The Good, the Bad, & the Ugly of Financial Reform (Part 1 of 2)

POTUS is on a tear, these days, isn’t he? Just weeks after the passage of a seemingly improbable health-care bill, one that many pundits still believe could cost his party dearly in November, our nation’s leader is moving on to his next big confrontation. This time, POTUS is gearing up to go after the entire financial sector. The fight to reform finance is not just one to rein in legions of Wall Street bankers and traders; this fight is apparently going to ensnarl everyone from small-loan providers on Delaware Avenue in McComb, Mississippi, to auto dealers on US 31 in Indianapolis, Indiana, to venture capitalists on Sand Hill Road in Menlo Park, California. And in time, sadly enough, it appears the fight that POTUS is picking will also have an impact on Axiom Strategy Advisors, LLC.

We will have to come back to the part about AxSA. For now, however, let’s keep this objective…

The overarching goal of the financial-reform legislation, which is being crafted into existence more so by Senator Christopher Dodd than by the legislative experts at the White House, is to effectively reduce systemic risks in the financial system. According to POTUS and his ilk, this should stave off future financial perils and the subsequent need for bailouts…Oh, if only it was that simple.

The Democrats vehemently believe they are justified in their pursuits, and to their credit, they could be marginally on point here. The real-economy downturn began, after all, as a result of upheaval in the financial world and the disruption to credit markets, and most of America’s taxpayers, whether liberals or conservatives, seem to blame Wall Street’s “reckless bankers” for the current state of the world.

Consequently, it would be tough to slow this train on the track to reform, but that doesn’t mean the effort is entirely prudent or just. After all, I did say that the Democrats were only marginally on point. Maybe that is why, when POTUS traveled to Manhattan to launch his second salvo, he did not have the audacity to go to Wall Street, where he knew he would have undoubtedly earned a cold shoulder. (Note: the first, actual salvo came in the form of a lawsuit from a weak SEC against the Goldman Sachs Group, Inc.)

A number of Democratic supporters would perceive Monday’s short-term victory by Senate Republicans to keep the bill from debate, as well as any Wall Street resistance, as typical, “party of no” antics designed to upend POTUS and his “change we can believe in” agenda, but it is not quite that simple. Some of these same folks (as well as most of the opposition) are unlikely to read the 1,300-page piece of legislation. If they would, then the majority would easily understand some of the problems with it and, yes, even why Republicans fought to stop it. Luckily, a guy like me will read it, because I am not one of most folks, and from that reading, I can tell you what’s to like and what’s not to like in this effort to fix an entire industry that is not quite as broken as some would lead others to believe.

In this two-part treatise of the financial-reform legislation, I hope to offer you, the readers of this blog, a primer that delves into the good, the bad, and the ugly components of the bill working its way through Congress. I think that it is important to understand this effort, because, if passed into law, as it stands, it will impact everyone from young entrepreneurs seeking new investors for their companies to young couples planning to buy their first homes. In the remainder of this missive, Part One, I will discuss what is good in the Dodd bill and why these pieces of the legislation need to survive. Later, in Part Two, I will focus on the measures that make this reform so troubling. It is from the latter that I contend the bill must be scrapped.

So, let’s get stated. Oh, and pay attention here, POTUS & Co. There are a few facts here that makes this a teachable moment for you guys.

The Good

Senator Christopher Dodd, the spearhead of the Democrats’ efforts to craft financial reform, recently said this: “Eighteen months later, and we are in no better position to protect ourselves.” Whether we like it or not, he is right. The market environment still functions in much the same way that it did in the months and weeks before the fall of Lehman Brothers, before the general public realized we were headed for a downturn. The only difference between then and now, I would contend, is that now government has assumed an unusual amount of the risks associated with questionable assets, in an effort to keep financial markets liquid. For banks, this has been a good course of action, because they have been able to unload billions in bad assets and rehabilitate their balance sheets. Unfortunately, all is not well with this approach, because, beside these efforts, nothing else has been done. Put another way, Senator Dodd might ask, “What is to stop another financial collapse from happening in two years or in eight years?” The answer is, unsurprisingly, nothing, at all.

Without some type of regulatory reform for the financial sector, the truth is, our financial system could be headed for Round 2 in this death bout. Sure, the likelihood of a second liquidity crisis in the financial sector is not readily obvious to most, but the possibility does exist, what with EU nations teetering on default, or what with delinquency rates of commercial real-estate mortgages heading higher and higher (2.77% at the end of 2007, 5.53% at the end of 2008, and 8.81% at the end of 2009). This makes Dodd’s point even more important. While the same conditions that plunged the financial markets into chaos do still exist, we also must recognize that now Washington, D.C., is a bigger stakeholder in this game, essentially propping up a house of cards. Hence, if there is another crisis, it stands to lose, as well.

Does any of this mean the system is broken? Hardly. For these reasons, though, do there need to be more safeguards or better ways to monitor financial markets’ biggest players? Absolutely.

The financial-reform legislation does include some elements that are good and that merit the attention of both Wall Street and skeptical Republicans. Here are just a few:

· Commercial banks would be required to hold more of their cash on hand. Until recently, it would seem that bank executives thought the best way to maximize returns was to leverage every dollar it had – and then some. By loaning out so much from its coffers, banks could draw greater returns from the interest payments. This is to say nothing about a bank’s proprietary trading. What’s more, more loans meant a greater diversity of returns and more returns to offset the bad loans.

