Financial Reform or Government Takeover
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. No Doubt That Financial Reform is Needed
2. Senate Financial Regulatory Reform Bill
3. Ending “Too Big To Fail”
4. The Volcker Rule & the Bailout Slush Fund
5. “Angel” Investors & the New “Accredited” Investor Rule
6. The Real Political Agenda of Financial Reform
7. P.S. - A Wellesley Investment Advisors Update
On March 15, Senator Chris Dodd (D-CT) stood alone at the podium on the Senate floor and announced his Banking Committee’s latest bill to reform our financial regulatory system. Like the House reform bill that passed late last year, Dodd’s bill would overhaul the regulatory system for both financial entities and any non-bank entities that the government deems to have “systemic risk” (ie – too-big-to-fail).
As a Registered Investment Advisor, financial regulatory reform is of particular interest to me, and I agree that we need reforms. But the fact is that the latest 1,300+ page bill was not well received by those on the political left or the right. For most liberals, it does not go nearly far enough; for conservatives, it is too intrusive and potentially confiscatory. Both sides would agree, however, that if enacted, the Dodd bill would create a huge new government bureaucracy.
The over-arching goal of all these financial regulatory reforms is to put in place safeguards that will prevent another financial meltdown and credit crisis in the future. Both the House and Senate reform bills envision a new advisory board made up of so-called experts that supposedly will be able to peer into the future and spot potential trouble and take action in time to stop it. Does anyone believe that a board of bureaucrats can actually see into the future and detect potential bubbles and financial crises to come? I sure don’t!
While I very much agree that we need serious financial regulatory reforms, I don’t believe we need a huge new government bureaucracy with over-reaching authority, in addition to the maze of regulatory agencies we already have. The agencies we have now just need to do their jobs!
So why does President Obama think we need a huge new government bureaucracy to regulate the financial industry? Because it is popular – people are mad at Wall Street – so he is pushing ahead, even though the current bills are fraught with problems and unintended consequences that I will point out this week. It’s a lot to cover, so let’s get started.
No Doubt That Financial Reform is Needed
Few in the financial/investment community would disagree that some amount of regulatory reform is needed. About this time two years ago, investment banking giant Bear Stearns got into serious financial trouble. It was saved only by the New York Federal Reserve Bank (Timothy Geithner), which provided a $29 billion loan-guarantee to J. P. Morgan to take over Bear Stearns.
Next came the collapse of Fannie Mae and Freddie Mac in early September. Treasury Secretary Paulson announced the nationalization of the two busted lending firms. A week later, Lehman Brothers, with over $600 billion in assets held, went down in the largest bankruptcy in US history. This series of events set off the worst financial/credit crisis since the Great Depression.
There is no question that the largest banks and investment houses abused their authority by ratcheting up their leverage and in-house speculative trading operations dramatically, and by creating exotic debt instruments too complicated and numerous to go into in this letter. As the subprime mortgage fiasco unfolded, the house of cards imploded, and this ultimately resulted in the $700 billion Troubled Asset Relief Program (TARP) intended to bail out the banks.
Clearly, some of types of reform need to be put in place. At one end of the spectrum, you have President Obama and the House and Senate calling for massive reform and a huge new government bureaucracy to enact and enforce it. On the other end, you have those who are calling for a return of the Banking Act of 1933, more commonly referred to as the Glass-Steagall Act, which was repealed in 1999. Glass-Steagall prohibited bank holding companies from owning other financial companies as they do today, thus limiting the ability for financial firms to become “too-big-to-fail.”
I would actually prefer a return to Glass-Steagall than a huge new government entity with the authority to take over large companies and either pare them down or close them altogether. With that in mind, I will summarize the Dodd bill, as it is currently envisioned. Keep in mind as we go along that the House bill is even bigger in scope and more intrusive than the Senate bill.
Also, keep in mind that President Obama has selected financial regulatory reform as his #2 signature legislation priority, behind healthcare, and he is desperate to get it passed before the mid-term elections in November. He is hoping that Americans are still angry at the big banks, and that they won’t mount an effort to stop these reforms and the creation of another big bureaucracy, as we did against healthcare. There are also other political perks to this strategy, as I will discuss later on.
