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John R. Talbott Headshot

The Failure of Financial Reform, Itemized

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It is really quite incredible that of all the things that went wrong to cause the latest economic crisis, the new financial reform bill does almost nothing with regards to the following key issues. Here are the original problems and the actions being taken.

1. Bank leverage: Very little is done about this in the new bill -- banks still can do things off balance sheet (what is the business purpose of doing things off balance sheet except to deceive?) -- still using risk measurements based on historical volatility of assets, VAR, which can easily be gamed by managements rather than strict capital requirements based on actual ratios to real equity book capital. Needs to get from 35 to one before crisis to proposed 20 to one under this legislation, but really should be below 8 to one. Larry Kotlikoff of Boston University suggests one to one is the right ratio and calls the concept Limited Purpose Banking (LPB). Without bank leverage, it is hard to imagine how a small regional economic downturn in say, Houston oil markets or Silicon Valley's semiconductor industry could ever spread contagiously nationally or internationally, thus stopping most recessions and depressions before they start.

2- Interest rates too low: Even lower today.

3- Lobbying and money in politics: Even worse today having been blessed by Supreme Court that corporations can fund campaign advertising directly and financial firms have stepped up with big donations and lobbying effort to stymie the reform bill itself.

4- Too much debt everywhere: Now, more, especially on local and federal governments including Europe and Japan and global banks. Banks slow to deleverage and consumers are not spending substantially less and saving more, they are just defaulting on their debts to lessen their debt loads.

5- Depositor insurance: Disguised as a benefit to depositors, it is actually a windfall to lower funding costs of banks and encourages stupid behavior by them because of the moral hazard with regard to riskiness of assets held, businesses entered and leverage undertaken. Increased permanently from $100K to $250K per account since crisis.

6- Bank consumer fees: Much higher now. Consumers and taxpayers are basically paying for a problem they had nothing to do with in creating. This was solely a banking and government problem. To blame homebuyers for accepting a no money down, 100% home loan at 2% per year to buy a home they never in their wildest dreams thought they could afford ignores the mistakes the banks made in offering these terms. Once you offer someone 100% financing, it is no longer his problem, it is yours. Individual home owners did not buy these properties, they were actually owned by the banks and their investors who put up all the money.

7- Predatory lending: Still active. Listen to the pitch for reverse mortgages to our seniors on television and try to explain how they actually work or try to calculate how much profit spread the banks have built into those transactions for themselves, then imagine having a touch of Alzheimer's and doing it correctly.

8- Global investor diversification: No change, investors encouraged to hold thousands of assets around the world through mutual funds, index funds or well diversified institutional funds making supervision of managements impossible and encouraging the hiring of too many financial intermediaries and consultants as supposed experts.

9- Credit Default Swap (CDS) market: Was the prime reason everyone was too interconnected to fail as one domino sent them all crashing. Nothing new to report as they either need to be shut down or regulated like insurance companies because that is what they are. Should be shut down because they create too much systemic counterparty risk that can crash the entire system, but at a minimum, you should not be able to buy CDS's naked, only as a hedge against a similar asset. It makes no sense to buy a company or its debt, buy CDS default insurance equal in value to a hundred times what you paid for the company, and then drive the company into bankruptcy, regardless of its financial health. This is the equivalent of buying fire insurance on your neighbor's home and then lighting the arson yourself.

10- Criminal behavior: Banksters, realtors, appraisers, mortgage brokers, investment bankers all broke the law with their fraudulent and criminal and conspiratorial acts and many private and public funds failed to perform their fiduciary duties or required investment due diligence. The scale of the criminal enterprise is vast crossing many industries and country borders and the damages incalculable as globally we have lost over 50 million jobs, 20 million have lost their homes, $20 trillion of savings has been permanently lost to investors and more than 100 million people have been thrown back into the destitution and poverty of earning less than$2 a day. No arrests, no yellow crime scene tape around Goldman's new office building, no seizing of computers and emails and phone records of the suspected banksters and their lawyers and accountants. Certainly, many congressmen should be imprisoned for taking bribes disguised as campaign donations that encouraged them to remove or ignore important financial oversight regulations, but since they write the laws I doubt this will ever happen.

11- Board control: Still dominated by CEO and company insiders and their friends as opposed to being controlled by shareholders directly. Get the CEO and other corporate executives completely out of the boardroom which should be run exclusively by genuine shareholder representatives.

12- Securitization: Little changed, talk of issuer having to hold 5% of securities issued, but this is still subject to how final regulation is written. Securitization market is dead until they straighten out the rigged ratings game and re-instill investors trust in banks and investment banks who purposely packaged the worst trash they had on their books, gift wrapped it as a CDO and laid it off on many of their biggest and best clients.

