Let's Try a Little Positivity for a Change, Huh?

Each day the business press churns out a vast amount of copy. There's probably more written about business issues than any other single subject beyond politics. This makes sense, given that advertisers are hoping to reach the most affluent among us. They're more willing to underwrite news they believe the affluent care about. What is more surprising is how limited the range of tone is in most of these opinion, news or newsy opinion pieces. A very large chunk of the business journalism out there falls into two categories. The first decries the incompetency of regulators and all of the unintended consequences their rules impose on the marketplace. The other camp are the conspiracy theorists, who take the completely opposite view. The regulators and lawmakers are so intelligent and devious that they are able to achieve ulterior goals in addition to the ostensible purpose of legislation. I simply can't understand, in a country with such abundance, where such a dim view of human intentions and capabilities comes from. Yes, we hit a rough patch over the past several years, but take a look around. We built a highly functioning society before that.

This piece by a "local lender" in AOL's Patch assumes that the Dodd-Frank's requirements that banks get verification of a borrowers income means that Congress is surreptitiously attempting to turn banks into IRS agents. Instead of saying that these rules are problematic for excluding people's whose income can't easily be verified, he tosses out a conspiracy theory that flies in the face of all common sense.

This article in The New York Post is another example of baseless bloviating that the financial services industry engages in each day in the press. In lists platitudes about how Dodd-Frank kills lending institutions' abilityto do their job, without proving how its happening. I'm totally open to this possibility. In fact I'm sure that increased regulations will dampen lending. Of course, it's a question of how and to what it extent this occurs, and whether we're receiving compensation through decreased systematic risk. But these commentators aren't interested in studying problems and producing solutions. They're interested in condemning boogeymen and fanning people's preconceived notions of what's wrong with regulation and government.

These are just two examples, but I read similar writing every day. I try to keep an open mind and consider all positions. I feel that a journalist has a responsibility not to disinterestedness or impartiality but to keeping an open mind. However, so much writing out there takes the form of screed without evidence to back it up.

TV Business News is Rarely This Entertaining

One of the more delightful consequences of easily recorded and regurgitated video content is the ability to make fun of people for stuff they got wrong. Or really really wrong. It's Jon Stewart's bread and butter. But it's a pretty easy thing to do at home too, and oftentimes Youtubers will get in on the party.

Peter Schiff, money manager and 2010 U.S. Senate candidate (Connecticut Republican Primary looser), was right about some stuff, as you can see. Schiff has since used the fame gained from such a prediction to call for the scaling back of regulations on the financial system and other libertarian policies. Schiff believes that it was too much government intervention in the markets that that precipitated the housing bubble, specifically through maintaining interest rates artificially low.

There are those who favor a more active government who also predicted the crash, however. The problem with lionizing guys like these is that they're often wrong too. Anybody who tries to predict the behavior of something as complex as the global economy always will be.

That video is still pretty hilarious/terrifying.

MF Global Reignites Debate on Regulation

In reaction to the meltdown of MF Global, Jeff Carter questions whether the Sarbanes Oxley and Dodd-Frank laws should have prevented the kind of accounting gimmicks that allowed the true health of the firm to go undetected. Carter argues that because accounting decisions are almost always to some degree subjective, fraud can never be eliminated from the system regardless of how stringent regulation is.

For instance, The Wall Street Journal is reporting that MF Global engaged in extensive "window dressing" of their financial statements. This is a practice whereby firms undertake financial transactions specifically to alter the picture presented to shareholders and regulators through its financial statements. In MF Global's case, the firm temporarily lowered its debt loads, and then re-levered after filing. This sort of behavior isn't illegal, and if it were made illegal, it'd be impossible to really prove in a court of law.

Carter concludes:

The best antidote to fraud is transparency, and the market destroying the company once the fraud is found out. The only way to be anticipatory is to set up transparent market structures that force companies to shed sunlight on their activities. The market is the greatest truth detector there is.

I couldn't agree more. But then again investors like Carter and Journalists like me are plain suckers for transparency. We thrive on information. Managers of companies don't necessarily want to show their hands all the time. There are increased costs for a company to report information to regulators, and shareholders can be harmed if a disclosure gives away some kind of competitive advantage.

Of course there is a limit to how much transparency can be practically added to the system. For obvious reasons, there must be restrictions to what the government can legitimately claim to need to know about a company or individual. Such concerns have recently been raised by Republicans about the Office of Financial Research. A bigger concern for advocates of transparency should be that at a certain point, more companies will simply eschew going public if the burdens of disclosure get too onerous. That will do nothing to promote financial stability or economic growth.

