Pearlstein: Regulatory reform bill

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Steven Pearlstein
Washington Post Columnist
Wednesday, March 17, 2010; 11:00 AM

Washington Post business columnist Steven Pearlstein was online Wednesday, March 17 at 11:00 a.m. ET to discuss the regulatory reform bill unveiled Monday by Senator Christopher J. Dodd (D-Conn.).

Pearlstein won a Pulitzer Prize in 2008 and is co-moderator of the On Leadership discussion site.

Read today's column: Dodd 2.0: Maybe we need a reboot.

A transcript follows.

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How big is too big?: How does the bill set the standard for when a bank is too big to fail? It seems like investors will want their money in institutions that won't have to liquidate upon failure. So how can you safeguard against the oligopoly of banks all targeting a size just below the Dodd/Corker/Warner standard, and operating as they always have (with the same implicit promise of government backing)?

I guess you could use antitrust law, but I'll believe it when I see it.

Steven Pearlstein: The Senate bill initially says that bank holding companies above a certain size (assets) will be regulated by the Fed, which is in effect designating them as systemically important. It will also mean they have higher capital standards. But the new systemic risk council, on its own or upon petition of the Fed, can also add other types of institutions that are deemed sysmetically important and therefore will fall under the Fed's watch. And there are no standards in the law for that in the law -- that is left to the Fed and the council. And you are right -- once that level is clear, you will get institutions that will make sure they don't get into the zone. That is either a good thing (banks will not get as big) or bad (they will stay below the line, but figure out cute little ways to grow that technically don't bring them into the too-big category). And that is what I mean about the game playing that you start when you design a regulatory structure with those kinds of notches. The better approach, it seems to me, is have one regulator for all banks and financial institutions that look like banks, irrespective of size, so you avoid those behaviors.

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Baltimore, Md.: Hi,

In your column, you say of the proposed consumer finance regulator within the Fed, "the only involvement the Fed would have with its new division would be to write a blank check to finance its operations."

Could the Fed zero the new regulator out, or at least fund it so poorly that it becomes useless?

Steven Pearlstein: No, it is literally a blank check. The agency gets its budget paid for by the Fed without the Fed getting to set it, as I understand the proposal.

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Los Angeles: Sunday's 60-Minutes included fascinating interviews of Michael Lewis (new book "The Big Short: Inside the Doomsday Machine") and Dr. Michael Burry (a California physician "with only one good eye" who doesn't practice because of a rare medical condition). Lewis and Burry faulted Wall Street investors and bond rating agencies for the creation and eventual collapse of subprime mortgage markets which they said was predictable. Burry said this market essentially consisted of "crappier mortgages being put into these pools" and that "it didn't seem investors seemed to care and it didn't seem the ratings agencies seemed to care." "There's no way the rating agencies had anywhere the manpower to look through all that was being issued." At some point, investors tried to use credit swaps to shore up faults in the subprime markets, but these only served to delay the inevitable collapse and allowed a few others who predicted the collapse to get rich by betting against the markets.

Lewis explained how "some of Wall Street's finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets." Asked what happened, Lewis said, "The incentives for people on Wall Street got so screwed up, that the people who worked there became blinded to their own long term interests. And because the short term interests were so overpowering, they behaved in ways that were antithetical to their own long term interests."

Do you see anything in Dodd's proposed financial regulation legislation that would prohibit/punish these types of practices by Wall Street firms and bond rating agencies?

Steven Pearlstein: Yes, there is lots in there. The consumer protection agency is supposed to prevent the worst kinds of abusive lending. The ratings agency reforms are meant to insure that packages of BBB instruments can't be turned magically into AAA bonds. The provisions on securitization are supposed to insure that banks that package loans keep the first-losses so that they have an incentive to know the risks in the packages they sell. The new capital standards will require that banks reserve higher capital against the exotic instruments they have on their balance sheet, and aren't allowed to do a lot of off-balance sheet nonsense. The credit default swaps and other derivatives will be traded on exchanges where the value of these instruments will be transparent, not subject to the whim of bank CFOs who overvalue them.

