Financial Reform, R.I.P.

James S. Henry and Laurence Kotlikoff

THE MAIN STREET JOURNAL

Forbes Magazine

July 15, 2010

So long Glass-Steagall. Hello Dodd-Frank -- the most comprehensive rewrite of financial rules since 1933. This 2,319-page colossus -- ten times the length of Glass-Steagall –- took 1.5 years to produce and will cost $30 billion and many more years to implement. Will all this time and treasure make Wall Street safe for Main Street?

No.

Dodd-Frank is a full-employment act for regulators that addresses everything but the root causes of the financial collapse. It serves up a dog’s breakfast covering proprietary trading, consumer financial protection, derivatives trading, executive pay, credit card fees, whistleblowers, minority inclusion, and Congolese minerals. Dodd-Frank also mandates 68 new studies of carbon markets, Chinese drywalls, and person-to-person lending, and many other irrelevancies.

ROOT CAUSES

None of this deals with the central problem – Wall Street’s reliance on claims of proprietary information to conceal the systematic production and sale of trillions of dollars in fraudulent securities.

Wall Street’s policy of full non-disclosure left only its CEOs and their top consiglieres in a position to know what their companies really owned and owed. Consequently, the valuation of Wall Street firms came down to trusting the people at the top.

As news of widespread financial fraud spread and the public realized that the “grownups” – the rating companies, boards of directors, regulators, and politicians – had been well paid to look the other way -- trust took a holiday. Wall Street’s house of cards began to collapse, taking Main Street down in the process.

Wall Street’s malfeasance was no organized conspiracy, but a self-expanding gravy train. Its participants included many of the world’s largest and most prestigious commercial and investment banks, insurance companies, hedge funds, credit raters, law firms, and accounting firms.

How many of the financial firms’ assets were fundamentally toxic is a question that may never be resolved. But that is really beside the point. With no way to independently verify, on line and in real time, the precise nature of a financial company’s assets and liabilities, any such firm can experience runs based on rumor as well as fact.

The serial collapse of Wall Street behemoths led Uncle Sam to step in and issue his own suspect securities – some $24 trillion (as measured by Neal Barofsky, Congress’ TARP watchdog) in contingent guarantees to all manner of financial creditors.

This is a colossal liability – more than twice U.S. national income. Were another massive bank run to hit Wall Street, say, next week, Uncle Sam would be forced to print trillions to cover these guarantees. But the prospect of getting paid back in watered-down dollars would lead people to run quicker -- to get their money and buy something real before prices skyrocketed. Hence, Uncle Sam’s guarantees are ultimately worth what they are written on – paper.

In short, Uncle Sam didn’t lead us out of the woods. Indeed, he led us deeper into the woods. While he temporarily saved Wall Street, he may have gravely endangered Main Street.

Meanwhile, Wall Street bankers are laughing all the way from their banks. One top banker after another has taken leave with their starter castles and yachts intact. Many have left with generous golden parachutes.

During the 1930s, Citibank’s CEO and the head of the New York Stock Exchange did serious jail time for financial peccadilloes; in the late 1980s, the S&L crisis led to more than 1000 felony convictions. This time around, aside from blatant thieves like Bernie Madoff and “Sir” Alan Stanford,” we’ve been far more forgiving. Dodd-Frank does instruct the US Sentencing Commission to reexamine its guidelines for financial fraudsters, but sentencing presumes conviction.

Yet the real criminal that needs to stand trial is our system of full non-disclosure.

PICTURES OF FOOD

Dodd-Frank contains some useful provisions – inevitably, in such a big bill. But this law is like being invited to dinner and served pictures of food.

Far from streamlining regulations, mandating greater transparency, and reducing uncertainty, Dodd-Frank provides government bureaucrats with seemingly unlimited hunting licenses. Only one of the roughly 115 current federal and state financial regulatory agencies has been consolidated. But 12 new regulatory bodies have been created with vast amounts of discretion. In the next two years they will hold an estimated 243 new rulemakings.

