Topic: Finance, Banking & Monetary Policy

Too Risky to Continue

The profits being reported so far this year by the major financial firms appear to be driven by proprietary trading (trading for their own account, as opposed to those of their customers). The recent $3.44 billion profit of Goldman Sachs in the second quarter is a dramatic case in point.

Proprietary trading is a high-risk activity and signals the financial sector is returning to its bad old ways. Returns cannot be systematically high unless risk is correspondingly high.

None of this would matter if it were just private capital at stake. But Goldman, along with other major financial firms, is being guaranteed under the dubious doctrine that it is too-big-to-fail. Better there were no government guarantees. As long as these guarantees are in place, however, high-risk activity must be curtailed.

The simplest solution is that a firm should not be permitted to take insured deposits and operate what amounts to a hedge fund within the institution. Goldman is a difficult case because it is not currently relying on deposits (even though it has a bank charter). It should be told to return to a private partnership.

A firm too big-to-fail is too-big-to-exist (as a federally insured entity).

A Want Ad for God

The press is still abuzz over Tim Geithner’s behind-closed-doors tirade against critics of the Obama administration plan to tighten financial regulation. As Mark Calabria writes below, Geithner offered a simple message to Fed chair Ben Bernanke, FDIC chair Sheila Bair, and others: “[Y]ou’ve been heard, so you were ‘included,’ now shut up.”

But while Bernanke, Bair, et al. quibble over details of the Obama plan, Geithner should be more concerned about the glaring flaw at its center: the idea that government can conjure up a “systemic risk monitor” that will identify and avoid future market bubbles.

Many of the great bubbles in financial history grew out of some belief that “everyone” (including financiers, politicians, and regulators) was confident was true, yet it turned out to be wrong (either because it was always wrong, or conditions changed in some unforseen way). Some examples:

  • The supply of Dutch admiral tulip bulbs was constrained though they were in heavy demand, so the 17th-century tulip mania was good investing.
  • The supply of land in the South Seas and the Mississippi Valley was fixed, so the 18th-century land-buying mania was good investing.  
  • The emergence of a nationwide U.S. marketplace in the early 20th century was a watershed event, so the post-WWI stock frenzy was good investing.
  • The emergence of the Internet marketplace, combined with path dependency and network effects, was another watershed event, so buying “dotcom” stock was good investing.
  • And of course, until the last few years,”everyone knew” that investing in real estate and mortgages was “safe as houses.”

That last bullet wasn’t just the belief of “greedy investment banks,” but also of government officials and regulators. My colleagues Peter Van Doren and Jagadeesh Gokhale have a forthcoming paper that notes, in part, that despite the populist rhetoric now being bandied around, banking is heavily regulated under international rules. However, those rules assume that investment in mortgages and mortgage-backed securities is low-risk (and indeed the rules push money toward those investments).

The paper also quotes numerous top-tier economists who claimed the soaring house prices of the past decade were supported by “the fundamentals,” or that a bubble wouldn’t threaten the broader economy. (Their paper doesn’t mention — but could — that Fannie Mae and Freddie Mac, along with their bureaucratic and congressional overseers, believed those firms’ investments in riskier mortgages were “safe as houses.”)

Everyone “knew” housing was a sound investment. It just turned out that everyone was wrong.

Hence the problem with a “systemic risk monitor:” Such a monitor would have to know when everyone is wrong — including financial experts and government analysts. And the monitor would need the power to force everyone to act contrary to their beliefs and instead obey the monitor’s judgment — and not fall prey to public and political demand that the monitor be replaced because “everyone knows” his judgment is flawed.

It seems the Obama administration is creating a position for God. But I doubt that God will leave his current job.

Someone might object: We wouldn’t have needed God to realize that there was a housing bubble over the past decade. But the problem with bubbles is that they only become apparent — and policies against them only become politically defensible — once they collapse.

And even then they might not be recognized. Consider another asset that experienced a dramatic price spike and collapse in the last decade: oil. Ah, someone might argue, there wasn’t really an oil bubble; we’re just experiencing a temporary decrease in demand. Oil is a scarce commodity with strong price inelasticities, and its price will soar over the long term. But the same was said of admiral tulip bulbs, and South Seas and Mississippi Valley land, and housing in high-demand areas.

