Speculating Banks Still Rule -- Ten Ways Dems and Dodd Are Failing on Financial Reform

None of this is reform. We are better off with nada than vapid promises and a false sense of security.

As we wind up for another dramatic bipartisan squabble over all the crap Wall Street flung at us, things are getting back to normal – for the wealthy. The top 25 hedge fund managers made a record $25.3 billion dollars in 2009. And despite all those dramatic congressional hearings, average compensation of Wall Street bankers rose by 27 percent in 2009. Meanwhile, banks are hiding their debt with the same old balance sheet magic they've been deploying for years and posting record new trading revenues—putting the economy at risk while creating no perceptible economic benefits.

On the other side of humanity, more sobering numbers include a record 2.8 million properties in foreclosure for 2009, a 21 percent increase over 2008's astonishingly high figure, with another 4.5 million foreclosures projected for 2010. Federal mortgage modification plans have not stemmed this tide, because lenders aren't required to particiapte; and lenders, in the words of Herman Melville's Bartleby, "would prefer not to" renegotiate a mortgage for which they'd then have to book a loss. As foreclosures continued to climb, so did bankruptcies, rising 35 percent in 2009 over 2008 levels.

Banks -- shockingly -- aren't helping. They posted their lowest lending rates since 1942; despite all the subsidies and cheap money they received from, well, us, including exceedingly low Federal Reserve loan rates (zero to 0.25 percent interest).

That brings us to Bubble Lesson 101, Greenspan and Bernanke edition:

Cheap Money + Intensified Trading = Disaster Waiting to Happen.

Banks are incentivized not to lend. When the Emergency Economic Stabilization Act (which included TARP) was passed in October 2008, it included some fine print allowing the Fed to pay banks interest on reserves (money, or capital, banks are obligated to park with the Fed to back their businesses), and on extra reserves (money they aren't obligated to park). In September 2008, the top banks were required to keep $43 billion dollars in reserve at the Fed, and placed $59 billion in extra reserves. Today, banks are required to keep $63 billion in reserves, but parked an extra $1.2 trillion at the Fed.

Meanwhile, banks are using other federal funds to bolster speculative operations. The biggest banks, such as Bank of America, J.P. Morgan Chase and Wells Fargo, are on a dangerous cycle of higher trading profits and mounting losses in their consumer businesses. In other words, banking businesses that are tied to the real economy are dying, but raw gambling disguised as finance is doing fine. Wall Street is making money by rolling the dice – again. All this risky activity seems to be going unnoticed in Washington. Without major reforms, the next crisis is going to be worse than the last. Because if you pump enough money into anything, it'll look good temporarily, and that seems to be all politicians in either party really care about. But without major reforms, the next crisis is going to be worse than the last. 

Today's juvenile partisan antics guarantee no meaningful reform bill will be produced, and mock our own history of bipartisan bank reform. In 1932, Senate investigations into the behavior of banks that precipitated the 1929 stock market crash were commissioned by a Republican Congress under Republican President Herbert Hoover. They continued under Democrat President Franklin Delano Roosevelt and substantive reform was passed, including the Glass-Steagall Act that decisively separated speculative from consumer oriented banks. Equivalent investigations this year are a joke. 

Senate Banking Committee Chairman Christopher Dodd's financial "reform" proposal (Barney Frank's wasn't much better) won't change the nature of anything Wall Street does. Dodd's needless watering down of a proposal to create a new Consumer Financial Protection Agency has been well-documented, so here is a list of 10 other problems Dodd's bill will not fix:

1) It won't make the biggest most "systemically important" banks (read: systemically destructive) any smaller. It won't even reduce the size of banks like Bank of America and Wells Fargo that are operating with more more than 10 percent of U.S. insured deposits -- a limit currently imposed by law. Instead, it will add another 10 percent liability cap that banks can ignore, allow the Fed to keep selectively merging banks, and then create a new council to determine still more concentration limits that can subsequently be ignored. Regulators had plenty of power going into the crisis. Congress needs to force them to exercise it, and force a breakup of the biggest banks, now. Those that failed the economy last time around cannot be expected to get it right next time with an expanded set of powers.

2) It won't reduce the economic danger from rampant, overleveraged trading activities. The bill would restrict certain banks from having proprietary trading operations (trading with their own capital) under the "Volcker rule," but it's full of problematic exemptions:

a) Banks that claim they trade on behalf of their customers (which they all say they do) escape the rule.

b) Banks that trade for "market-making" purposes (i.e. Goldman Sachs betting against its own clients) are home-free.

c) Banks aren't required to itemize their trading operations to regulators, so they get to decide what they consider trading for their customers and what they consider proprietary. I wonder how that will work out.


