Too Politically Important to Liquidate, Job Loss in Financial Regulation Wars, Government Debt Burden and the 26 Million in Job Stress

Too Politically Important to Liquidate, Job Loss in Financial Regulation Wars, Government Debt Burden and the 26 Million in Job Stress
Carlos M Pelaez

The objective of this post is to analyze the Senate Financial Stability Act (SFSA) in a national and international perspective. The sections below consider (I) the SFSA, (II) international regulatory arbitrage, (III) government debt and interest rates, (IV) economic indicators and (IV) brief conclusions.
I The Financial Stability Act. The objective of the proposed Senate financial regulation is “to promote the stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect consumers from abusive financial services practices and for other purposes” (http://banking.senate.gov/public/_files/TheRestoringAmericanFinancialStabilityActof2010AYO10732_xml0.pdf http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf ). There are seven major issues and corresponding regulatory measures in the SFSA that are critically discussed in turn.
(1) The Procrustean bed of the causes of the credit/dollar crisis and global recession. The objective of the SFSA is to rein in banks and related financial institutions that allegedly created the crisis by irresponsible conduct. Irresponsibility of banks and the financial system allegedly manifested in excessive leverage, low liquidity, financing long-term instruments with short-dated funds in a “shadow banking system,” lax credit standards in origination of mortgages and generation of short-term profits in order to capture millions of dollars in immediate cash remuneration. The SFSA departs from an erroneous interpretation of the origins, propagation and duration of the credit crisis by entirely ignoring the causal and interactive policy impulses. The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (i) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (ii) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (iii) the housing subsidy of $221 billion per year; and (iv) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the FOMC from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 percent in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change, inducing wide swings in world financial variables through distortions such as the carry trade of short positions in the dollar and long positions in emerging market stocks and commodities. The return of confidence after Mar 2009 reversed the carry trade, causing another opposite round of oscillation of financial variables. The inevitable adjustment of the fed funds rate creates now an environment of expected market stress similar to that during the increase from 1 percent to 5.25 percent in 2004-2006. The SFSA assumes perfect knowledge in legislation and regulation while in reality there are deficient forecasts of financial variables and the economy required for policy and inadequate knowledge about their interrelation. Most policy is a shot in the dark. The SFSA has passed the analysis of the crisis through a Procrustean bed to justify regulation already decided before any analytical considerations.
(2) Rush to regulation. The SFSA is proposed in a threatening tone of urgency that if it is not implemented the world may experience another devastating financial crisis. The rush to regulation contrasts with the lack of convincing technical analysis of the adequacy of the provisions to solve alleged individual vulnerabilities. There is no rigorous analysis of how the set of measures would work together in preventing financial crises. There is the more audacious contention that if the SFSA had been implemented there would not have been a credit crisis. This is a counterfactual (Pelaez and Pelaez, Globalization and the State, Vol. I, 125) or what would have occurred after 2006 if there had been careful implementation of the SFSA. The exercise would require data including the implementation of the SFSA before the credit crisis while only data without the SFSA are available. The future may reserve an actual adverse set of data of weaker economic growth because of lack of financing of innovation and financial crises after implementation of the SFSA. Past regulatory reforms have claimed that the system would be free of crises, such as the trust in central banking because of a long period of growth with low inflation known as the “great moderation” (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195) only to awake to the surprise of an even deeper and adverse financial event. Prudence in analysis and choice of measures is not characteristic of the SFSA that resembles the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ) that reduced credit limits and increased interest rates for almost everybody before its implementation in Feb 2010 with evident harms to consumers and the overall economy.