The law continues to provide no single regulator for deposit-taking institutions. The SEC and the CFTC continue to share authority over derivatives. A toothless National Insurance Office will “gather information” from 50 state regulators; the Fed’s new Bureau of Consumer Financial Protection will tip toe around the SEC and the FTC; a new Credit Rating Agency Board will rate credit raters; the Fed gets unfettered discretion to delay implementation of the Volcker Rule until 2023, and …. you don’t want to know.

Dodd-Frank is not just a prescription for regulatory sclerosis. It’s a bonanza for Wall Street lobbyists and lawyers, who will help determine what the law’s 283,985 words actually mean.

In 1990-2009, Wall Street spent an average of $2973 (in 2010 dollars) per Congressman per day on campaign contributions and lobbying. All this spending kept disclosure off the table and helped today’s financial giants to monopolize the industry.

PATHS NOT TAKEN

In 1982, seven people died in Chicago from consuming Tylenol tainted with cyanide by some criminal who is yet to be caught. Overnight, Johnson & Johnson found no market for its global 30 million bottles of Tylenol. Talk about a toxic asset!

J&J recalled all 30 million bottles, threw them away, and replaced them with safety-sealed bottles. In so doing, it disclosed the contents to be Tylenol not cyanide. Its toxic asset problem was solved for good.

Dodd-Frank’s approach is different. This law is akin to J&J restocking the shelves with the same unsealed bottles, hiring thousands of people to randomly inspect drug store aisles in the hope of catching the miscreant, and contracting with funeral companies to quickly pick up the dead. Indeed, a major part of Dodd-Frank focuses on arranging speedier funerals for failing financial institutions rather than preventing such funerals in the first place.

Dodd-Frank also relies heavily on the failed “good bank”-“bad bank” model of regulation. In this model, “bad banks” that take extra risks will be allowed to fail, while “good banks” are protected.

Earth to Congress: We tried this in September 2008. “Bad bank” Lehman was allowed to fail, and its failure blew up in Uncle Sam’s face. Citigroup, a "good" bank, would have failed but for a bailout; Goldman Sachs, a "bad bank,” might have failed had Uncle Sam not intervened. AIG wasn’t even a bank. But it was bad, and it was saved. When push comes to shove, the distinction doesn’t help.

THE RIGHT FINANCIAL FIX

Were we really serious about fixing our financial system, there’s a very simple alternative -- Limited Purpose Banking (LPB). LPB would transform all financial intermediaries with limited liability into mutual fund companies. Under LPB a single regulatory agency – the Federal Financial Authority – would organize the independent rating, verification, custody, and full disclosure of all securities held by the mutual funds.

Per force, by dint of competition and transparency, “liar loans,” off-balance sheet gimmickry, and toxic assets would disappear. LPB would let the financial sector do only what Main Street needs it to do – connect lenders to borrowers and savers to investors.

The financial sector’s job is not to take taxpayers to the casino and collect the winnings. This kind of “cowboy capitalism” is far too dangerous to maintain. But Dodd-Frank does precisely this, albeit with many more regulatory cops on the beat.

In contrast, LPB puts an end to Wall Street’s gambling with taxpayer chips. Since mutual funds are, in effect, small banks with 100 percent capital requirements in all circumstances, they can never fail and neither can their holding companies. Under LPB, financial crises and the severe damage they inflict on the economy would be history.

Of course, there will be losers. Some Wall Street executives would have to find employment in Las Vegas or offshore banks. Many lobbyists, lawyers, credit analysts, and accountants would need to find higher callings. And politicians would have to solicit more support from Main Street.

Alas, Dodd-Frank bears no resemblance to Limited Purpose Banking. But bad laws don’t always last, and this one may lead us to LPB by showing us precisely what not to do – if we ever get another chance.

James S. Henry is an economist, lawyer, and investigative journalist and former chief economist for McKinsey & Co. He is the author of Banqueros y Lavadolares (1996), The Blood Bankers (2005), and Pirate Bankers (forthcoming). Laurence J. Kotlikoff is a professor of economics at Boston University and author of Jimmy Stewart Is Dead – Ending the World’s Financial Plague with Limited Purpose Banking.