3) It won't change the nature, transparency, size, complexity or usage of the most heinous derivatives. Why?Because the derivatives that are not standardized or over-the-counter (OTC) will not be required to be traded on regulated exchanges, though they may have to show up on trading depositories (private entities, whose boards are comprised of bankers).

4) It won't prevent the creation of new toxic assets. It will require issuers of these assets to retain 5 percent of any package they sell off to investors (keeping some skin in the game), but there is no way to monitor which 5 percent is kept, and even that rule has a bunch of embedded exemptions.

5) It won't contain the risk to the shadow banking system from hedge funds, private equity firms and venture capital funds. Venture capital and private equity advisers still won't have to register or report to the SEC, though hedge funds with over $100 million in assets will. There's also no statutory definition of what actually constitutes a hedge fund, and the bill doesn't close the tax loophole that allows fund managers to be taxed at the lower capital-gains tax rate of 15 percent, rather than the higher income tax rate of 34 percent. If it sounds crazy to you that the richest people in America are being taxed at the lowest rates, it is: the loophole cost taxpayers about $5 billion this year alone.

6) It won't remove the conflicts of interest between banks that issue securities and rating agencies that rate them, and get paid a fee for doing so. Rather than nationalizing the rating process for these unconstrained securitized deals, it would create a new entity (Office of Credit Ratings) within the SEC to examine rating agency practices and methodology annually and at some point in the future, issue rules to keep sales and marketing considerations from influencing ratings, leaving a lot of exemption room. The SEC had authority to regulating the rating agencies before the collapse, and it didn't exercise it.

7) It won't contain systemic risk. The Dodd bill's primary attempt to limit systemic risk is the creation of a new Financial Stability Oversight Council led by the Treasury Secretary to help the Fed develop more better standards regarding the biggest banks it oversees, based on recommendations, not rules. Another effort is to suggest an (undefined) increase in capital requirements that will be deferred to the Fed for the biggest banks. And, as mentioned above, banks are already hoarding capital at the Fed, and increasing their trading operations and decreasing lending, so that doesn't really help better the system. Let's not forget—if the Fed wanted to raise capital requirements on big banks it could do so right now, with no Congressional action whatsoever. What are the odds that this suggestion from Congress will result in meaningful action?

8) It won't wrest control of our economic future from the banks the Fed couldn't regulate over the past decade. It states that the Fed, as consolidated supervisor for the largest banks, "can see risks whether they lie in the bank holding company or its subsidiaries," as "they will be responsible for finding risk throughout the system." This was true over the past decade, and it was meaningless.

9) It won't constrain the Fed's future bailout operations. It appears to limit the Fed's ability to lend money freely to firms in trouble by "allowing" its system-wide support only for healthy institutions or systemically important market utilities. But what's to stop the Fed from designating any company a "systemically important market utility"? That was basically the rationale behind the AIG bailout.

If the Fed does funnel money to these entities, the Fed must report the details of this assistance to Congress within seven days, unless the Fed believes it would "compromise the program or financial stability." It then can delay disclosure of the recipients as well as the size of the loan and collateral pledged under the facility for a full year. If, after one year, the Fed still feels disclosing this information would be "counterproductive," then the Fed "must" provide a report to Congress explaining why within 30 days, and report on a yearly basis until the "disclosure is complete." There is no time limit for this ridiculous process. It could literally go on for decades. Should the Fed decide not to make the required disclosures-- drum roll please--the Comptroller General should issue a report to "evaluate whether that determination is reasonable." And, there we are, back to square one, with big, secret bailouts. 

10) It won't prevent bank failures by separating speculative banking from deposit-insured commercial banking a la Glass Steagall, but instead contains plans for resolving them, after the fact. The funeral plans include asking large companies to submit "living wills," and to be penalized with higher capital requirements and growth restrictions if they don’t submit acceptable plans. The scary reasoning for this funeral blueprint is that, "Plans will help regulators understand the structure of the companies they oversee and serve as a roadmap for shutting them down if the company fails."

Ostensibly, this confirms that regulators don't understand how these banks operate now. But these living wills won't help shut down big banks. They conduct millions of dollars worth of trading operations, including complex derivatives trades, every single day. The living will would be out of date hours after it was authored.

None of this is reform. We're actually better off with no legislation than we are with this vapid 1,336-page opus—the false sense of security it creates will only encourage greater risk-taking. If the Dodd bill passes in its current version, we absolutely, unequivocally will see another system-wide crash that will invoke greater hardships on the country than the last collapse.

Nomi Prins is a senior fellow at the public policy center Demos and author of It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street.