Senate Financial Regulatory Reform Bill
Whenever you see a piece of Congressional legislation that is 1,300+ pages long, you can be sure that: 1) it is the product of a great deal of negotiation; 2) it is a product with a great deal of influence from special interest groups; and 3) that it will contain unnecessary and costly provisions, unintended consequences, and a host of things we won’t like.
At the heart of the Senate reform bill is the creation of a new federal agency to be named the Consumer Financial Protection Bureau (CFPB), which will have the sole job of protecting American consumers from unfair, deceptive and abusive financial products and practices, and will supposedly ensure that people get the clear information they need on loans and other financial products from credit card companies, mortgage brokers, banks and others.
The CFPB will officially be a part of the Federal Reserve in Washington, as opposed to a stand-alone entity (which many on the left badly wanted). Although it will be a part of the Federal Reserve, Senator Dodd insists that it will be completely independent from the Fed, with complete authority to write rules and regulations.
Whether the CFPB would be truly independent from the Fed remains to be seen, should the bill make it into law. Much of the language in the Summary released by Sen. Dodd suggests the Fed will play a much greater role in the new financial regulatory agency. There are many who believe that the Fed has a tarnished record of overseeing our monetary system, but that is another story for another time.
The CFPB would be headed by an independent director appointed by the President and confirmed by the Senate. The agency would have the authority to examine and enforce regulations for banks and credit unions with assets over $10 billion and all mortgage-related businesses (lenders, servicers, mortgage brokers, and foreclosure scam operators) and large non-bank financial companies, such as large payday lenders, debt collectors, and consumer reporting agencies. Banks with assets below $10 billion will continue to be examined by the appropriate bank regulators they report to today.
To help guide and assist the Consumer Financial Protection Bureau, the Dodd bill would establish an advisory board to be called The Financial Stability Oversight Council (FSOC). The FSOC would consist of a nine-member council of current federal financial regulators (examiners from the Fed, SEC, CFTC, FDIC, etc.) and one independent member, and its chairman would be the Treasury Secretary. The FSOC’s sole job would be to: “identify and respond to emerging risks throughout the financial system.”
The Financial Stability Oversight Council is charged with the following (direct quote from the Dodd Summary of the bill):
Ending “Too Big To Fail”
When the Obama administration called on Congress to write the financial regulatory reform legislation, one of its main requirements was that the new rules would contain provisions that would grant the government the power to break up large companies that are deemed to be “too big to fail” (TBTF). TBTF companies are those deemed to have “systemic risk,” such that their failure could endanger the economy, the financial markets or both.
In the bullet points just above, we can see that the new reform legislation grants the FSOC and the CFPB the power to not only break up TBTF companies, but also create disincentives for companies that seek to become large enough to be deemed TBTF in the future. Remember, this would apply not just to banks and financial firms – it could apply to virtually ANY firms, including insurance, mortgage, credit card and investment firms, among others.
If the Financial Stability Oversight Council deems a firm to be TBTF, the CFPB can require the company to voluntarily downsize, OR it can move in, fire the board of directors, remove and/or replace management, and it can immediately put the company into liquidation.
Unfortunately, this power grab is riddled with opportunities for political abuse. You have a group of hand-picked regulators making life-or-death decisions for companies that are, in their opinion, TBTF. You can just imagine how this could affect the political contributions that large companies make.
Aside from the direct political implications, the existence of the FSOC and the CFPB could have potentially serious implications for the business cycle and the markets. Over time, these new regulatory agencies will make clear what types of business activities they approve of and which ones they don’t. As this occurs, it would only be natural that large companies would adjust their business models accordingly.
Unfortunately, this onerous power grab is very likely to be included in the final financial regulatory reform legislation. President Obama wants it, and Congress seems more than happy to deliver. I guess when you have a government that was willing to nationalize GM, Chrysler, AIG, and Fannie and Freddie, we should not be surprised.
The Volcker Rule & the Bailout Slush Fund
Both the Senate and House versions of financial regulatory reform contain the so-called “Volcker Rule” (for former Fed chairman Paul Volcker, now a senior adviser to President Obama). The Volcker Rule would impose new restrictions that would prohibit banks, their affiliates and bank holding companies from continuing proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds. Ditto for non-bank firms that the government would designate to apply the Volcker Rule.
So-called “proprietary trading” is the trading of the firms’ own capital. In many large financial firms, the proprietary trading desks are one of their largest sources of revenue, but apparently the Obama administration and Congress have decided that this type of investing their own capital is too risky. This is nothing short of tyrannical, in my opinion.
