In reform, more of the same

Marshall Auerback analyzes the Geithner/Summers regulatory reform plan and sees a chance for real reform squandered.

Tim Geithner and Larry Summers offered a sneak peak at the plan in an op-ed in yesterday’s Washington Post, proclaiming, “we must begin today to build the foundation for a stronger and safer system.”  Among the proposals: “raising capital and liquidity requirements for all institutions”; “consolidated supervision by the Federal Reserve”; “robust reporting requirements on the issuers of asset-backed securities” including “strong oversight of ‘over the counter’ derivatives”; and providing “a stronger framework for consumer and investor protection across the board.”

As with so much of the Obama administration, great-sounding words, but nothing in the way of substantive change.  Particularly disturbing are the moves on derivatives, notably “credit default swaps”. Excuse us for not liking a market that is rigged in favor of the sellers, the monopoly dealers, who even today refuse to allow open price discovery in credit default swaps among and between other dealers.  True to their Wall Street ethos, Summers and Geithner have capitulated on the most important aspect of derivatives, by refusing to place these instruments on a regulated exchange, where transparency and standardisation would be far more operative.

The credit default swap market–indeed, virtually all non-exchange listed derivatives–are deceptive by design.  They are a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades.  These instruments represent a retrograde development in terms of the public supervision and regulation of financial markets. Of course Wall Street hates this:  Wall Street loves opacity because the very lack of transparency of these products has done so much to fatten the profits of its largest firms.  But reducing the profits of Wall Street is precisely what we want.  We want finance to become a much less dominant component of the US economy, a sector which doesn’t contribute to over one-third of GDP (versus around 2 percent over 40 years ago).

Simply stated, running these instruments through “centralised clearing houses” is a fig-leaf that does nothing to alleviate the problems of transparency.  The deliberate opacity of the CDS market is a dedicated subsidy meant to benefit one class of financial institutions, namely the large dealer banks, at the expense of other market participants. Every investor in the markets pays the credit default swap tax via wider spreads, and the taxpayers in the industrial nations pay due to periodic losses to the system caused by the AIGs of the world. For every large overt failure like AIG, there are dozens of lesser losses from over-the-counter derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets.

As with all of the Obama financial “reforms,” these latest steps start from a flawed conceptual premise: Restore bank balance sheets and profits, and credit will invariably flow, thereby reviving our economy.  Of course, nothing can be further from the truth.  The key is to restore personal balance sheets and aggregate demand as a precondition for improving bank balance sheets.  Improved creditworthiness and improved credit conditions will invariably follow.  The history of major banking crises unambiguously shows that insolvent financial institutions need to be resolved.

There are variations on the theme: The government can take them over and recapitalize them, clean them up and re-sell them, as in Sweden.  You can wipe out equity investors and bondholders; you can try new twists, like various good bank proposals that have surfaced lately (making new entities out of the deposits and good assets and leaving the dreck with the existing bond and shareholders). While there would be many important details to be sorted out, this is not path-breaking, except in the scale at which it needs to occur. And now, having had four acute phases of a credit crunch, the Fed and other central banks have plenty of liquidity facilities ready to deal with any initial overreaction. Rest assured, although radical measures would not be pleasant or easy, there are plenty of models and precedents.

But…here we have two Rubin proteges, serving up the same fatally flawed approach as before: Let’s just throw money at the banks and hope they get better. This is tantamount to using antibiotics to treat gangrene. You waste good medicine and the progression of the rot threatens to kill the patient.

Let’s hope they do better with health care, or that Congress grows a spine and actually tries to introduce real financial reform which will prevent a recurrence of our recent credit fiasco, rather than simply offering yet another huge subsidy to Wall Street under the guise of “reform.”

Braintruster Marshall Auerback is a market analyst and commentator.