13- Ratings agencies: Reform ignored fundamental problem with issuers paying for ratings rather than investors.

14- Fannie Mae and Freddie Mac: So far, no change, their restructuring was not included in this bill, they are still making loans of which many are going to turn out bad as they are one of only a few institutions lending into areas that are experiencing steep price declines currently and the best predictor of future default is home price declines in a region.

15- Too many financial middlemen: Because of overemphasis on diversification, investors, both individual and institutional, hold such far flung and complex investments that they become overly dependent on a long list of financial advisors and consultants and managers. At best these advisors have different motivations than the primary investor, don't care as much about protecting against losses since it isn't their money, and increases the risk of fraudulent and criminal behavior somewhere in the long and complex investment food chain.

16- Who regulates?: Very little change, same guys in congress and at the Fed, Treasury and the FDIC who got us into this mess.

17- To big to fail (TBTF): Has gotten worse as the size and power of the biggest banks has increased dramatically.

18- Bank market concentration and monopoly power: Has become more concentrated.

19- Adjustable Rate Mortgages (ARM's): Probably the biggest single cause of increased defaults as mortgage payments could jump as much as 50%, little to no change from bill.

20- Teaser rates: Still legal. Still a joke.

21- Low down payments required: Ads on radio still promoting the idea.

22- Personal bankruptcy law: Nothing done, judge needs authority to be able to adjust mortgage balance.

23- Regulating long maturity asset industries: Bank and insurance companies are long maturity asset and liability games with no short term implications to managements or their compensation from losses occurring long into the future. Needs special regulation of these markets but little has been done to address the problem.

24- Regulatory capture: The same, revolving door, industry groups and big money in politics writing our legislation and regulations, or in some cases, erasing them.

25- Managing risk: Need to separate principal investing, trading, investment banking and other risky activities within deposit taking commercial banks. No return to Glass Steagall or prohibition on these activities in the bill with the exception that foreign exchange, gold and silver trading will have to be done in a separate subsidiary or could be banned completely by banks.

26- Bankruptcy proceedings for banks and corporations: Plan addressed for FDIC banks to liquidate quickly if overseas subsidiaries do not create a problem, which they will, but still have to create an accelerated process for all corporations so debtors as well as stockholders can take a hit to their poorly invested debt capital rather than bailing all creditors out at par.

27- Hedge funds: Still no investigation of their role as counter-party and enabler to a lot of bank and derivative nonsense, still no bill to tax their managers at ordinary rates rather than capital gain rates.

28- Management incentives: Still not complete, no one has asked why if bank executives were given long vesting stock options before, why weren't the managers thinking long term and thus be better aligned with shareholder perspective. Not just a question of when executive receives bonus, must also have skin in the game. All stock and options can't be free or executives have no downside to worry about and act like pure upside option holders.

29- Complexity of mortgage and investment banking products: Banks introduced complexity to products on purpose to confuse investors, to reduce competition and increase profit spreads. This ends up reducing liquidity. Very little of the real problem has been addressed.

30- Bad bank loans: Most still on banks' books and losses have not been realized. TARP was supposed to be used for this, but then Paulson decided not to. Fed trying desperate measures to hide bank problems on its balance sheet and eventually transfer the bad loans to Fannie and Freddie where they will never be seen again but taxpayer will pay for losses.

31- Government stimulus: Saved or created zero new or imaginary jobs, just an excuse to keep public employees fully employed. If state, local and federal governments hire and promote their workers during good times, but won't lay them off during bad times, how do we ever make government smaller and more efficient. Simple math tells you that under this formulation, eventually, everyone will be working for the government, I don't know how we will be able to pay our tax bill however.

32- Severity of new bank regulations: The stocks of the big banks went up on news that this financial reform package was going to pass. What does that tell you?

33- Bank executive compensation: The same, if not worse as the bonuses are just as big, but now there are losses at the banks rather than profits and much of this bonus pool money is coming directly from US taxpayer.

34- Undervalued Chinese currency: Extremely slow progress.

35- Globalization: Created vast inequality as American workers were forced to compete with workers from $1 an hour wage countries. Raghuram Rajan argues that inequality contributed to the financial crisis by encouraging our government (through Fannie and Freddie) to promote home ownership aggressively to make up for lost wages and benefits of the American worker. Globalization allowed US companies to avoid taxation and regulation (environmental, banking, disclosure, workplace rules, union rules, product safety, etc.) and geographic horizons of institutional and individual investors were stretched so far as to make investment analysis and supervision of management teams completely unmanageable.

