Detention Won’t Change a Delinquent

Dear Readers: Today, I would like to turn the Shrine over to Professor Athena (a truly “wise woman” highly placed in the financial services industry).

*****************************************************

Treasury Secretary Timothy Geithner is in Congress proposing expanded powers for the Federal Reserve to regulate “firms that pose a risk to the financial system”. One may wonder first how that qualification is made under their watchful eyes, and second what they plan to do about it that is different from the current moral hazard hanging over U.S. financial markets, which is the reality that nothing a private company does really matters in terms of risk, because the government will step in and either bail them out with a liquidity loan, or merge them, or in some cases own them. But, to understand why this expansion isn’t going to fix things, let’s look at Geithner and his biography, one which speaks volumes about what is really wrong with the U.S. financial system.

Geithner has never held a job in the private corporate sector, unless you count his first three years out of school when he worked for Kissinger & Associates. He has from the time he emerged from the high-dollar collegiate womb worked for the U.S. government, and is what defines an academician and not a specialist in the private side of the securities markets. As a lifetime political hack he sees only the wreckage in hindsight when development of a product results in a demolition. Saying he is an expert is similar to saying a guy who drives a bulldozer is an expert at building you a house.

The dearth of real private sector experience and skills in the Obama administration is not a new point, and has been much written about. Timothy Geithner fits right in with the professors and theorists. Why don’t we see giving the Fed “expanded authority” as a good thing? It boils down to what they haven’t acted upon.

Lying and fraud are illegal. Yet the SEC somehow missed Bernie Madhoff and his family’s giant scam through lack of proper audit. Others like him litter our current financial landscape, where risk products were structured and sold through hedge fund managers. Instead of accurately blaming the completely unregulated credit default swap markets and market makers for participating in what is a classic case of naked short selling and all of the unlimited loss potential that it represents, politicians and media with them have instead chosen to blame who? The banks, of course. And let’s not forget to mention that the national banks are who the Fed and the OCC currently have oversight and examination authority for. At some point we should ask why so many U.S. banks were in trouble with their asset quality, when they had so many examinations and oversight. Someone at some point should use the phrase beginning with “foxes” and ending with “henhouse”.

When you have lifetime politicians running private corporations and writing law, they miss the eternally-creative product development designed to circumvent them in the private sector. You get the 20-something guys working on Wall Street who are intent on maintaining their Upper East side Manhattan address and making their yacht payments. You get guys like the hedge fund managers and Bernie Madhoff, and you get AIG, whose massive underwriting of credit default swaps put their company at risk of bankruptcy. You get layered risk, where a risky loan was defaulted upon by a mortgagor, the mortgage which was structured (layered risk), and which was then leveraged to a firm’s capital by 30 to one (i.e. Lehman), and which was then sold down to nothing by the hedge fund guys using the CDS markets. The amount of layered risk was systemic, but if the Fed didn’t know it all along, then they cannot recognize junk bonds when they see them. I know this because I was there, and I saw it, and I recognized it. That’s what 30 years of on-the-ground experience in fixed income capital markets will get you as opposed to a decade or so of politics or academics. A poor credit choice, both from the point of the borrower as well as the lender will eventually punish both. But, it won’t typically take down an entire financial system. That takes manipulation, and that’s what we had. Bringing the government in for the rescue will most assuredly mean that the private sector never learns the essential lesson that exponential risk means exponential damage.

The entire threat of this same situation materializing again can be addressed cheaply and efficiently, in a couple of ways. The existence of structured product with regard to mortgages is already over. No one will buy those, but in the event that someone suddenly loses their memory of the pain of owning them, a structured products oversight and regulatory board of the OCC should prevent any U.S. financial institution from owning the more “layered” classes. Reaching for yield will at some point mean reaching for risk and potential closure by regulators. Just discard them as legal investments for banks and other FDIC-insured financial institutions to begin with. This is as simple an examination “tweak” as I can envision, and could be immediately put into action. Loans should be thoroughly examined and independently evaluated as a portfolio, and priced by an independent pricing service. Large collateral pools have been entirely ignored at the federal and state examiner level. They have focused on interest rate risk, and not on credit risk. It is time to change the rules and make them go do their work in the asset class that was always the most risky, and on which they have spent the past twenty-plus years ignoring. Further, CDS should be regulated at the federal level, ownership of the underlying stock or cash should be required (preventing naked short sellers and the hedge fund sharks), and capital of the underwriters of CDS should be monitored to stress the exposure to default on a constant basis. No more OTC markets without transparency. This could and should be regulated by joint authority of the CFTC and the SEC, with the emphasis on immediate enforcement. We do not need more layers of bureaucracy put into place that will make loans more expensive to the consumer and that will make business impossible to transact for loan originators. Expanded powers of the Fed won’t be a magic wand to fix what they always had the ability through their leadership and authority to address in the first place.

In conclusion, supervision of investment or banking firms was never the problem. There was an abundance of supervision, and a systemic lack of enforcement. It boils down to the inescapable fact that the most intricate laws in the world fail miserably if everyone ignores them. This is instead high school, where no one is paying attention in class. The administration’s current plan to have authority to send people to detention won’t change who the students are. It will take something call life and experience to shape that.

*****************************************************
MUT’s Money Links:

Roger Kimball: Are We There Yet? Preparing for the Coming Tax-Revolt. I would like to answer this question: When the founder of one of the largest Tea Party groups is a Democrat, the answer is – Yes, we are there.