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Monday, June 15, 2009

Assessing Obama's New Regulatory Framework

In an oped today in the Washington Post, Obama's two chief economic advisors laid out the principles for the administration's new regulatory framework. There are five principles.

1) More focus on systemic risk

The administration believes that not enough care was put toward making sure that companies that posed a so called systemic risk were both fully capitalized and safe in times of systemic risk. The administration will thus propose that bigger firms will have to carry more capital and they will make the Federal Reserve the new systemic risk manager.

The second idea is a horrible idea. The Federal Reserve is far too powerful as it and the administration now wants to give that organization even more powerful. I think controlling the world's money supply is plenty power enough. I think being in charge of banking regulation is enough power along with controlling the world's money supply. To give them the duty of systemic risk manager continues to consolidate power in an organization with far too much power already.

The first idea may or may not be a good idea. The devil will be in the detail. It all depends on just how much capital will be required of these massive institutions. If they require a very cumbersome amount of capital in reserve then it will slow down lending and investment. That will mean that in order to avoid an economic collapse the administration will guarantee a perpetual state of small growth.

I am not convinced that under capitalization was the problem to begin with. I believe the problem was that too many of these institutions were far too capitalized in Mortgage Backed Securities. That is an issue of a lack of diversification not a lack of capitalization.

Second, they will impose more transparency on Mortgage Backed Securities and also require that the originator carries some of the risk. This is both needless and counter productive. There is almost no market left for MBS and other similarly securitized assets. After their blow up, the market for them went away. Coming in to impose major regulations is sort of like demanding better levees in New Orleans after Katrina. The damage has been done and they are really no longer being used much.

I am all for more transparency in these though of course the devil is in the detail here as well. Giving the originator some financial risk in the asset is both ludicrous and unnecessary. First, most of the contracts between banks and securitizers already have some financial risk exposure in case of serious defaults. Second, any onerous financial risk applied to the banks only insures that banks never ever get back into this market again. If we want some sort of sub prime mortgage market ever again we aren't going to get there by imposing significant risk to players that get into it with the assumption that they have little risk. Banks aren't ever going to get back into subprime still face default exposure even after they have sold the loan. The whole point of selling the loan is to remove that exposure. There has the be some buyer be ware in this market.

This also runs counter to the manner that loans are structured. When a loan is approved it is approved based on guidelines created by the securitizer not the bank. It isn't Wells Fargo that approves your loan ultimately but Fannie/Freddie. The same is true for MBS. The securitizers decide how they will approve the loans they buy and securitize. So, they should run the risk for defaults. The administration wants the banks to run those risks even though they aren't ultimately the ones creating the guidelines.

3) Fighting predatory lending. I predicted this and in this piece I explain why it is ridiculous. You can read it to see why this will be nothing more than a sham.

4) A new tool to manage the resolution of financial crises. Here's how they describe it.

resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.

If you have noticed a theme it is that the government doesn't currently have enough power and they need a lot more. Anyone who is a libertarian must be rolling over right now. This is by far the scariest portion of their plan. The language here is so vague that it's impossible to know just how it will be used and for what purpose. Keep in mind that we already have an SIPC, FDIC, Federal Reserve, SEC, FTC, among many, many government regulators designed to regulate financial services firms. If that isn't enough, how much is enough?

5)They want to make all of this global.

That speaks for itself and should put a chill on anyone that believes in the libertarian foundations of our country.

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