The problem with sussing all these issues out is that commercial lobbying groups tend to protest any new regulations. This makes it difficult for fair minded citizens, who believe in finding the right balance of regulations, to make an informed decision. Many on the left reflexively dismiss concerns raised by lobbying groups because of a kind of "boy who cries wolf" dynamic.

What's Up With This Spooky "Shadow Banking' System?

The St. Louis Federal Reserve Bank has just issued a paper asking the question, "Is shadow banking really banking?" In the report Economist Rajdeep Sengupta and research associate Bryan J. Noeth give a clear description of what defines a bank and whether the infamous 'shadow banking' system that reportedly helped cause the financial crisis qualifies as banking. By their definition, banks are "intermediaries that obtain funds from lenders in the form of deposits and provide funds to borrowers in the form of loans." The purpose of banking, according to Sengupta and Noeth, is what they call "maturity transformation." Those who deposit funds with banks prefer to be able to access their funds in fairly short windows. Borrowers, however, need much longer maturity horizons to fit their funding needs. That's where a bank comes in. Since banks hold funds from a large swath of depositors, they are able to lend out much of that money knowing that only a small fraction of depositors will actually need to access their cash at one time.

The shadow banking system, according to the report, is a much more complicated process, but one that essentially serves the same function. The shadow banking system is the venue whereby financial insitutions securitize and sell off debt through off-balance sheet constructs called "special purpose vehicles." A bank will sell their loan to a shell company that has no other purpose other than to hold those loans. These shell companies are "bankruptcy remote," meaning their financial health can't affect the financial health of the company that sells it the loans and vice versa. From this special purpose vehicle, the securities are then sold to investors. In this model, companies or mortgagors issuing debt are the borrowers, and investors like pension, hedge or mutual funds are the lenders. Essentially this is just like our traditional banking system, just a little more complicated.

The report concludes, "The reader may question the rationale behind the development of the shadow banking system and all its components. While some analysts have asserted that the shadow banking system is redundant and inefficient, it is not difficult to see the benefits of securitized banking. Securitization allows for risk diversification across borrowers, products and geographic location. In addition, it exploits benefits of both scale and scope in segmenting the different activities of credit intermediation, thereby reducing costs. Moreover, by providing a variety of securities with varying risk and maturity, it provides financial institutions opportunities to better manage their portfolios than would be possible under traditional banking. Finally, and contrary to popular belief, this form of banking increases transparency and disclosure because banks now sell assets that would otherwise be hosted on their opaque balance sheets."

There appear to be several benefits of securitization and the use of special purpose vehicles. I addressed securitization in my first post, but let me explain why these special purpose vehicles might create value. If a financial institutions buys a bunch of loans and then chops them up and securitzes them, anyone who buys that security has to worry not only about the credit risk of the initial issuer, but also about the health of the financial institution that is securitizing these loans. Placing those securities in a bankruptcy remote special purpose vehicle, possibly one that is insured, will relieve that extra layer of risk and make it cheaper for issuers to borrow money. While this maybe a real benefit of these accounting constructs, I would have liked to have seen more attention paid to the potential abuses of these SPVs. After all, it was special purpose vehicles that aided Enron in its fraud a decade ago. Also, financial institutions used these special purpose vehicles to get loans off their balance sheets and therefore avoid regulatory requirements dictating they hold a certain amount of capital in reserve to back up loans. I would have liked to have seen these concerns addressed. All in all, however, the report is a good explanation of what the shadow banking sector is and how it mimics traditional banking.

Who Regulates Whom?

The Chicago Federal Reserve Bank's website has just posted an updated picture the US regulatory authority over payment, clearing, and settlement systems. It is a hot mess to say the least, a visual representation of why some are calling the Dodd-Frank law too complicated. Then again life and our financial plumbing are pretty complicated too.

Some definitions:

• A payment system is just what it sounds like: a way to transfer funds from one party to another.
• A clearing system, or clearinghouse, is an organization that takes on "counterparty risk" in a given transaction. If Party A sells a good to Party B through a clearinghouse, the clearinghouse vouches for Party B's ability to pay up.
• A settlement system is one whereby the actual good is transfered from one party to the next.

As you can imagine, the health of these organizations are vital to the proper functioning of the financial system as a whole.

Get Yo Links: Bankers don't like Dodd Frank, Rick Perry Thinks Pre-Crisis Regulation was Satisfactory

The November cover story of American Banker has some very unflattering things to say about the Dodd-Frank legislation. The nearly 4,000 words piece takes aim at the legislation, arguing that the law places undue burdens on smaller community banks, and that the long drawn out rule making process, that isn't even halfway complete nearly two years after the law's passage, is creating uncertainty that is hostile to the banking business. One of the more interesting complaints from bankers interviewed is that regulators are taking too much of a quantitative approach to determining the soundness of loans, as opposed to evaluating each loan on a case by case basis. With all the extra regulators on board at the FDIC, you would think this would be easier to do. American Banker doesn't press the regulators on this. Frankly it doesn't give many opportunities for regulators or law makers to respond to bankers concerns, either.