So yes, the problem Lewis explains is very much motivating the reform effort.

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Princeton, N.J.: Great column today! One I can agree with every word. There are a few things I wish you had added like not allowing credit default swaps when neither party has any material interest in the security being insured, but hey, you only have so many words (750?).

But I want to ask a more basic question. What can we do to prevent this kind of thing where powerful special interests take over the debate and the legislative process? I believe, although you may disagree, that a similar situation occurred in the health care debate where the facts were generally hidden, lies were told, single payer was off the table, etc. I believe I have done all an old fella with a computer can do, but it is clear the bad guys have won. Even if HCR passes, it will be a pale imitation of what could have been done.

And as you point out, it is happening again. What can we do?

Steven Pearlstein: Well, I wrote that exact column about not allowing "naked" hedging last week. You must have been away.

I think this bill is different than health care, in that it is a pure special interest play, politically speaking. The public knows it wants a reform bill, but unlike health care it has neither the interest nor knowledge to get involved with the details of the policy. It's way too wonky. No member of Congress is going to lose his job because he voted, or didn't vote, to move regulation of state chartered banks from the Fed to the FDIC, or decided that the Fed should (or should not) be the systemic risk regulator. This is all about the industry and the existing bureaucratic interests and the consumer groups duking it out. The most potent force here is home town bankers, who for some reason have incredible sway over not only Republican members, but Democratic members, who are unwilling to stand up to them even when they are just plain selfish, which they are about a number of things. It's rather disappointing, actually.

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Woburn, Mass.: How is the resistance to allowing the OWNERS of a company to vote on how much to pay their top employees not straight up communism? Has the right forgotten what capitalism means, its the capitalists who should control their own capital, and the shareholders are the only ones in a corporation in the capitalist role. Its only government intervention that allows a worker like a CEO dictate his own salary with the help of other workers on the board. Why has the Republican Party totally abandoned all pretense of supporting capitalism?

Steven Pearlstein: The Republican party supports unregulated, unrestrained capitalism, for the most part. It supports the idea of an unregulated, untaxed corporate sector. It does not support corporate democracy -- in fact it is against corporate democracy. It believes that the corporate oligopoly should control the economy and if, as an investor, you don't like the way a particular company is run, then you can sell the stock or even sell its stock short. That's your option as an investor. Period.

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Dennis, Mass.: How can we assume that a reboot would result in anything different given the political requirements? The implication of your arguments is that any compromise of Dodd's original "elegant" proposal is unacceptable?

Steven Pearlstein: You can't be sure. I realize political compromises have to be made to accomodate political realities. But I think the compromises made have, in many instances, been the wrong ones. Rather than watering down each provision so that it is somewhat screwy and half-baked, I would rather see them make compromises in a different way -- I'll give in on this issue, you give in on that issue. That's a bit harder to do politically, because the interests around different issues are different. But it is worth the effort because a lot of the so-called compromises in Dodd 2.0 just are not likely to result in a very robust regulatory architecture.

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Laurel, Md.: Professor Elizabeth Warren, overseeing TARP, is probably the nation's leading expert on the relationship of big banks to personal finance. Is anything being done to reduce the practice of "confusing people out of their savings" with over-complex mortgages, credit cards, and other lending?

Steven Pearlstein: That is what the consumer protection fight is all about, and Elizabeth Warren is the leading candidate to head to the new agency, assuming it is powerful and independent enough to attract her interest and support.

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Kensington, Md.: The regional Fed banks aren't THAT powerful. There are a lot of banks, credit unions, S&Ls in this country, and most of what the district banks do is humdrum check clearing and cash operations, and gather tons of required data. The only institutions the Fed regulates directly for safety and soundness are holding companies (look to the Board as much as the District banks) and state-chartered commercial banks (there aren't that many).

