The Folly of Financial Reform

I come bearing bad news. Reform of our financial services industry is going to be a failure. Leave aside the preconceived notions that politicians will come up with faulty or halfhearted regulations, that they are writing bills in cahoots with the big banks or conversely ACORN & Co. or that the Obama administration in general is anti-business.

While these ideas may all have merit, the reason that financial reform will be disastrous is that all legislation points towards dealing with symptoms rather than addressing the root causes of our financial collapse. While of course the narrative in the MSM centers on greedy “fat cat” bankers taking big risks and predatory lenders taking advantage of hapless borrowers, the fact of the matter is that in every aspect of this crisis government was the major enabler. Ironically all financial reform centers around giving government more power.

Consider housing. As we know, under the CRA and due to the “activities” of ACORN and subsidization from our taxpayer-owned siblings Fannie and Freddie, banks granted mortgages to borrowers far riskier than they would have in an uninhibited mortgage market. That one of the innovations to meet the demand for mortgages was, for example, the adjustable-rate mortgage which reset to sky-high rates after a specified amount of time was not predatory but rather the natural way for banks to compensate for the massive incremental risk being taken by lending to uncreditworthy borrowers.

To castigate and regulate lenders for charging interest rates deemed “unfair” or “punitive” as our politicians have spoken to in their reasoning behind creating a Consumer Finance Protection Agency (a moral hazard-enabling bureaucracy, if ever there was one) is not only reckless but also ignorant. Absent fraud, the lender and borrower are both responsible for voluntarily signing the contract.

When large financial institutions bought up pools of mortgages and created what were essentially bonds that paid interest from the cash flows of the mortgages, this would not have been an inherently flawed enterprise if the pools of mortgages had been rated properly. But remember, it was the government-stamped oligopoly of ratings agencies that gave the banks their blessing to rate junk as if it was gold.

Granted, there is an inherent conflict of interest in that the banks pay the ratings agencies to rate their financial products, but absent government cartelization with regards to credit rating, there would be far greater competition in ratings for investors, including perhaps a proliferation of investor-funded agencies. Further, investors might be more apt to do their own homework instead of relying on an oligopoly in the first place. In an unencumbered economy, just as those who took out mortgages would take responsibility for their decisions, so too would investors. It is not the job of the state to “protect” them, and the state makes the economic system inherently more dangerous by absolving people from performing their due diligence.

Besides these issues, mistakes were amplified by the moral hazard inherent in having an SEC purportedly created to protect investors, an FDIC which effectively removes all responsibility from commercial banks in the loans they make and the past bailouts of large US businesses including those in finance.

I would argue that most importantly, fueling the bubbles that occurred in housing, stocks, commercial bonds, consumer credit and numerous other assets was the Federal Reserve, which set interest rates artificially low, leading to excessive and imprudent lending and concomitant excessive and imprudent investment and spending. Jefferson was prescient when he said,

If the American people ever allow private banks to control the issue of their money, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered…I believe that banking institutions are more dangerous to our liberties than standing armies.

It is important to understand that shrouded behind its mystique, the Federal Reserve is merely a handful of bankers that centrally plan the price of credit, the interest rate. For them to ever pick the Federal Funds rate, of which almost all interest rates are based, is a fool’s errand. The monopoly control over money supply by the “quasi-private” bank suffers from the same defects as the central planning of the supply of any good in a socialized economy. The true or real interest rate would reflect the intersection of the supply of and demand for loanable funds, which would come from the savings of people. By driving interest rates down and printing money, the Fed distorts the rate and causes unsustainable and unjustifiable bubbles.

Given the aforementioned conditions, is it any wonder that banks levered themselves up to obscene levels, took reckless risks and grew supposedly too-big-to-fail? The “heads I win, tails you lose” attitude engendered by institutionalized moral hazard, history and the distortion of the economy by the cartelized banking system under the Federal Reserve is only natural. Excluding the Madoff’s of the world (whose schemes may incidentally be loosely based on our Social Security system), government enabled this crisis, and government has failed to acknowledge its endemic role in it. Yet despite its essential role in the crash, government is now asking for an unprecedented even greater amount of control over finance.

Financial services was already the most heavily regulated before this crisis. Even if regulators were angels, their efficacy would still never match that of market participants. Individuals who put their money at risk in an environment in which regulators merely seek out and punish outright fraud are going to hold businesses accountable for decisions on leverage, compensation, size and business model better than even the most well intentioned public servants.

Curtailing risk-taking, limiting firm size, implementing compensation standards, breaking up prop trading from traditional banks and almost all of the other changes being proposed are not only whimsical and detrimental to market discipline but merely deal with symptoms rather than root causes. Onerous regulations will lead to capital flight and likely deter competition and innovation as it becomes increasingly less attractive to enter the financial services industry. There will likely be other more insidious consequences to any major legislation as well.

In sum, I submit that an honest conversation on financial reform must deal with causes rather than symptoms. Word out of Washington in my view fails to address these causes, but focuses on controlling business rather than the culprit enabler of the state. Contrary to the arguments of Chris Dodd, Barney Frank and friends and foes alike, the antidote to our problems in finance and our economy in general will not come from Big Government but from Big Individual.