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

What is the magic number for defiant Republicans in the United States Senate? Well, it appears to be three.

In the last week of April, Democrats made three attempts to open a floor debate on their financial-reform legislation, and each time they did, the Republicans shot them down. By acting as a unified front, the Republicans wanted to make certain that, if this debate was imminent, they would have a real seat at the table. Of course, for their part, the Democrats were quick to criticize the Republican tactic. In an email to supporters of President Obama’s 2008 campaign, for instance, the community-action group Organizing for America called on voters to pressure their Republican senators to support the reform bill. The OFA even claimed that, for many of these legislators, it was not too late “to cross the aisle and stand with Main Street”, as if everyday citizens had actually taken an interest in the bill’s formulation. Such typical Beltway rancor could have gone on for a while, and believe it or not, we might have been better for it. But, somehow, ultimately, a deal was reached, prompting the both sides to dial back their bravado.

The one concession Senator Christopher Dodd and the Democrats did seem to give Republicans dealt with a controversial proposal in the bill. According to this proposal, big banks and financial firms would have been subjected to a new set of fees for the creation of yet another government agency, this one designed to unwind these same firms in the event of their failure. The truth cannot be ignored that, where banks are concerned, this is already the responsibility of the FDIC, and to most Republicans, the measure was akin to structuring a permanent bailout fund, something untenable to the populist crowds in both political parties. Therefore, it is easy to see why the Democrats were willing to drop such a dubious component of their financial-reform legislation. Unfortunately, that is only one bad component in 1,300 pages of equally bad policies.

In Part I of this treatise, we explored some of the better elements of the financial-reform legislation crafted over more than a year by Senator Christopher Dodd & Co. To mitigate systemic risks in the future, the Democrats correctly seek to raise the capital requirements of banks and the margin requirements in commodities and derivatives trades. They also hope to strengthen the abilities of the Securities & Exchange Commission, by giving the agency annual funding that bypasses Congressional approval. What’s more, the Democrats want to broaden investor protections. With these efforts in mind, I reiterate my belief that they are marginally on point…Yes, marginally.

For every good measure being proposed by the Democrats, the reform bill headed to debate on the Senate floor contains another equally bad measure – and much more. If passed, this bill would stretch the tentacles of government far beyond the true sources of our current economic troubles and into areas where such interference are certain to stymie innovation and growth. Sure, that last statement sounds a lot like a Republican sound bite, but that does not make it any less true. In fact, few can deny that the reform bill actually amounts to anything less than a wholesale seizure of control by the federal government over vast sectors of the financial system, and such an act, in and of itself, is not good for anyone, least of all the very government proposing it.

The Bad

Perhaps the far-reaching thrust of this current reform legislation was best clarified that by the Treasury Secretary Tim Geithner. In April, during a Sunday morning interview on Meet the Press, Secretary Geithner said that the financial-reform legislation was “about the basic financial security of the country, [and] the financial security of all Americans”. Indeed, those were frightening words to those of us who understand that financial security was rooted financial intelligence and individual responsibility, not in the government supervision.

For the moment, though, let’s follow the Geithner line of thinking. He and the Democrats seem to have concluded that America can avert another downturn and find the high ground of “financial security” through broader regulation of all things finance. On that premise, they would have to go far beyond just mitigating the spate of systemic risks that caused the downturn, and instead, under the same banner of reform, they would have to impose more rules and more government supervision on any and every aspect of our economy that might rely on the financial markets. The premise seems simple enough to understand, but it also helps us to understand why their line of thinking, as well as the resulting legislation to this effect, is so badly flawed.

We should begin by taking a look at some of the more vexing parts of the reform bill. To be sure, while there are some sensible proposals, like those noted in Part I, they are totally outshined by the bad ones, making the bill a tough one to support. Yes, I agree that reform is necessary, but I must further contend that this bill, in its current form, must be scrapped. Here are just a few reasons why:

• · Perhaps the most atrocious proposal in the financial-reform legislation deals with angel investing. In practice, when entrepreneurs need seed money to form and operate their businesses in the early stages, they go to angel investors. These angels are traditionally high net-worth individuals who are willing to use their own money to make investments in these young companies. Currently, the process has been pretty straightforward; young enterprises got cash from their investors, after a bit of heavy bargaining, in exchange for equity positions in those enterprises. What’s more, to entice such investment in young but risky ventures, the sales of these securities from young companies to accredited investors have largely been exempt from SEC disclosure rules and from state securities laws upon the submission of the Form D to the SEC.
  
  
  With this bill, the rules for angel investing and the process by which we raise capital are set change dramatically. First of all, the bill proposes raising the “accredited investor status” from $1 million in net worth and $250k in income to $2.3 million in net worth and $450k in income. What’s more, as another blow to these young businesses, any start-up seeking angel investment will have to file with the SEC for a 120-day review of its plan, and the exemption from state securities laws disappears.
  What is the total effect of this move? Well, for young companies, it is tantamount to death by a thousand cuts. By raising the bar for those who can be described as in accredited investors (as if anyone’s income makes them more or less financially sophisticated than his peers, particularly as of late), thousands of would-be angels will deemed “non-accredited”, and even their presence in investment opportunities compels a series of mandatory filings. Today, it is rare for many big investment offerings to include non-accredited investors, due to the compliance costs and regulatory mandates associated with the rules set up to protect them, and so, it is easily conceivable that the majority will be left out entirely. Take for example the case of one AxSA client. While this client is hoping to raise over $5 million in seed financing his new Louisiana-based, computer-graphics software venture, he concedes with frustration that these rules push out family member and friends as potential investors, due precisely to the regulatory mandates.
  
