Inside FInance Reform
I returned to Manhattan from Canada's Western Frontier a few days ago, where I spoke at two major events, the first co-sponsored by Societe Generale and First Energy, the second by the Canadian Investor Relations Institute (CIRI), all arranged by my speaking agent, James Robinson of IPG, LLC.
On a Global Speaking Tour
I was in a city named Calgary, a place situated on a vast flatland beneath the snow-capped peaks of the Rocky Mountains, which faces terrible winds screaming in from the Tundra for eight months of the year. The city is a cluster of high-powered skyscrapers interlocked by tunnels to shield the residents from the pitiless winters. Calgary is one of the great energy capitals of the world.
A former New Englander like myself might think the main topic of conversation would act as a smarting reminder of Team USA's heartbreaking overtime loss to the Canadians, in the Gold Medal round of this year's Vancouver Olympics. But it wasn't. Sure, there was a ribbing here and there, but most people wanted to know about finance reform, and how these titans of the energy world would be effected.
The Big Thursday Kickoff
This Thursday, the-beginning-of-the-end of Wall Street as we know it will kick off. Congressional Democrats and Republican leaders will begin the "Conference" process on combining the House and Senate finance reform bills. In the history of the US financial markets, we have had many boom and bust periods, panics and scandals, and typically there is a public backlash to a severe financial crisis. The more severe, the further back the pendulum arcs. After the Crash of 1929 we had the Securities Act of 1933 and 1934 as well as the Investment Company Act of 1940. Eleven years of reform. These pieces of legislation dramatically changed the face of public finance, the capital markets and the future of Wall Street.
As a former Lehman Brothers distressed bond trader I know firsthand the need for financial reform. I was on a ship traveling 172 m.p.h. when it crashed into the biggest sub-prime iceberg the world has ever seen. As I wrote in A Colossal Failure of Common Sense "even the Titanic swerved." Words cannot express the outrage I still feel over Lehman Brothers, and how so many innocent people around the world, business owners and investors were blind-sided by an avalanche of recklessness. The Lehman bankruptcy was like ten Enrons collapsing on one morning. Bigger than Enron, Worldcom, Adelphia, General Motors and Chrysler combined. Right now it is my passion to tell the world what really happened at Lehman, and how Washington allowed this crime of the century to take place.
There are three main reasons why the next three weeks may be the most important time for Wall Street in decades.
First, the Democrats control the House by 258 - 177. Likewise, Republicans trail the Democrats in the Senate by 59-41. Senate Majority Leader Harry Reid's D-NV sub Bush approval rating in the 30s has many incumbents concerned. The growth of the Tea party movement is symbolic of an anti-incumbent rage and a fuming of the electorate. Democratic members of Congress would like nothing more than to disappear from front page news, and inflict some pain on Wall Street as a way to cozy up to disenfranchised voters.
Second, the total failure of the Sarbanes Oxley legislation, written to prevent excessive corporate fraud, must be infuriating the men and women on Capitol Hill. What an embarrassment to have a piece of legislation which took almost 14 months to produce, who's sole purpose was to prevent another off-balance sheet deception like Enron, only to have Lehman implode in a similar fashion, and with it the global economy. Taxpayers received all the downside of Sarbox, but none of the upside.
And Third, as I've mentioned, the severity of the recession (10% unemployment for the 1st time since the early 80s), the selloff in the stock market (14,000 high to 6500ish low the last 3 years) and the size of the Federal Bailouts of the Financial System (TARP, TALF, Cash for Clunkers, First Time Home Buyer Tax Credit, Money Market Guarantees, Goldman Sachs issuing 1% paper guaranteed by the FDIC, Fannie and Freddie bailout = don't make me count, trust me it's in the trillions).
The rift that now lies between Wall St. and Main St. looks more like the Grand Canyon these days. The October news out of Goldman Sachs on their planned $23 billion bonus pool went over about as well as the March 2009 announcement of AIG's $165 million award package. You can say it until you're blue in the face that Wall Street needs to highly compensate talent to keep talent, but Joe Six-Pack flat-out just doesn't buy it.
This conundrum is the obvious byproduct of Moral Hazard. When Hank Paulson and his team went "all in" to protect the financial system, they created this illusory, monster V-shaped recovery. It's because Capitalism's natural selection of letting losers fail did not happen, except for Lehman of course, that we ended up in bonus season in 2010 with too much liquidity. This created about as much tension between the Obama Administration and Wall Street, as a whore who's just found religion and estranged her pimp.
Now the infamous members of the Democratic party from Wall St. include Jamie Dimon and Lloyd Blankfein. Wall Street, once the platinum money provider to the Obama campaign, has hit the breaks. According to the Center for Responsive Politics, four of the top ten contributers to Obama's Camp were Citigroup, Morgan Stanley, Goldman Sachs, and JP Morgan. John Heilemann of the New York Magazine recently wrote Jamie Dimon even took his family to Washington for the inauguration. How times have changed.
