. Many experts disagree, saying that access to the information provided by other supervisors would solve the problem.

“I don’t think that supervising individual banks is important to making monetary policy,” Alice Rivlin, a former vice chair of the Fed, told the Senate Banking Committee last summer. “That was said around the table when I was at the Fed, but I didn’t really experience that we learned a lot from the supervising [of] particular banking institutions.”

The Fed’s critics have long complained that the central bank is captured by the financial industry. A good example is the Fed’s famous dual mandate—to pursue both low inflation and maximum employment. While the financial industry prefers low inflation, the labor market cries out for a more dovish attitude toward interest rates; it’s no surprise who usually wins. Today’s crisis is the rare case when the Fed has turned to very low interest rates. But what will it do when the immediate financial crisis is over, and its characteristic inflationphobia returns? this confusion over its constituency­— citizens or bankers?—was reflected in the central bank’s unwillingness to use its consumer-regulation powers. Reformers the american prospect

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concluded that an independent agency was needed to regulate everyday lending, from mortgages and automobile loans to check cashing and savings accounts; only a single point of accountability would provide the correct incentives.

What happened next illustrates the challenges of making these proposals a reality. Legislators crafted a strong proposal for a Consumer Financial Protection Agency (CFPA), and Rep. Barney Frank, who led his chamber’s financial-reform effort, secured a final bill that included an independent agency, albeit one with significant loopholes that exempted entire industries from coverage.

In the Senate, Dodd engaged in political horse-trading to find Republican votes, first endorsing an independent agency, then suggesting its placement in Treasury, and finally deciding to house the bureau back where it started—inside the Fed!—but with several layers of political and financial insulation from its landlord. However, the Senate version also closes many of the House’s loopholes. Nonetheless, while the plan may work, it adds another layer to an already messy institution inclined to inaction.

The difference between the Dodd and Frank bills, at least when it comes to the Fed, is a question of degree. Both bills restrict the Fed’s emergency-rescue powers with new checks by a council of other regulators. The House bill includes the audit provision lacking in the Senate, while the Senate bill includes more governance reforms than the House. Both give the Fed the ability to regulate the largest financial firms whether they are banks or not, while passing more prosaic bank supervision to a consolidated regulator.

Ultimately, reformers hope that when the Senate passes Dodd’s bill—expected sometime in May—the conference procedure to bring the two pieces of legislation together will amplify the good ideas in both bills while further streamlining the institution’s functions. carnell told me a story of his interactions with the Fed after leaving to be an assistant Treasury secretary in the Clinton administration. He formally requested that the Fed deploy some of a 22 j u n e 2 0 1 0

its regulatory powers to pursue predatory lenders, and the Fed, in so many words, formally declined. Disappointed, Carnell called a Fed official he knew to get a straight answer. “Only if the industry wants it,” he was told.

The anecdote underscores the need for a clearer approach to the Fed’s role. It is not balancing its institutional responsibilities.

Reform demands real structural change, including making regional branches less conflicted and more accountable, giving direct supervision to a consolidated regulator, and making a consumer protection agency as independent as possible. Letting the Fed focus on its central monetary policy responsibilities—while playing a key role alongside other regulators on a systemic risk council—would maximize its institutional effectiveness.

But the Fed fix, as currently envisioned, is confusion. The overhaul takes away some regulatory powers and adds others. It doesn’t do much to fix the regional branches and uses extensive oversight and new checks as a replacement for a clear mandate and transparency. The legislation removes consumer protection and puts it back in, albeit with more safeguards for independence.

All this comes at a time when the Fed’s very existence is being questioned by populist critics on the left and right.

Restoring its legitimacy requires transparency, so that people understand what the institution does and respect the decisions it makes. Further confusing its structure and mandate will only increase criticism of the Fed. That’s a systemically risky move indeed. tap

Banking on Presidential Leadership Obama’s engagement salvaged health reform.

Can his personal intervention achieve what’s needed on financial reform?

By Robert Kuttner

A

s the articles in this special report have demonstrated, America missed an epic opportunity for fundamental reform last year when the new Obama administration continued the Bush policies of propping up failing banks without demanding profound changes in return. Now that the banks are back to profitability, thanks to more than a trillion dollars of government aid and trillions more in Federal Reserve purchases and guarantees, they are healthy enough not just to pay their executives outsized bonuses but to use their resurgent political power to resist reform.

In early April, Jamie Dimon, the CEO of JPMorgan Chase, sent his shareholders a letter accusing politicians of “demonizing” big banks. Is that chutzpah or

what? The banks did a perfectly fine job of demonizing themselves. Dimon added that he supported the administration’s basic approach to financial reform—a revealing indictment of its inadequacy.

If only more politicians were building the systematic case for a basic structural change in the way banks do business.

