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Obama's False Financial Reform Is Nothing But Smooth Talk and Some Fuzzy Plans

Missing in the Obama plan are hard rules -- the classic quality of laws that command behavior by prescribing "thou shalt" or 'thou shalt not."

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The president, for instance, proposes to raise the requirements for capital and liquidity held by commercial banks with strict limits on leverage -- their ability to borrow. That is a virtuous proposal, but it begs the question. Why did the legal limits already in place fail to restrain the appetites of bankers? Indeed, several times in the last two decades the Fed and other central banks enacted new and supposedly more effective capital requirements to curb the excesses. The big dogs of banking broke free of the leash again and again while vigilant watchdogs at the Fed and elsewhere looked the other way. Why should we expect different results next time?

One reason why old restraints failed is the so-called "modernization" that shifted the credit functions outside regulated banks and into a variety of unregulated money pots -- the so-called shadow banking system of hedge funds and private-equity firms. These all interact intimately with traditional banks and give the banks profitable ways to evade the old rules or conceal the actual condition of their balance sheets from both regulators and innocent investors. This interactions are dazzlingly complex -- too complex for even the bankers themselves to fully understand -- but this was not an accident of nature. It was the goal of financial deregulation enacted by Bill Clinton, arm-in-arm with the Republican Congress.

Likewise, banks were allowed to play these games by legislative creation of "off-balance sheet entities" where they can park their holdings -- debts or assets -- beyond the view of casual observers. This is essentially the same accounting trick that empowered Enron and other corporations to hide their true condition (then collapse). The biggest bankers played roughly the same game. In fact, it was the bankers who taught Enron and others these tricks. What public purpose is served by these devices except to conceal reality from public investors? For that matter, what is the public purpose of letting corporations, banks and wealthy individuals park their wealth in the Grand Cayman Islands? Everyone in Wall Street knows the answer. It allows them to evade "legally" US regulations and tax law.

Summers-Geithner suggest the shadowy banks like GE Capital or major insurance companies can be regulated by the Fed as "Tier 1 Financial Holding Companies." No real details available. As Joe Nocera recently noted in the New York Times , "Tier 1" sounds like the new name for "Too Big to Fail." The Fed will watch them (we are assured) to prevent "systemic risk" that could lead to national breakdown. But that is what the Federal Reserve was supposed be doing already as the "lender of last resort" charged with defending the "safety and soundness" the banking system. The Securities and Exchange Commission, likewise, is supposed to monitor hedge funds and private-equity firms that thrive on secrecy. Since the SEC failed miserably to police regular corporations, it does not sound reassuring.

Another example of extremely wishful thinking is the proposed rule on securitization of mortgages. The method of bundling home mortgages and turning them into saleable bonds was supposed to reduce risk but did the opposite. The mortgage lenders were able to execute dubious, even fraudulent loans, collect their profits up front and then sell the package to unwitting investors around the world. Obama's answer is to require the originating lender to retain a 5 percent interest in the mortgage and pass on the rest. That seems ludicrous and innocent of how that cutthroat world actually works. The financial geniuses who created the subprime mortgage scandal could hide 5 percent of the mortgage value with a couple of keystrokes -- adding fees, closing costs or other dodges. To hold lenders genuinely responsible, they should be made to hold onto something like 50 percent of liability for the original loan with perhaps the other 50 percent assigned to whatever bank or investment house packages the mortgage security and sells it to financial markets. That would be "responsibility" with old-fashioned force.