Then there is what I call the “bailout slush fund.” Both the House and Senate versions would require the big banks and other large financial institutions to contribute their own money to a special fund that would be set up to pay for any new bailouts and/or liquidations that may be needed. The House version calls for a $150 billion fund, contributed entirely by the largest financial firms, while the Senate version calls for only $50 billion.
Republicans have been quick to criticize this slush fund as just supplying Wall Street a permanent bailout option. Reacting to this opposition, Sen. Dodd held a press conference last week strongly denying that his bill perpetuates bailouts. Given the strong opposition, the Obama administration announced last Friday that it would agree to dropping this slush fund from the Senate reform proposal.
The real issue is whether to accumulate a fund in advance to handle liquidations of large financial firms facing collapse, or to raise the money from the financial industry after the fact. The Dodd bill and the financial reform bill passed by the House both have an advanced funding mechanism which would create a fund that could be used as a political football. It remains to be seen if this huge slush fund will make it into the final legislation.
“Angel” Investors & the New “Accredited” Investor Rule
So-called “angel” investors are typically reasonably affluent individuals who provide capital for business start-ups, either in the form of loans or in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or networks to share research and in some cases, pool their investment capital.
Angel capital fills the gap in start-up financing between “friends and family” who initially provide seed funding, and the next step which is often venture capital. Since most venture funds are looking for deals that are, at the minimum, in the $1-2 million range, angel investment is a common second round of financing for high-growth start-ups. According to Wikipedia sources, angel investors “account in total for almost as much money invested annually as all venture capital funds combined, but into more than ten times as many companies (US$26 billion vs. $30.69 billion in the US in 2007, into 57,000 companies vs. 3,918 companies).” [Emphasis added.]
So what do angel investors have to do with the new financial regulatory reform bill? I must admit that I did not see what follows in any of the lengthy summaries of the Senate bill that I read. However, my old friend, John Mauldin, pulled the following quotes from the latest Venture Beat, a venture capital publication (http://venturebeat.com/2010/03/26/angel-investing-chris-dodd/):
“There are three changes that should have a particular effect on angel investors, a catch-all category which includes everyone from friends and family members who invest in a startup, to unaffiliated wealthy individuals, to side investments made by venture capitalists acting on their own.
First, Dodd’s bill would require startups raising funding to register with the Securities and Exchange Commission, and then wait 120 days for the SEC to review their filing. A second provision raises the wealth requirements for an “accredited investor” who can invest in startups - if the bill passes, investors [individually] would need assets of more than $2.3 million (up from $1 million) or [annual] income of more than $450,000 (up from $250,000). The third restriction removes the federal pre-emption allowing angel and venture financing in the United States to follow federal regulations, rather than face different rules between states.” [Emphasis added.]
Emphasizing the point that this is not a partisan issue, Venture Beat goes on to quote Chris Sacca, a former Google employee, angel investor, and Obama supporter:
“Obviously, I’m deeply concerned about Senator Dodd’s proposal to place these restrictions on angel investing. I think angel investing is undeniably one of the largest engines for job creation as well as innovation and competitiveness on the global scale for the United States. There’s no doubt about it that the restrictions that he’s proposing would absolutely chill investing. [Emphasis added.]
Specifically, one of the things we need to take into account is while 10 years ago it may have taken years to build a company, companies are now built in a matter of weeks. So this 120-day waiting period is frankly ridiculous. I have companies with tens of thousands and hundreds of thousands of users that are built in a matter of weeks. They’re generating actual dollars of revenue, creating jobs, investing in real estate office space, capital equipment, etc. If they had to wait 120 days to actually apply for the ability to obtain financing it would absolutely just crush that market.
I think this is a very short-sighted proposal. It seems far afield from the problems that the banking committee is actually trying to address.”
As an investment professional, this is one of the most ludicrous and mal-intended things I have seen come down the pike from Washington! The requirement that start-ups and small businesses must register with the SEC and wait 120 days for approval is ridiculous, and it will kill angel investing quickly. Even worse, if the SEC raises the accredited investor net worth requirement from $1 million to $2.3 million and raises the annual income requirement from $250,000 to $450,000, that will eliminate millions of current accredited investors.