What would happen if a systemic risk monitor were to come to Washington and immediately mandate that we abandon ”energy sustainability” policies because they’re premised on a bubble? Would he be right? Who would believe him? And would politicians and the public stand behind this judgment?

Barney Frank Endorses Regulatory Protectionism

When a government increases the burden of taxes, spending, and/or regulation, this makes it more likely that productive resources - on the margin - will gravitate to jurisdictions with better economic policy. Crafty politicians understand that the freedom to cross borders is a threat to statist policies, which is why international bureaucracies dominated by high-tax nations, such as the Organization for Economic Cooperation and Development, are trying to undermine tax competition between nations by imposing fiscal protectionism. The same is true for regulation. The Chairman of a key House committee wants to impose regulatory protectionism to restrict the ability of Americans to patronize banks and other financial services companies based in jurisdictions with more laissez-faire policies. The Financial Times has the unsavory details:

Barney Frank, chairman of the House financial services committee, said he was concerned the new U.S. push to regulate banks and brokers more rigorously could put it at a competitive disadvantage if other countries did not follow suit. As a result, he would like to ban U.S. banks from doing business with countries not subject to similarly tough standards on everything from leverage limits and capital requirements to rules on transparency and clearing of derivatives. “Once we have rules  . . . we will say to anybody who wants to be an outlier, ‘you forfeit your right to participate in the American system’,” Mr Frank told the Financial Times. “We will instruct the [Securities and Exchange Commission] and Treasury and the Fed to deny access to the American financial system to any country that holds itself out as a haven to escape our financial regulation.” …“It is absolutely the wrong approach,” said a top industry lawyer, who did not want to be identified criticising Mr Frank. “The assumption is that everybody has to do business in the U.S. and we can set global standards. That is absolute nonsense. There are alternatives, including Hong Kong,” the lawyer added. …Tim Ryan, president of the Securities Industry and Financial Markets Association, said that U.S. regulations should not be imposed on other countries. …Mr Frank’s interest in banning groups from non-co-operating countries stems in part from the U.S. experience after it adopted the Sarbanes-Oxley corporate accountability law. Many overseas companies opted to list outside the U.S. rather than comply with Sarbox requirements.

Timmy Throws a Temper-Tantrum

As reported in yesterday’s Wall Street Journal, Treasury Secretary Tim Geithner called fellow bank regulators, included Fed Chair Ben Bernanke and FDIC Chair Sheila Bair, over for an obscenity-laced rant about their audacity in raising questions about his scheme to fix our financial system.

Reportedly the Secretary told regulators that “enough is enough” and that they’ve been heard, so the time for debate is over.  This sounds eerily like the President’s previous comments about including Republicans in the talks over the stimulus - you’ve been heard, so you were “included,” now shut up.   The shouting down of debate is becoming all too much a signature of this Administration.

The Secretary apparently also told the regulators in attendance that it was the administration and the Congress that sets policy.  Perhaps next he’ll tell us that the power of the purse lies with the Treasury and the Congress.  Secretary Geithner has no more constitutional authority to set policy than do any of the bank regulators.  It is the job of Congress to make laws, not the Treasury Secretary’s.  He can offer his opinion, just as they can, and should, offer theirs.

Of course, Secretary Geithner’s frustrations are understandable, given that his regulatory proposals have hit a brick-wall with both Congress and the Public.  He has made no effort to explain to either Congress or the public how exactly his plan will stop future bailouts.  Instead, any reasonable read of his proposal would lead to the conclusion that we will have more bailouts, rather than less, under the Obama-Geithner plan.  Instead of directing his energies at anger, he should put them toward coming up with solutions that actually increase the stability of our financial system.

We were all told during his confirmation process that we must overlook such facts as his failure to pay taxes, because Tim Geithner was the “boy-wonder” who would save our financial system.  As his recent out-bursts demonstrate, “boy-wonder” is only half-right.