Heilemann points out that over the last six months, President Obama's ear has been owned by White House Chief of Staff, Rham Emmanual, and White House political maven, David Axelrod. But of course, Tim Geithner has taken a back seat. Heilemann quotes a financial industry lobbyist, who wrote, "If Bob Rubin or Hank Paulson were Treasury Secretary, they would have walked into the Oval Office and said, "Mr. President, I know you'd like to do this, and I know your political advisers want you to do this, but I'm sorry. You can't do this."
The fireworks were in response to the Obama Administrations' spring of 2009 crashing trial balloon, which floated the idea of a 90% tax on the bonuses of Wall Street chiefs who received bailout money. The radical measure died in the Senate, but it sent a strong message to Wall St. The warm and fuzzy days of the inauguration are over. The real President Obama has arrived.
I'm Hearing President Obama wants a Bill on his desk by the G-20 Meeting in Toronto, June 27th
As we head into the critical next few weeks of the "conference" process, here's the tale of the tape.
House Financial Services Committee Chairman Barney Frank (D-MA) will chair the conference committee charged with "harmonizing" the House and Senate bills and has provisionally named conferees, largely on the basis of seniority. Frank has recommended to House leadership that the House conferees include 8 Democrats and 5 Republicans.
The Democratic conference members would comprise Frank as well as the chairs of the House Financial Services subcommittees: Kanjorski (D-PA), Watt (D-NC), Gutierrez (D-IL), Meeks (D-NY), Moore (D-KS) and Joint Economic Committee Chair Maloney (D-NY).
Senate conferees have also been selected based largely on seniority and will be Senators Dodd (D-CT), Johnson (D-SD), Reed (D-RI), Schumer (D-NY), Shelby (R-AL), Corker (R-TN), Crapo (R-ID) and Gregg (R-NH) from the Senate Banking Committee and Senators Lincoln (D-AR), Leahy (D-VT), Harkin (D-IA) and Chambliss (R-GA) from the Senate Agriculture Committee, for a total of 12 Senate conferees in a 7-5 Democratic-Republican split.
One team I rely on more than any other when it comes to important actionable information and analysis out of Washington D.C. is an independent investment research and advisory firm called ACG Analytics, Inc. They work with institutional investors, and specialize on how anticipated policy actions will likely impact their clients' portfolios.
ACG makes the point that financial reform can be separated into 6 categories or battle grounds: Derivatives Language, Risk Management, Consumer Protection, Federal Reserve Accountability, Resolution Authority, and Investor Protection.
Derivatives Language
Senate Version
Force banks to spin off their derivatives business or keep it in a subsidiary separate from the part of the company that may receive Federally-insured deposits. Provision may be dropped in conference.
Derivatives required to go onto a public exchange that would provide investors with details on the transactions.
House Version
Lynch Amendment: financial firms may not own more than 20% of an exchange.
My Comment:
Senator Blanch Lincoln, author of the controversial Lincoln Amendment (Provision 716) faced a runoff election primary yesterday in her home state of Arkansas. In theory I support this amendment. When I sat down with Charlie Munger four weeks ago in Omaha he was just amazed that a bank with a trillion dollars of FDIC insured deposits can sit on $25 trillion of derivatives. When Lehman failed, the vicious stock market crash stemmed from Lehman's derivatives book... because nobody could predict the counterparty risks. Investors were simply running for their lives.
All the trillions in credit default swaps were traded over the counter, not on an exchange, but in private, in some cases recorded with hand-written contracts between two parties. When in doubt, don't trade or lend was the order of the month. This froze the credit markets; the hardest freeze for decades. Trust evaporated from the banking system, and LIBOR shot to an all-time high. The yield on 3-month Treasury bills went negative because everyone on earth wanted to be in US treasuries and not in a bank.
It's a complicated amendment that needs to be simplified. It may be too much too soon. We need transparency when it comes to derivatives. An exchange would be a good start.
Risk Management
Senate Version
Volcker Rule: Banks prohibited from proprietary trading except for transactions that benefit customers. Also limits banks ability to own hedge funds and Private Equity funds. New board established to assign credit rating agencies to the securities they are to judge. Leverage limitations left to regulatory discretion.
House Version
Speier Amendment: 15:1 leverage limitation
My Comment:
Lehman Brothers owned stakes in seven different hedge funds and private equity shops at the top of the market in 2007. Lehman was levered 40-1 at the top, and some of the funds Lehman owned were levered 10-1. This leverage on leverage infuriated Hank Paulson and one of the reasons he and his team let Lehman fail. Banks with federally insured deposits have no business owning hedge funds.
Lets get back to basics. In terms of proprietary trading, it's so important you understand this following point. There is nothing wrong with a trader making markets for customers, agency business. I had a $450 million trading ledger at Lehman Brothers, making markets for customers and taking some proprietary positions to help facilitate the making of markets. This business has been a part of Wall Street for decades.
Where it all went wrong at Lehman, Bear Stearns, Merrill Lynch, AIG and Morgan Stanley was contained in a small group of people operating inside each of the firms, all taking gigantic proprietary bets. It was pure gambling which had little to do with the customer facing business. At Lehman we had 35% of our net tangible equity in three commercial real estate positions! Morgan Stanley had one trader who lost the firm $8 billion on subprime mortgage CDOs! This madness must end.