While Rick Perry was on CNBC unveiling his new flat tax, he took the time to say he believes financial regulation, pre-crisis, was adequate. This new line of thinking from Republicans is something I expect we'll see more of as the events of the financial meltdown fade in people's memory (even if the effects of said meltdown don't).

Time magazine has a new piece up about the much ballyhooed Volcker Rule, which in its simplest form forbids deposit taking institutions from speculative trading on their own accounts. Paul Volcker, the former Federal Reserve chairman for whom the rule is named, has turned against the iteration of the rule passed in the recent Dodd-Frank legislation. He argues it contains too many loopholes. This piece gives a nice explanation of how all those loopholes got in there.

Federal Reserve Officials have been increasingly vocal about their willingness and ability to further stimulate the economy. Many Wall Street Watchers are seeing this as a sure-fire sign that more quantitative easing is on the way. Quantitative easing is a process by which the Federal Reserve buys United States treasury bonds, bidding up the price of those bonds, and therefore bidding down the interest rate at which the U.S. government borrows. Since most interest rates are based off of what the U.S. government pays, this will theoretically lower borrowing costs for individuals and businesses, giving them extra cash to spend. Giving consumers and businesses more cash will help stimulate the economy. Others fear that this will put too much extra money into the system and lead to escalating asset prices, otherwise known as inflation.

GAO Report Tackles Conflicts of Interest at the Federal Reserve

The Government Accountability Office released a report Wednesday which studied conflicts of interest and diversity amongst Federal Reserve Officials. Though the 127 page GAO report didn't accuse the board of corruption, it does warn, "directors' affiliations with financial firms and former directors' business relationships with Reserve Banks continue to pose reputational risks to the Federal Reserve System."

The report points to the example of Stephen Friedman who was chairman of the New York Federal Reserve in 2008, when Goldman Sachs applied to become a bank holding company in order to receive cheap loans from the central bank. At the time, Friedman was a shareholder and board member of Goldman Sachs. The New York Federal Reserve sought a waiver to allow Friedman to remain president even though normal rules would have prevented this arrangement. The waiver was granted on the logic that finding and installing a replacement in the middle of a banking crisis would be difficult and potentially harmful to the economy. In January of 2009, an "automatic stock purchase program" triggered Friedman's purchase of additional stock in Goldman. The backlash from this forced his resignation.

The politics surrounding the Federal Reserve are tricky in the best of times. During crises, people get a bit more worked about about this institution, to say the least. Ironically, the Federal Reserve's main purpose is to steer the national economy through times of crisis.

Financial markets are basically a virtual crowd of people. And no matter how rational an individual human being is (and individuals' rationality is certainly up for debate), we all know that crowds are given to bouts of irrationality, especially when fear is involved. If everybody believes that credit is about to freeze up, nobody will be willing to lend any money. This becomes a self fulfilling prophecy.

English economist and journalist Walter Bagehot famously called the British central bank the "lender of last resort." This description has survived until today as a succinct description of a central banks role. When nobody else is willing to lend, The Federal Reserve, America's central bank, should continue to lend to institutions that are solvent. This, theoretically, will prevent unnecessary financial turmoil brought on by the vicissitudes of financial "crowds."

This is all well and good in theory, but in practice it can get kind of messy, as the past few years have shown. For a central bank to be effective in a democracy, it must be insulated from quickly shifting political winds. If representatives had direct control of the bank, they would be tempted to use the institution to goose the economy in the short term, sacrificing stability for gains that might help them electorally. In addition, central bank actions must be swift and decisive and avoid the gridlock of representative democracy.

However, when an institution is so insulated from popular oversight, there is plenty of room for actual or perceived corruption. The Federal Reserve is a fairly complex system made up of a board of governors and several regional banks each with its own boards. The Federal Reserve has 7 member Board of Governors appointed by the President and approved by the Senate. The regional banks have boards of governors themselves, 2/3s of which are elected by the member banks in their respective regions. There are three classes of boards of governors of the regional banks, one of which can be affiliated with financial institutions regulated by the fed, and two of which cannot. All are supposed to have knowledge of the economy and financial system, for obvious reasons.

The main issue here is that those who are most expert in financial system are those who have gained and stand to gain substantially from the financial system. The GAO report acknowledges this, and its solution is basically more transparency. Transparency can stem temptation to abuse the system by its officials, and it can assuage the fears of critics who believe the system is being abused. Reform will be a delicate process, but considering Washington isn't accomplishing much these days, it may be a while until we see any changes at all.