Obama’s regulation proposals work — except for all those major parts that don’t

What works in the Obama’s new regulatory proposal is overshadowed by what doesn’t–and what isn’t there at all. Jeff Madrick dissects the plan’s weaknesses.

Wall Street has been a runaway train for years now. I didn’t fully appreciate what was happening on Wall Street myself until I started reading some of the good recent books on the subject, the good stuff of which was largely extracted from Justice Department or Securities and Exchange Commission complaints. 

But the proposed Obama administration regulations won’t be not enough to slow the runaway train down or even keep it on the track. The Obama administration seems determined to produce a passable piece of legislation in short order.  They keep arguing that we should not let the “perfect” be the enemy of the “good” (or, in Obama’s words, ”the essential.”)  In fact, we are not letting the “good” get in the way of the politically “expedient.”   This all requires a lot more thought and some more time.  

A first rule of regulation is that if it is largely left to the judgment of regulators, all will depend on how they enforce it.  Thus, if the Federal Reserve is in charge of systemic regulations, what is to make us think the job will be done well? 

There is little doubt that some of the changes proposed are necessary and worthwhile.  Higher capital requirements, more disclosure, registration of all investors of size—all these are for the good.  But when we get to what actually toppled the financial community, the regulatory proposals seriously weaken. 

Securitization is at the heart of the problem. The Obama team will require that originators own five percent of their mortgages—the famous “skin in the game”–when they sell it off to packagers.  This is not enough.  European regulators suggested 20 percent.  But even that is not the point.  These bankers already owned a lot of these mortgages that they wrote in their hedge funds and Structured Investment Vehicles, and it did not make them more cautious.  Once speculative fever rose to a profitable pitch, even the potential to lose money did not deter foolish investment. 

The fact is that institutions that take federally insured savers’ deposits should probably not be allowed to make any old risky investment it wants to.  This is the key missing part of the Obama plan.

On the issue of derivatives, a major stimulant of risk-taking in recent years, a loophole called “customized derivatives” has been created by Timothy Geithner.  All the rest but these would be traded on an exchange—a good idea.  But what are these customized derivatives, which will remain privately traded?   

Derivatives as true insurance raise another issue. How much can we trust the counter-parties?  That is, how good are these credit default swaps in a time of stress?  Life, property and health insurance are regulated across the nation, and especially well in New York State. Why shouldn’t there be a direct overseer for securities insurance, given the constant failure? 

And then there is compensation.  The conductors of the runaway train were not on it, so to speak.  The faster the train went, the more money they made, but if it got off the tracks, they were not hurt. They were like your kid running his Lionel set.  It was you and I who were actually on the train, those who never got a chance to put away ten or fifteen million dollars a year—or much more—and now may lose our jobs and have already lost much of our retirement savings and house value.   The compensation system has to change.  Apart from companies that get huge government bailouts, the administration thus far is not presenting new requirements for compensation. 

One welcome addition is a federal agency for financial product safety.  We need this badly.  We regulate drugs and children’s toys.  These complex financial products require that standards be set and met and that people understand what they are buying.

I applaud Obama’s willingness to take on this enormous subject.  But who did his people ultimately listen to? Scores of bankers and their lobbyists and a handful of consumer trade associations?  And where was the public?  We can’t get this done right without public support and if there are no hearings to tell the America people what has actually gone down on Wall Street and who did it, the administration won’t have adequate support to do what’s necessary.  Perhaps that’s why they present a plan with few new concepts.  It is more patchwork than restructuring. It contains nothing like the boldness of the New Deal.

Braintruster Jeff Madrick is fellow at the Schwartz Center for Economic Policy Analysis, The New School.