In terms of the rating agency proposal, this is one of the most important reforms we face. S&P's and Moody's business models simply do not work, their staff is under paid, and they are less talented than the investment banking teams structuring securities. In 2007, on the trading floor at Lehman I heard joke after joke about them. There is no question Wall Street was gaming the rating agencies in 2004-8 in ways which we have never seen. The conflicts of interest are too great as well.
The rating agencies are paid by the Wall Street banks, the very same people who are asking them to rate securities. One of the main causes of the financial crisis was too many investors around the world were relying on poor quality research from the ratings agencies. Senator Al Franken D-MN has proposed a new board of "wisemen" to over see the ratings agencies and select which agency a Wall St. firm can use.
Today, SEC rules still give the rating agencies an oligopoly, and require Wall St. firms and money market funds to hold securities highly-rated by S&P and Moody's. This designation is called the Nationally Recognized Statistical Rating Organization or NRSRO. Smart people I speak with call this a Cartel.
The Franken amendment actually strengthens this Cartel and does not allow any competition with S&P and Moody's. The major debate will focus on whether to create another layer of government to assist the agencies rate corporate bonds and CDOs (Collateralized Debt Obligations). Others in Washington want to smash this Cartel. A good idea I heard from a large buy side client is to set up a jury duty system where Hedge Fund Managers and Mutual Fund Managers will be on the committee. Have professionals help the agencies, not amateurs.
Consumer Protection
Senate Version
Create a Bureau of Consumer Financial Protection as an independent division within the Federal Reserve.
Give more power to state attorney generals to make tougher laws than the Federal standard.
Durbin Amendment: Require Federal Reserve to limit debit card interchange fees and allow retailers to offer discounts to customers based on how they pay for their purchases.
House Version
Would create a freestanding Consumer Financial Protection Agency. Allows the Comptroller of the Currency to pre-empt state consumer protection laws.
Prevents new consumer protection regulator from overseeing auto dealers.
My Comment:
I still don't understand why Congress is consumed with Consumer Protection around bank credit and debt card charges. One of the main causes of the financial crisis was in the area of mortgage fraud. This should be the focus of the legislation. To me this is a classic abuse of power by Congress, piling on. Keep it simple. The most disgusting abuses of the US consumer took place in the mortgage market. This is where this legislation should be focused.
Federal Reserve Accountability
Senate Version
Requires a one-time GAO audit of Fed operations within one year.
Requires Fed to disclose the names of recipients of emergency credit on its website by Dec. 1.
House Version
Allows GAO to audit balance sheets of the Fed and its regional banks
My Comment:
Ron Paul has some good points here, we need more transparency when it comes to the Fed, not secrets.
Resolution Authority
Senate Version
FDIC would have authority to tap credit line at the Treasury to cover the costs of failure.
Prevents creditors from receiving payments in excess of what they would have won in U.S. Bankruptcy Court.
House Version
Large institutions would be charged upfront fees that would go into a $150B fund to cover any future bailout.
Miller-Moore amendment: Requires secured creditors of failing institutions to take losses of up to 10% on claims before they could recoup losses from restitution fund.
My Comment:
This part of financial reform means a lot to me because the main objective of a "Resolution Authority" is a controlled unwind of a big dangerous troubled company. Lehman's bankruptcy preparation left so much to be desired. In a normal bankruptcy there should be weeks of planning, this is what a Resolution Authority hopes to provide. But in the case of Lehman Brothers a giant game of chicken was being played by Dick Fuld and Hank Paulson.
Almost as a threat Lehman did practically no planning for bankruptcy. And this wasn't just any bankruptcy, it was the biggest bankruptcy in the history of the universe, and would have required over a month of proper preparation to ensure the markets were not violently disrupted. On September 15, 2008 when Lehman filed their Chapter 11 petition, only a skimpy 14-page document was presented to Judge Peck.
The stock market crashed 300 points every afternoon in Sept - Oct 2008, because trading desks and hedge funds all over the world knew Lehman was liquidating their giant portfolios. Leveraged loans, stocks, bonds, mortgages, and commercial real estate loans were all being sold by the bankruptcy restricting firm Alvarez & Marsal. The legislation is in its current form will prevent this "too big to fail" mindset. Bond holders, stock holders and corporate executives must know they can be wiped out in bankruptcy. This is the problem today, when investors think there is a Government in charge, they don't prepare responsibly to protect large investments. The contributory bailout fund proposed by the house of representatives is silly. There must be accountability. A resolution authority is fine but we must end too big to fail.
Investor Protection
Senate Version
SEC to define "private equity funds" and "venture capital funds." $100 million AUM threshold for SEC registration; state regulation for those under threshold.
House Version
SEC to define "venture capital funds." $150 million AUM threshold for SEC registration; state regulation for those under threshold.
Private funds required to disclose information needed to assess potential systemic risk to investors, counter-parties and creditors.
My Comment:
It is critically important the regulators create a level for systemic risk that hedge funds and private equity funds must obey. There are thousands of hedge funds, some big, some small. The large ones obviously bring more risk to the system. Long Term Capital Management proved to us all in 1998 that no oversight is a terrible idea.