Paul Tullis's Grim Tidings

Bitter musings on politics and policy

Three key financial reforms

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If you want to follow whether the financial-reform bill introduced by Sen. Dodd and recently sucking up a greater percentage of oxygen inside the Beltway now that health care is done, actually means anything in the end: Pay attention to these three key changes. Each will be a crucial factor in preventing a repeat of the breakdown of the financial system that occurred in fall 2008 (or not, in which case my advice is to invest in canned soup and bottled water, arm yourself, and move to a cabin deep in the woods somewhere.)

1) The bond-rating agencies, especially Moody’s, must become truly independent entities that are not paid by the companies whose products they are rating. As things currently stand, Moody’s is under strong structural pressure to rate crummy bonds and other debt instruments highly because they know who’s paying their bills. And with the most explosive products being issued by only a few institutions, there’s a paucity of data to rely on to rate them– it’s not like corporate or sovereign bonds, of which there are very, very many issued by very, very diverse institutions. Moreover, the data the ratings agencies rely on to rate the products comes from the very same banks whose products they are rating, and the models they use to forecast default are similar to what the banks use to create them. So what’s the point of a ratings agency at all, if that’s the situation? What happened in the lead-up to 2008 was, a bunch of shitty loans with low ratings and high likelihoods of default were packaged into securities which magically had higher ratings than the loans of which they were composed. This Alice-in-Wonderland logic misled investors to believe that the products they were purchasing were safe from default, when in fact the opposite was true. If Moody’s isn’t getting paid by the people whose products they are rating, this routine is likely to become less of a farce.

2) No more opaque transactions between banks. As things now stand, collateralized debt obligations and credit-default swaps are not only traded away from open exchanges, they are traded off the books of the parties to the transactions. How is this possible? Markets require information pertaining to them to be available to all participants in order to act efficiently. And yet—thanks to the intervention of Bob Rubin, Larry Summers, Allen Greenspan, and others, all of whom told Congress that regulating these derivatives was not only unnecessary but dangerous, when the opposite proved to be true—trillions of dollars are traded in ways completely invisible to investors or regulators. This is heretical to one of the core tenets of capitalism about which every economist who endorses the system from, Krugman to Friedman, agrees, and it must end if we are to be safe from another calamity.

3) No more side trading with taxpayer-backed funds, i.e. the “Volker Rule.” Since the repeal of the Glass-Steagall Act, which was implemented to fix many of the problems that led to the Gerat Depression, in 1999, banks whose deposits are backed by the full faith and credit of the US government, the most credit-worthy institution in human history, can go around making whatever bets they like to the benefit of their own company (rather than their customers). So if they bet wrongly often enough or severely enough, the public foots the bill—even though it would’ve been a private institution profiting had the bet gone well. This is just patently unfair; if banks want to rely on the Treasury to back them when they fuck up, they should be cutting the Treasury a check when they succeed. (Try getting Jamie Dimon or Lloyd Blankfein to agree to that one.) Moreover, this state of affairs motivates banks to take chances they wouldn’t otherwise take—because they know that ultimately it’s not their asses on the line. If an institution wants to engage in this kind of activity, about which there is nothing wrong per se, they can get off the public till and become hedge funds or private-equity groups, which are not backed by the FDIC and which eat their own losses when they lose.

Unless, of course, they’re Long-Term Capital Management.


One Response

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  1. Here’s wishin for the return of Glas-Steagall.


    April 14, 2010 at 10:57 pm

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