Sarbanes-Oxley’s Harms Are Magnified by the PCAOB’s Unconstitutional Structure

Passed with scant deliberation amid a stock market panic, the Sarbanes-Oxley Act of 2002 vastly expanded the federal government’s role in regulating corporate governance and the accounting industry. As part of that effort, Congress created a new agency to “audit the auditors.” Known as the Public Company Accounting Oversight Board, the agency has broad rulemaking and enforcement powers to set accounting standards, investigate accounting firms, punish criminal violations, and make whatever rules “may be necessary or appropriate in the public interest or for the protection of investors.”

Remarkably, the PCAOB (pronounced “peek-a-boo”) also has the power to fund its own budget by levying taxes on publicly traded companies. Despite giving the PCAOB all this power, however, Congress insulated it entirely from presidential oversight. Unlike with an ordinary “independent agency,” the president has no power whatsoever to appoint or remove PCAOB officials. Those officials may be removed only “for cause” by the SEC, not the president; and SEC officials may themselves be removed only for cause.

The Free Enterprise Fund challenged the constitutionality of the PCAOB and appealed to the Supreme Court. Cato’s supporting brief focuses on the PCAOB’s practical policy consequences, illustrating how the PCAOB’s unconstitutional structure has created incentives for out-of-control spending, agency aggrandizement, and lack of coordination between regulators. Our brief also highlights the PCAOB’s efforts to impose American accounting standards abroad, which has caused confusion and invited retaliation from foreign regulators.

I previously blogged about this case here and here.

A Deregulation That Could Reduce Foreclosures

One of the obstacles to reducing mortgage foreclosures is that so many of the homes being foreclosured upon are not occupied by their owners.  Approximately 20 percent of homes are vacant investor-held properties, while according to the National Low Income Housing Coalition another 20 percent are occupied by renters.

Addressing the issue of renter occupied foreclosures has been one of the harder nuts to crack.  We should have no sympathy for vacant homes purchased purely for speculative gain - the best course of action for those homes is foreclosure, or even better, speculators should be expected to continue paying those mortgages even in the face of losses.   Where homes are currently rented however, it may be in the interest of both the bank and the renter to continue that relationship.  Unfortunately, there is one larger barrier:  the very same bank regulators who are pushing lenders not to foreclose.

As banks are not in the business of property management, their regulators strongly discourage banks from keeping foreclosured properties on their books.  In fact bank regulations generally prohibit lenders from entering into long-term leases with tenants.  Legislation (HR 2529) introduced by Republican Gary Miller and Democrat Joe Donnelly would allow banks to do so for up to five years.  While the bill is sure to have some flaws - it merits a closer look.

Although most banks are unlikely to want to become property managers, allowing some to do so, even on an interim basis could reduce both the unnecessary eviction of renters and foreclosures on rental properties.   And unlike proposals that would force banks to make uneconomical modifications, or prohibit lenders from taking ownership of a renter-occupied home, relaxing regulations governing bank management of foreclosured properties could keep some families in their homes without having to violate contracts or re-distribute wealth.

Administration’s Fiscal Muddle

Recent comments by Treasury Secretary Tim Geithner and National Economic Council Director Larry Summers illustrate the incoherence of the administration’s fiscal policy. Previously, they were against raising taxes in the short-run because that would damage the economic recovery. Now they are hinting or suggesting that recovery depends on raising taxes to reduce the deficit.

Previously, they supported rising levels of spending and deficits to supposedly grow the economy, but now they are saying that deficits need to be cut for the economy to grow. Geithner and Summers seem to be repeatedly changing their message depending on the political requirements of the news cycle, rather than providing a consistent program based on economic theory.

The reality is that rising taxes and spending suck resources out of the private sector economy, which damages growth whether we are in an expansion or a contraction. That’s because governments in America already consume more than one-third of everything produced in the nation, and so further resources added to the government sector produce very little or negative returns.

Geithner and Summers ought to stop trying to manipulate the short-term macroeconomy, and instead focus on economic reforms to remove obstacles to private sector growth over the long-term.