  
  Beyond just that, a new regulatory regime for ventures seeking angel investments will only raise other compliance costs and legal fees, as ventures are forced to meet the securities laws of different states. Return to the example of the AxSA client. As he hopes to raise funds from high net-worth individuals in Colorado, Virginia, and Texas, under provisions of the reform bill, should it be made into law, this young entrepreneur will need to make certain that his offering is now compliant with the securities laws of three states, in addition to his own. Immediately, he will see attorney fees, consulting fees, state filing fees, and a horde of fees compound –and this is before his business ever gets a dime of new capital.
  
  
  With this summarily bad policy, the Democrats hope that they can sift out potentially bad companies and future cases of fraud, but I contend that they will do more harm than good. By raising the accreditation threshold, they block many would-be investors not only from good venture opportunities, but also from other types of investments like hedge funds. Also, these rules will not stop the large percentage of business failures; there will just be fewer businesses around to fail. And as for fraud – well, we have seen how effect the SEC is at rooting that out, haven’t we?
  
  
  · The Dodd financial-reform legislation includes a plan to deal with hedge funds, as well. At present, hedge funds are a largely unregulated investment pools only open to accredited investors and typically managed by experienced professionals. They scour nearly every part of the global and every type of market for investment opportunities, along the way picking of anything from shares in publicly-traded companies to partnerships in secluded resorts, all in an effort to maximize returns for investors. With the new reform bill, any hedge funds with $100 million in assets under management will be made to register with the SEC, and with that registration, they will be compelled to disclose their trading strategies and information about their significant positions. Naturally, these filings will become public record, and that seriously undermines the very secretive operating culture of most successful hedge funds.
  
  
  Democrats will quickly cite the disastrous fall of Long-Term Capital Management as proof that hedge funds can pose a systemic risk. That is not untrue; however, I am not certain that even a vigilant SEC can prevent the next LTCM from going down and taking lenders and investors with it. Instead, I think that it is best that we stick to the model that history has given us: LTCM was bailed out. And for all practical purposes, there is no reason to believe that another hedge fund of this size would not be bailed out in the years to come, even if there was SEC supervision.
  
  
• · Of course, in the event that we do need to act, according to provisions in this legislation, the government will be given the power to seize and break up any large financial firm that it deems too big…Such a measure might seem to be popular with the denizens, but it is patently un-American. Government agencies have no right to take over private property on the pretext of prevent harm to the common good, but if they do, there are some clear questions to be asked. What will be the criteria for making such a decision? How will the products and services offered to customers be divided among the disparate, new entities? Who will compensate the shareholders for losses associated with a firm’s dismemberment? Indeed, I would contend that, given all of these uncertainties, it is better that we encourage financial firms to be better capitalized and trust the markets to do their jobs, before “we the people” try to tread in waters that are too deep and too murky.
  
  
• · With this ability to takeover banks, the financial-reform legislation also calls for commercial banks to end all investment-banking and proprietary trading activities. This effort has become known as the Volcker rules, named after Paul Volcker, the former Fed chairman who has the ear of POTUS. Mr. Volcker is normally a very sensible gentleman, but on this matter, he is mistaken. By barring these firms from investment banking and from trading, banks will not simply shut down their operations and assume some limited-purpose existence. Rather, we run the risk of driving those operations out of the United States; places like Canada, Hong Kong, and the UK, where the rules are not as stifling, will benefit from such the capital and talent exodus from the United States. Indeed, this rule would have detrimental consequences on market liquidity, because it would, in effect, be diminished by an unknown sum, should banks not be allowed to participate and move that capital elsewhere.
  
  
• · Adding to the new burdens on America’s banks, the financial-reform legislation seeks to fulfill the wish from POTUS to charge them a fee associated with the banking bailouts from the Bush administration. POTUS justified his fee on banks by saying this: “… [T]o save the entire economy from an even worse catastrophe, we had to deploy taxpayer dollars. Now, much of that money has now been paid back and my administration has proposed a fee to be paid by large financial firms to recover all the money, every dime, because the American people should never have been put in that position in the first place.” What he fails to remember is that most banks had to be forced to take these funds.
  
  
  An even bigger problem with this fee is that it will act as a “stealth tax”. POTUS hopes to use the fee on banks and other financial firms as a tool for raising $90 million dollars over the next decade. If the reform bill is passed into law, no one should expect banks to take it lying down. In fact, if anything, we should fully expect them to pass these fees on to their customers. That is the formula for taxation by stealth. To be sure, the fee may not come directly from Washington, D.C., and POTUS will be able to maintain his campaign promise not to raise taxes on Middle America. Nevertheless, large portions of the services fees to be charged to bank customers, including those bank customers from Middle America, will end up in the federal government’s coffers. Therefore, it is a tax, even if it is applied indirectly.
  