If these onerous new rules are passed, it will be one of the largest job killers ever foisted on the American people. It is small businesses and start-ups which create the most new jobs in this country. As for the giant increase in the accredited investor requirements, I completely oppose that as well. I have never understood why the government should establish how much money one has to possess to be able to see certain securities offerings, such as private offerings.
If President Obama is serious about creating jobs, he needs to get these onerous provisions removed from the financial regulatory reform bill ASAP.
The Real Political Agenda of Financial Reform
After the very divisive healthcare bill passed, many political pundits expected the Obama administration to address other liberal causes such as immigration reform or environmental/climate change legislation or labor/union (“card check”) legislation. Instead, Obama chose to address financial reform, which is almost sure to produce mind-numbing complexity as well as a high-stakes game of Wall Street lobbying.
Actually, taking on financial reform is likely to be a good political move for the Democrats. Many in Congress are still taking heat from their constituents for their support of the healthcare legislation. The latest Rasmussen poll finds that 56% of Americans still oppose Obamacare; this figure has not gone down as lawmakers had hoped. Thus, many Congressmen are looking to financial regulatory reform to redeem themselves among voters before the mid-term elections.
Financial reform may offer the perfect solution for these struggling Democrats. After all, financial reform has strong public support in light of the huge bonuses paid to Wall Street executives after they nearly crashed the economy. Voters also hold Wall Street firms responsible for their 401(k) and other investment losses, as well as for the current state of high unemployment.
At the same time, Democrats know that the Republicans will oppose certain reforms because, like the Dodd bill, they create a bigger government and would hamper free market solutions to problems. However, since most voters don’t understand either of these issues very well, the Democrats can paint any Republican opposition as cozying up to the fat cats on Wall Street. What better solution to a mid-term election fiasco than to help voters forget about healthcare and demonize Republicans?
There is a lot not to like about the financial regulatory reform bill, with or without the bailout slush fund. I could write many more pages about this attempt at financial reform, but space does not permit. If you wish to read more about the details of the bill, click here to read the Summary put out by Senator Dodd, but beware that it is very slanted in favor of the bill.
Put simply, President Obama and the Democrats are all about growing the size of government and increasing their control over our money. And this is the perfect opportunity for them to create another giant federal bureaucracy.
While I very much agree that the financial industry needs reform, I do not believe that another huge new bureaucracy – that will ultimately have thousands of government employees – is the answer. In fact, I might suggest such an entity could make things worse. I certainly do not believe that these hand-picked regulators will have the ability to peer into the future and see problems and bubbles and be able to stop them before they blow up.
It is my strong opinion that we have enough regulatory agencies already: SEC, CFTC, OCC, FDIC, FHFA, FINRA, etc. Plus, each state has its own securities agency with broad regulatory authority. We don’t need more regulators; we need the existing regulators to do their jobs. I would actually prefer that we revisit Glass-Steagall, and break up the too-big-to-fail companies if need be, rather than create a huge new bureaucracy.
Despite my concerns, I predict that the Senate will pass Dodd’s reform bill, following some heated debate, of course. Remember, they only need one Republican vote to pass it. I find it most interesting that the SEC decided to charge investment banking giant Goldman Sachs with fraud last week, just as the Senate debate over financial regulatory reform kicks off. The Goldman news will be one more reason for Senators to vote for this intrusive reform.
At the end of the day, I just hope that someone in Washington comes to their senses and pushes to remove the parts of this reform that have to do with “angel investors.” Requiring small business and start-ups to register with the SEC and wait 120 days for approval to raise money is so wrongheaded in so many ways. It has long been noted that apprx. 80% of new jobs are created by small businesses. This restriction on angel investing could kill job creation by millions of small businesses.
Likewise, I hope they remove the change in the “accredited investor” definition. By raising the net worth requirement for individual investors from $1 million to $2.3 million, they will eliminate millions of current accredited investors. Ditto if they raise the annual income requirement from $250,000 to $450,000. If you are an accredited investor, under the current requirements, I encourage you to let your congressional representatives know that you oppose the change.
In closing, I hope everyone understands that President Obama and Congress have chosen to pursue these financial regulatory reforms at this time so as to curry favor with Americans who are mad at Wall Street, in the hopes that they will forget about healthcare being jammed down our throats. I hope they are wrong!
Very best regards,
Gary D. Halbert
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