(3) Liquidation mechanism. The SFSA provides new authority to Treasury for the liquidation of banks and other institutions engaged in financial activities that pose a risk of bailouts with taxpayer funds in an alleged end of the “too big to fail.” An initial mechanism consists of a fund of $50 billion or $150 billion or more in other superfund proposals created with fees collected from banks to be used in “orderly” liquidation of big firms. The Congressional Budget Office (CBO) estimates that “the operations of Fannie Mae and Freddie Mac added $291 billion to CBO’s August 2009 baseline estimate of the federal deficit for fiscal year 2009 and $99 billion to the total deficit projected for the 2010-2019 period (http://www.cbo.gov/ftpdocs/108xx/doc10878/01-13-FannieFreddie.pdf ). Treasury eliminated the $400 billion ceiling of support of Fannie and Freddie, which “may tell the real story about the cost to taxpayers” (http://professional.wsj.com/article/SB10001424052748704671904575193910683111250.html ). Treasury entered into an agreement in Dec 2009 with Fannie and Freddie to provide “funds, as needed, to correct any net worth deficits for calendar quarters in 2010 through 2012” (http://www.fanniemae.com/kb/index?page=home&c=investors ). There will not be “funerals” for “the too politically important to liquidate” will enjoy existence with the wasteful use of taxpayers’ money. The liquidation mandate opens the opportunity for government ownership of financial institutions. Government ownership and control of banks over the world has been disastrous (Pelaez and Pelaez, Regulation of Banks and Finance, 227) and the Swedish bank workout was successful with an agreement by the major political parties of not nationalizing the banks (Financial Regulation after the Global Recession, 170-1).
(4) Systemic risk council. The SFSA provides for an oversight council that “will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system” (http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf ). The task of this council is dismembering big financial entities because of fears that they will fail, causing failures of other entities. There is no operational theory of systemic risk. A motivation for the council is that companies engage in complex financial transactions that they do not even understand. If this were true, how can the council understand the transactions and their effects through the financial system? A bank may be viable under the current structure but could become unviable if limited or dismembered by such a council. Much the same is true of the financial system as a whole such that the council poses the risk of triggering by its actions adverse effects throughout the entire financial system. In its dismembering role, the council may frustrate financial innovations that are required for financing technological change in the overall economy that has been the driver of United States economic growth, prosperity and job creation. In short, the council may frustrate progress and also create its own adverse financial events.
(5) Transparency and accountability for exotic instruments. The system of securitization of credit and risk management with derivatives functioned without problems until monetary and housing policy induced a flood of nonprime mortgages. There were few if any problems with non-mortgage backed securities and derivatives. The transfer of derivatives transactions to formal exchanges with standard contracts will prevent clients in “Main Street” as well as in “Wall Street” financial institutions from obtaining risk management products that are tailored to their needs in size, notional value and term. It would also eliminate sources of profit diversification to banks, concentrating risk on credit. The derivatives transactions will migrate to other jurisdictions, weakening the international competitiveness of US banks.
(6) Consumer protection. The effects of consumer protection can be predicted from the CARD Act: lower volumes of lending at higher rates. Politicizing consumer credit will scare investor capital away from banks engaged in consumer credit. Lower Tier 1 capital will force contraction of consumer lending volumes.
(7) Executive compensation and corporate governance. The SFSA is preventing financial institutions from hiring the talent at market rates of remuneration that is required for successful management. There is here again the Procrustean bed by cherry picking a few cases to cloud the knowledge provided by the vast majority of cases. A few believed in 2007 in widespread mortgage default and protected their net worth with defensive positions but the intent of the legislature is to penalize their success. In fact, those defensive or short positions were beneficial because the sooner real estate prices inflated by housing and interest rate policies declined to a trough the faster and stronger the recovery. Efforts to prevent real estate prices to reach rebound levels prolong the adjustment and raise its costs (Pelaez and Pelaez, Globalization and the State, Vol. II, 210-3, Government Intervention in Globalization, 182-4). The flight of talent and financial institutions overseas will erode the quality and competitiveness of US financial institutions.
II International Regulatory Arbitrage. The communiqué of the G20 meeting of finance ministers and central bank governors on Apr 23 informs the commitment to complete financial regulation rules by end-2010. It states that: “these rules will be phased in as financial conditions improve and economic recovery is assured, with the aim of implementation by end-2012” (http://www.g20.utoronto.ca/2010/g20finance100423.pdf ). Key member countries in the International Monetary and Financial Committee of the IMF (IMFC) (see Pelaez and Pelaez, International Financial Architecture, 96-100, Globalization and the States, Vol. II, 114-25) favor a regulatory environment “helping to promote a level playing field” (http://www.imf.org/external/np/sec/pr/2010/pr10166.htm ). The SFSA is jumping ahead of the world, allowing other jurisdictions to arbitrage regulation so as to attract the financial industry away from the United States. Financial institutions and their customers will be forced by the SFSA to incur heavy costs of regulation, known as transaction costs, and even outright prohibition of lines of business that had nothing to do with the financial crisis. The loss of competitiveness by financial institutions will drive them to other jurisdictions, causing direct losses of jobs. The higher cost and lower volume of credit will reduce innovation, growth and job creation.