There’s no way to accomplish that without tough criticism of the status quo.

Real reform is not about punishing banks, as Dimon contended. It is about insisting that the financial system do its job of serving the rest of the economy rather than exposing it to speculative ruin. The current legislative proposals largely fail that test. But deeper reform is possible if the administration and the Democrats will only seize it. w w w. p ro s p ect. o rg

fi n a n c i a l r e fo r m since the democrats’ near-death experience when Scott Brown was elected to the Senate Jan. 19, we’ve seen a newly assertive Barack Obama. He rose to the occasion and used presidential leadership to win enactment of a health reform that many assumed was a lost cause. Indeed, thanks to Obama’s personal involvement, the final bill not only survived but was better in many respects than either the House or the Senate bill, and Obama threw in reform of the pr ivately corr upted student loan for good measure.

If Obama is willing to demonstrate the same resolve, financial reform should be easier politics than health reform. As Dimon recognizes, large banks are not exactly popular. The problem is less Republican obstructionism than a failure of Democrats to promote tough reforms and dare Republicans to oppose them. In the case of the health bill, a combination of bad decisions by Democrats and misrepresentations by Republicans left a lot of voters skeptical.

Would the health bill subject Grandma to death panels? (No.) Would it tax premiums of good insurance? (Yes.) Would it divert Medicare funds? (Yes.) This skepticism, in turn, made the vote a difficult one for many Democrats.

By contrast, Democrats should find it easy to vote for a measure to constrain the rapacity of Wall Street—that is, if they are looking for the support of voters as opposed to lobbyists and campaign donors. Looking back at the policy proposals in this package of articles, you have to wonder: Which voters are going to be opposed to new consumer protections? Or to a tax on pure speculation? Or to policies that keep credit-rating agencies honest? Only the tiny minority of voters who represent the financial industry.

And if Democrats, beginning with the president, can muster the nerve to offer tougher reforms, how do Republicans justify their obstruction this time?

During the period when Senate Banking Committee Chair Chris Dodd was trying to find common ground with either the committee’s ranking Republican Richard Shelby or the quasi-populist Republican Sen. Bob Corker of Tennessee, you could see the rising Republican unease at the prospect of opposing a measure to contain Wall Street.

Some of the reforms are extremely arcane and difficult for ordinary voters to fathom. The industry and its allies in Congress are hoping that general bewilder ment about derivatives or securitization will leave banking reform as an insiders’ game in which the banks win.

On the other hand, with some leadership, the basic

Foreclosures are still increasing faster than rescues. Here too, the administration’s solicitude for bank balance sheets has taken priority over concern for the precarious economic condition of households facing financial ruin.

Mandatory reductions in principal and interest, coupled with a direct federal loan program, would be more effective medicine as well as better politics. If a true public option is good enough for a corrupted student-loan program, it should be good enough for a mortgagerelief program. in the days after the Scott Brown wakeup call, President Obama started distancing himself from the big banks. In the space of four days, he called for a new tax on bank profits; he reversed the advice of his economic team and endorsed Paul Volcker’s call for a new Glass-Steagall Act to control banking speculation; and he

Financial reform should be easier politics than health reform: Promote a tough reform program and dare Republicans to oppose it. abuses are not so hard to fathom. Lloyd Blankfein, CEO of Goldman Sachs, sought to defend his company’s practice of selling investors securitized bundles of high-risk mortgages at the same time that Goldman was using credit-default swaps to place bets that the securities would collapse. Phil Angelides, the chair of the new Financial Crisis Inquiry Commission, memorably compared the practice to “selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars.” We need more of this brand of “demonization” from our leaders.

Also, the most basic financial malady aff licting ordinary Americans— the decline in housing values and the increase in mortgage defaults and foreclosures—is not esoteric at all; it’s pure kitchen-table economics. So far, the administration’s approach of purely private and voluntary loan modifications and refinancings (lubricated with taxpayer subsidies) has been far too feeble.

announced his strong personal support for an independent Consumer Financial Protection Agency. But it remains to be seen if Obama will put his personal influence and prestige on the line to support these proposals the way he did with health reform.

At this writing, Sen. Dodd has tucked away the consumer agency safely inside the Federal Reserve, and he is far from enthusiastic about a new Glass-Steagall Act. Despite the heroic efforts of Gary Gensler, chair of the Commodity Futures Trading Commission, tough derivatives regulation will not happen absent strong presidential leadership, either.

However, the recent fraud case against Goldman Sachs could mark a turning point in the public’s understanding of the depth of Wall Street’s corruption and the president’s leadership to achieve deeper reform. Health care was defined by both parties as the make-or-break issue for Obama’s presidency. It’s time to accord that honor to fixing Wall Street. tap the american prospect

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