As we have seen, though, it is easy for bankers to get sloppy drunk on profits, and they will quickly become overleveraged. Putting this into perspective, in 1976, the financial sector’s debt holdings measured up to about 16% of America’s overall economic output. By 2007, though, those holdings skyrocketed to 116% of GDP. And a commercial bank like Bank of America, in 2008, had an unconscionable $134 in assets (on and off its balance sheet) for every one dollar it actually had in its coffers. Any small decline in the value of some of those assets – and Bank of America would have been summarily annihilated.

Understanding this, the financial-reform bill does aim to raise capital requirements for commercial banks. This measure would not only require them to keep more cash on hand, but it would also mean that their lending standard would need to improve. And as we have witnessed by the example of Canadian banks, whose government already enforces stricter leverage caps, such a move could help to keep our banks from slipping into insolvency in the face of another shock to financial markets.

· The financial-reform legislation also calls for greater margin requirements in the commodities and derivatives markets – and this, I insist, is absolutely essential.

For now, we will only focus on commodities…It is true that, for example, a trader of, say, sugar could buy a contract today for 50k pounds of the sweet stuff, set for delivery in December, and holding a price of, say, $2 per pound. The trader is only obligated to put down a small percentage of the contract’s value, and let’s say that his total margin requirement is 15%. That means that our trader is putting down $15,000 for a contract valued at $100,000. Now, let’s assume that, before December, the price of sugar goes way north, and he’s able to sell the contract for $140,000. Then our trader has mad off with a handsome ROI of 26.6%.

We can be happy for this trader, but what if I told you that this trader was trading on behalf of your bank? And what if I told you that the price of sugar went the other way, hence the trade was a loss to trader? Suddenly, that low margin requirement might seem to be too low, or pose to great a risk, for such volatile markets, no?

We should put that thought aside for the moment, and focus on why these markets might seem so volatile, anyway. The reason is that commodities markets don’t require much skin in the game. Whereas margin traders in equities are required to put down 50% of value, in the commodities markets the margin requirements are far lower, and the idea of greater gains from lower initial investments makes these kinds of trades more attractive. In fact, it is partially from this psychology that we got the run-up in oil prices in 2008, and it is what prompted oil analyst Fadel Gheit, in 2007, to implore upon Congress the need to raise the margin requirement to 50%. Where commodities are concerned, Gheit called the current system of trading criminal, and he said, rather bluntly, “A family of four is going to have to cut corners to benefit a Wall Street trader who makes $20 million a year.” He was right; many families did. And without reform to this end, we will surely see these out-of-control commodity prices again.

· The proposed financial-reform legislation also gives the Securities & Exchange Commission funding that does not have to go through annual budget approval by Congress. This might not seem like a lot, but it is more than we know. The SEC is a frail agency, but its responsibilities continue to mount. Following Sarbanes-Oxley, the SEC has been buried in documents from public companies, all of whom are forced to disclose increasing amounts of information under the force of law; the SEC has been totally unable to keep up. What’s more, this regulatory body cannot compete with the private sector for talent. Until its budget is strengthened and its infrastructure for monitoring and policing some of America’s biggest enterprises is improved, we will continue to be disappointed by the SEC’s ability to do its job. This bill seems to suggest that there is an understanding of that fact, and it takse the first step to rectify the problem.

· Under guidelines in this bill, more brokers and financial planners will come under regulatory scrutiny, and the concept of fiduciary duty will be broadened to better protect investors. This should be self-explanatory, but most people qua investors never seem to remember that their brokers and advisors are among the best-paid salespeople in the country. All too often, these individuals must sell their firm’s latest products, or speak in union with the firm’s interests, in order to keep their jobs. Unfortunately, that can be outside of the interests of the investors. Such was the case for the father of a dear friend who, in the wake of the 2008 stock market slide, was told by his financial advisor (a relative, no less) that, in spite of his retirement plans, it was a perfect time to pour more money into the market and not to close his battered accounts. He was not the only investor getting the same advice from brokers and planners at the time, but as an investor, he should have been able to trust that any advice from his financial advisor, particularly during times of uncertainty, was being given to him with his best interests in mind. That this type of trust has to be legislated in order for it is exist is truly disappointing, but it is also part of the simple reality of our times.

In an effort to identify and combat systemic risks, as well as to afford better protections to investors, no one can argue that the Democrats have gotten it wrong with the aforementioned measures. Senator Dodd should be commended for his work, and I believe both sides of the political spectrum should ultimately come together on these measures. Unfortunately, the same cannot and should not be said for some of the others.

For all of the good elements in the legislation, there are some truly bad components being jumbled under the banner of reform. The Republicans were right to block a floor debate on it, if only because, in some instances, the proposed financial-reform legislation simply was too far-reaching. It would have wrapped governmental tentacles not just around the derivatives arena, where our troubles began, but also around other arenas like angel investing, retail lending, and hedge funds, just to name a few. In Part Two of this treatise, I will discuss some of the bad elements of this legislation, and I will clearly explain why some of them, if allowed to pass into law, will have the ability to do more harm than good.

…Stay tuned.