  
• · The financial-reform legislation also calls for the establishment of a consumer finance-protection board, to afford borrowers safeguards against predatory lending practices. On the surface, this might seem like a noble gesture. After all, at the outset of the financial crisis, many homeowners found themselves buried by mortgages they could not repay. What’s more, there is evidence that thousands of those borrowers got loans with terms that acted as time bombs. With this measure, the Democrats want to give borrowers peace-of-mind as they sign up for new mortgages, car loans, credit cards, et al. The only problem is a lack of strength to back that consumer confidence.
  
  
  Critics of this measure correctly complain that the board does not have enough power to truly protect consumers. Initially, they point to the fact that, as proposed, the agency will be operating under the auspices of the Federal Reserve. Yes, it is an awkward fit, because the Fed places greater priority on monetary policy and financial stability than on consumer protection. (Talk about your mystery wrapped inside of someone’s enigma.) Critics argue that this setup voids any notion of independence and leaves the agency toothless. Beyond that, given all of the opposition to the very existence of such an agency, those critics might actually be very right; this setup is all wrong, and this agency seems to only be granted an illusion of effectiveness.
  
  
• · Of course, no financial-reform legislation would be complete without taking a stab at the very things that led to calls for reform in the first place. Derivatives – the financial instruments that brought down a number of financial firms and wrecked the economy in 2008 –are still entirely unregulated and largely unseen. Consequently, the Democrats seem to be positioning themselves to fix that matter…in a way.
  By calling for the creation of a formal exchange and a clearing system for the trade of derivatives, the Democrats believe that they can bring transparency to this dark corner of the financial world.
  Unfortunately, their approach could be very problematic. For starters, in order for the derivatives to trade in a transparent setting, there is serious need to standardizing these derivatives, making the underlying value of one derivative the same as another. Without this, markets participants will have a difficult time determining true values of any two instruments that, at least ostensibly, seem to be identical. And while this is an important fact about transparent market trading, the Democrats have seemingly missed it. Neither the reform bill from Senator Dobb nor the version created by the U.S. House of Representatives calls for standardization.

There are a number of other bad proposals in the financial-reform legislation. For example, the bill gives the Federal Trade Commission rule-making powers over the banking industry, immediately usurping any state regulations on banks. It calls for the creation of yet another bureaucracy, this one to oversee the insurance industry. And in nothing that relates to the financial sector, at all, the bill also calls for the shareholders of publicly-traded companies to have a nonbinding vote on executive pay, and for any company listing on an exchange to have on its compensation committee, at minimum, one independent member, as well as to empower that compensation committee to hire consultants. Indeed, there is a lot of over-reaching in this reform bill.

The Ugly

For all of the good and bad components of the financial-reform legislation, it is clear that the bill will not do some fundamental and very necessary things. For example, while there is a greater emphasis on consumer and investor protections, the legislation from the Democrats does nothing at all to promote the advancement of financial literacy in these groups of people. To that end, it may not end the epidemic of bad loans and murky investment products, because no genuine standards are set to control each of these. Also, much to the chagrin of populists in both parties, the legislation does not avail the Federal Reserve to Congressional oversight. And perhaps more profoundly, the bill does not totally prevent another financial crisis or the need for structured bailouts, because it realistically cannot.

Markets are markets. They naturally rise and fall in cycles, and there is little any of us can do to control those cycles. Our government can acquire bad debts from some business’s book, or even take an equity stake in the business, but that does not make the risk disappear. It only shifts the risks onto the government. Our government can try to restrict certain type of business activities within its borders, but today’s businesses are adept at, and almost indifferent about, moving those operations aboard. And in the face of regulatory, markets and their participant are quick in their ability to change and maneuver around such rules. In short, the invisible hand will always find a way to outsmart its sibling, the iron fist. I suspect that the Democrats know this to be true, even if they refuse to admit it.

The Democrats, for all the reason listed here, might be well-served to take another look at the legislation that they are proposing. They need to better understand the full impact to come if it becomes law. Indeed, the consequences of this financial-reform legislation will be enormous, slowing the growth of new enterprise, twisting the corporate governance of public companies, building more layers of government, granting entities unprecedented powers – but never fully tackling the real source of the problems in the financial markets. For these reasons, the financial-reform legislation must be scrapped.

It appears that this bill is headed to the floor for debate. We can only hope that it is rigorous and highly charged. This is an excellent opportunity for Republicans to demonstrate the fullness of their understanding in these matters and to stand upon for the private sector. After a horrid defeat in the health-care debate, another loss on financial reform cannot be tolerated. If the Democratic reform bill is passed into law, then, it should be clear that we need a new batch of Republican leaders, and the current crop should be jettisoned from office. More importantly, if this bill passes into law, then the more sensible and concerned people of this country have to muster up a significant challenge to the Democrats, and they too should be dealt with at the polls in November.

Sorry, POTUS – but you should not have your way all of the time, and especially not this time.