36- Bank transparency: Probably worse given their derivative positions, their off-balance sheet shenanigans continue, and the fact that all the new regulation and bank mergers means lots of restatements and footnotes and asterisks and fine print in the financial reports.

37- Externality costs and collective action problems: Very little progress, still don't know how you manage your risks and maintain market share when you as a banker are offering conventional 30 year fixed rate mortgages with a required 20% down payment to your customers and a new bank competitor opens across the street from you offering interest only, pay only if you feel like it, never repay the principal, zero down, zero closing costs, no income, no job, no problem, 2% teaser rate for five years, no prepayment penalty, no closing costs, feel free to take as much money out to buy that new car you always wanted, adjustable rate mortgages. Until long maturity industries like banking and insurance figure out this collective action problem and how to control it, they are doomed to these same crises in the future, The free market alone cannot address this unique type of problem where the dumbest makes the most and gains the most customers with losses postponed for decades.

38- Federal Reserve independence: We get a one-time partial audit and presidents of local boards no longer appointed by banks, but entire Fed continues to be dominated and controlled by banks and does their bidding rather than the people's.

39- Response times to crises: Our understanding of how to respond quickly and effectively to systemic financial crises hasn't improved. Not much learned, but we will get another chance real soon. Just look at the length of problems in this list and ask how many we really understand or believe we have solved for the future.

40- Underwater mortgage holders: No real help. Very few mortgage modifications. No mark downs of mortgage amounts. 25% of mortgages now underwater nationally where the mortgage balance is greater than the current home value and possibly as much as 50% of mortgages in California are already underwater.

41- Social Security (SS) and Medicare Impacts: Debt investor concerns on looming SS and Medicare blowup and potential insolvencies affects viability of entire financial system and the dollar. Not addressed by congress although it could be a $50 trillion problem that is a big enough number to cause the US to default on some obligations in the not too distant future.

42- The media: Corporate owned media dependent on corporate sponsored ads heavily biased on bullish buy side of market, always - Nothing's changed. CNBC never saw a stock they didn't like.

43- Insider trading and market manipulation: Policing and enforcement, especially at hedge funds, nothing to report.

44- Public reporting and transparency of publicly traded corporations: Derivative positions of $600 trillion notional amount make reading and analyzing an annual report almost meaningless as it is impossible to know the company's exposure to risky events and assets.

45- Overnight repo market: Nothing done to prevent funding of banks and investment banks with many long term obligations with overnight borrowings. Could mean the start of another possible run on the banks from their overnight lenders similar to what happened in this crisis.

46- Corruption in government: Two party system encourages collusion when investigating ethical and legal oversights, money in politics distorts all votes, and gerrymandering election districts assures us that the Democrats and Republicans that survive their primaries will be so far to the right or left as to make cooperation and governance in Washington nearly impossible. Much of this crisis could have been avoided with more effective government supervision as market economies are poorly prepared to manage systemic risk, collective action problems, externalities and ethical questions a bank corporate charter has no opinion on. Corporations were created to make profits, governments were created to solve problems that markets have difficulty understanding. We are quickly becoming a banana republic where government and the media act as paid employees of oligarchs and big banks and corporations. We invented government and the corporate form, they are virtual entities, they exist only in documents in DC and in lawyer offices' filing cabinets, and yet now we find ourselves controlled by them, a true Frankenstein horror.

47- Global banking system: In worse shape now given that Europe has sovereign debt crisis to deal with. Just like the AAA layers of Collateralized Debt Obligations (CDO's) that European banks bought during the mortgage crisis and now are experiencing default rates of 93%, now we have trillions more of what were supposed to be AAA sovereign credits being held by the same European banks but represent countries with 14% government budget deficits (Greece), 20% unemployment (Spain), countries with banks that are eight times bigger than their entire GDP (Ireland) and whose populations are aging and retiring so rapidly they will not see big real GDP growth for generations. These countries, and many others in Europe, will certainly be downgraded significantly in the near future and outright government defaults are not out of the question. The problem is exasperated by the fact that Value at Risk (VAR) accounting allowed these European banks to hold AAA assets like CDO's and sovereign debt with almost infinite leverage so they have very little equity standing behind these loans which means once again that the taxpayers throughout all the countries of Europe, and the US, will be picking up the tab when these countries do default or restructure their debt.

John R. Talbott is the bestselling author of eight books on economics and politics that have accurately detailed and predicted the causes and devastating effects of this entire financial crisis including, in 2003, The Coming Crash in the Housing Market. He is currently working on a new book that will be published in September 2010 entitled, The $200 Trillion Crisis. It will be published electronically and will be available for pre-order on Kindle and iPad starting in August 2010.

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