07/07/2010 05:12 am ET | Updated May 25, 2011

The Folly of the Financial Regulation Bills

With the debate over financial regulation reaching a crescendo, it is essential that Congress keep in mind what needs to result from this exercise - a new system which reduces the likelihood of the financial debacles which caused the Great Recession. Unfortunately, recent comments and actions of many legislators and regulators reflect a different purpose, namely to punish the financial sector for its real or imagined sins. Can everyone now spell Goldman Sachs?

What caused the financial meltdown was a series of bad decisions on the part of many individuals and firms. That is, as we have seen from the various high profile bankruptcies and bailouts, far too much was borrowed, lent and securitized based upon far too little collateral and unrealistic assumptions about the value of the collateral which was posted. The result of the bursting of this bubble has been a drastic contraction in spending and lending activity which has driven up unemployment. Changes in the regulatory framework, if they are to be helpful, must do something to reduce the likelihood and consequences of such bad decisions.

Yet, pending actions seem largely unrelated to this purpose. For example:

• Many bills, such as the one championed by Sen. Lincoln, would limit or prohibit many banks from engaging in securities or derivatives trading activity. Some bills would apply such rules only to large banks or require derivatives to be traded on exchanges or through "clearinghouses." However, there is little or no evidence that such securities or derivatives trading were the genuine cause of the meltdown. The underlying problem was the incurrence of the debts and not the manner in which they were packaged. If anything, this measure is likely to make matters worse by preventing the use of derivatives for genuine hedging, i.e. risk reduction purposes. It also ignores the fact that so many of the bad loans were originated by parties other than large banks, i.e. small and medium sized banks, mortgage brokers, finance companies, etc.

However egregious Goldman Sachs' conduct was (or wasn't) in the situation addressed by the SEC, it is indisputable that it pertained to selling of interests in existing mortgages. As such, it did not cause any incremental loss from such mortgages. It only changed the identity of the parties bearing such loss.

• While pending bills, such as the one being pushed by Sen. Dodd, pay lip service to the need to prevent bad borrowing decisions at the consumer level by creating a consumer financial protection agency (CFPA) within the Federal Reserve, they will only reduce the supply of credit to worthy borrowers. As far as can be determined, such an agency would be charged with simplifying financial products in order to avoid consumer confusion. The problem is that about all that can be simplified is the interest rate and payment schedule verbiage, but the economic problem is with the amount borrowed.

Witness the current problems in the commercial real estate area where borrowers were sophisticated (or at least had access to counsel) and not deceived, and the documented failure of administration efforts to assist consumers by reducing interest rates. A recent survey by Fitch Ratings indicated that more than 11% of securitized commercial loans are expected to be at least 60 days past due by the end of 2010. The problem is too much debt and not confusing interest rate provisions.

There is no way to simplify the disclosure of principal amounts, so the efforts of a CFPA are likely to be irrelevant at best. To the extent that the effort to force lenders and borrowers to contract under "plain vanilla" products which they would not otherwise utilize, have any effect, they are likely to reduce lending by removing options that both parties find beneficial regarding allocation of risk of interest rate changes which is what is done with "complicated" financial products. At present, the last thing we should be doing is reducing lending.

• None of the bills impose direct liability on anyone connected with a financial institution for the results of their bad lending decisions. Existing corporate law is highly process-oriented, which is to say that as long as officers and directors jump through the right hoops in making their decisions, they are not liable even for catastrophic consequences. By addressing "resolution authority" for failing firms, pending bills only divert the focus from holding responsible those who made the decisions which require the resolution, and encourage more bad decisions, albeit through proper process. The underlying decisions which caused the problems are the decisions to extend so much credit to weak borrowers and rely upon rosy assumptions as to collateral value. We need legislation which deals directly with such activity.

• The Dodd bill, with its narrowing of the accredited investor definition, will inherently reduce the flow of capital to start-up businesses. By definition, this will inhibit job creation. How can this be good for the economy?

One hopes that before our economy can be further damaged from ill-advised measures, the proverbial cooler heads will prevail and reflect on what is really necessary.