III Government Debt and Interest Rates. The current World Economic Outlook of the International Monetary Fund provides estimates of the fast increase of the government debt as percentage of GDP for advanced economies from 2008 to 2015: Canada 22.6 to 30.4, France 57.8 to 85.1, Germany 59.3 to 74.8, Italy 103.9 to 122.1, Japan 96.9 to 153.9, United Kingdom 45.5 to 83.9, United States 47.2 to 85.5 and Euro Area 59.5 to 84.9 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf ). The IMF states that “without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders” (http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/summary.pdf ). The recovery of the world economy will be constrained by taxation and increases in interest rates resulting from the fiscal imbalance in countries that account for more than one half of the generation of world economic activity. Sovereign debt events in certain countries in Europe are causing oscillations in yields of Treasuries. The yield curve on Apr 23 shows an increase in the yield of the 10-year Treasury to 3.82 percent from 3.77 percent in the prior week (http://markets.ft.com/markets/bonds.asp ). The 10-year sovereign bond of Canada traded at a negative spread of 12 basis points (bps) relative to the 10-year Treasury (3.70 versus 3.82) and the 10-year German sovereign bond at a negative spread of 75 bps (3.06 versus 3.82). The ask rate of the 10-year swap traded at 3.81 percent or 1 basis point less than the yield of 3.82 percent of the 10-year Treasury (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-230410 ). United States government debt could trade at a risk premium unless there is a credible deficit and debt control effort that does not rely exclusively on taxes such as the balloon trial of a stealth value added tax (VAT) and new taxes on energy.
IV Economic Indicators. Housing could be reaching a bottom, industry leads the recovery, inflation is subdued and recovery of employment will take time. Two reports find improving conditions in housing. First, existing home sales reported by the National Association of Realtors increased by 6.8 percent in Mar, reaching the seasonally adjusted annual rate of 5.35 million units relative to 5.01 million in Feb and higher by 16.1 percent relative to 4.61 million in Mar 2009. The inventory of existing homes available for sale increased by 1.5 percent in Mar to 3.58 million, which is equivalent to 8 months of supply and 21.7 percent below the record of 4.58 million in Jul 2008 (http://www.realtor.org/press_room/news_releases/2010/04/ehs_favorable ). Second, sales of new single-family houses increased by 26.9 percent in Mar from a 411,000 seasonally-adjusted rate relative to the revised Feb level of 324,000; Mar sales are 23.8 percent higher than 332,000 in Mar 2009 (http://www.census.gov/const/newressales.pdf ). Sales in these reports were likely influenced by the rush in capturing the home-purchase stimulus before expiration on Apr 30. The producer price index increased by 6.0 percent in the 12 months ended in Mar 2010. However, the increase in prices for consumer foods of 2.4 percent caused 70 percent of the increase in the index of finished goods. Prices of finished goods increased 0.7 percent but prices excluding food and energy increased by only 0.1 percent (http://www.bls.gov/news.release/pdf/ppi.pdf ). New orders of manufactured durable goods decreased in Mar by 1.3 percent but increased by 2.8 percent excluding transportation. New orders increased by 11.9 percent in the 12 months ending in Mar 2010 and excluding transportation by 13.8 percent (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). Initial claims for unemployment insurance in the week ending on Apr 17 were 456,000, decreasing by 24,000 relative to 480,000 in the prior week. Seasonally-adjusted insured unemployment in the week ending on Apr 10 was 4.644 million, declining by 40,000 from the prior week’s 4.686 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V Conclusion. The SFSA will destroy jobs because of higher costs of business resulting from new regulation that will increase interest rates and reduce credit volume. By anticipating regulation ahead the rest of the world, the US will export its financial industry and jobs to other jurisdictions with more competent and prudent regulation. Another adverse financial event in the US precipitated by regulatory attacks on banks will spread throughout the world. Economic recovery will be limited by the rise in taxes and interest rates resulting from fiscal profligacy in the form of government debt catapulting toward 100 percent of GDP. There is still time to modify the agenda to ensure future progress and job creation that will rescue the 26 million persons in the United States in job stress. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 ).