The dirty little secret is that the Fed has historically been gun-shy in enforcement cases because for as large as it is, it does not have a whole lot of lawyers working for it. You've basically got the auditor/accountant types cutting deals with accountant types at the banks, but nobody with the big stick threatening civil penalties.

My big Fed reform plan would be to fire half the economists and replace them with really ambitious, hungry lawyers; and make the Board's chief council an appointee with some independence from the Chairman (Greenspan was notorious for keeping the Board's legal staff on a short leash).

Maybe someone at the Post ought to do a story on this!

Steven Pearlstein: Ah, spoken like a ..... lawyer?

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The Daily Show: Did you catch Jon Stewart's take on the causes of the financial crisis last night?

Steven Pearlstein: No. Do tell.

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Atlanta: I think there is a little misconception. A bank 'failing' means they have to liquidate -their- assets, not the depositor's assets - therefore...if you own say, stock, and it's in an account administered by a certain bank - you own that stock regardless...they do not need to sell your stock - you can transfer to another bank. Of course, if you own their CD, or something like that - then yes, you are a creditor (right?) and that will probably be liquidated. But your small bank can go bankrupt - too.

Steven Pearlstein: Not sure what your point is. One of the main points of the legislation is to insure that if a bank is run in a way that leads it to or toward insolvency, then under a new regime the stockholders will be wiped out and unsecured creditors will suffer a haircut commensurate with the degree of insolvency. The process will be similar to a bankrupcy but, because of the need to avoid undue harm to the financial system, not precisely the same. The government might step in and provide temporary liquidity to pay off some portion of unsecured liability to give the institution time to make an orderly sale of its assets (in order to maximize their value). The government's "advance" would be the first to be paid off once the assets are sold, and then anything left over would be sent along as a final payment to the unsecured creditors.

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Princeton, N.J.: I give you the following line from Wikipedia's article on Credit Default Swaps:

"Credit Default Swaps became largely exempt from regulation by the U.S. Securities and Exchange Commission (SEC) with the Commodity Futures Modernization Act of 2000, which was also responsible for the Enron loophole."

I want to point out that this Act was passed by adding it in the dead of night in a footnote to a conference report on an Ag bill. It never went through any committee, it was never debated on the floor, and most legislators had no idea they were voting on it. Think about that when you complain about the Democrats tactics on the Health Care bill.

Steven Pearlstein: Thanks, Len.

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Kansas City, Mo.: Jon Stewart's review of Sen. Dodd's bill last was great. He said if the Supreme Court says corporations can be like individuals that individuals should act like corporations and explaining how his new "United JonCo International" could leverage his 1984 Volvo station wagon into $2.5 million with the help of JimmyCo, his rating agency. He eventually ends up with bonuses for not leaving and $10 million in severance pay for trashing the company...

Steven Pearlstein: Interesting.

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The public knows it wants a reform bill, but unlike health care it has neither the interest nor knowledge to get involved with the details of the policy. : Come on Steve! You really think the public knows even the basic facts on health after all the lies they have been told? They know that other countries get better care at much lower cost with government run systems? They know about Medical Loss Ratios and compliance costs?

If you do, I have a special for the next 3 hours on the Key Bridge.

Steven Pearlstein: No, but the public does have views about things like public options and managed care and choice of doctors and what might be driving up health care costs, because it interacts with the system all the time. Obviously there are also lots of more technical issues that the public won't get involved with, but in general it has much more experience and understanding and passion about health care than about financial regulation. I think that is obvious.

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Bryn Mawr, Pa.: The new regulations that are being proposed: are they fool proof, or will we just see these same people finding a way around the new regulations? With all the "lawyers" that are involved, you would think that there would be someone who could write a regulation that would be fool proof.

Steven Pearlstein: No regulation is ever fool proof.

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Washington, D.C.: Republicans oppose all regulation of the financial sector? Really? Can you point to any bill or speech that supported that position, by any Republican that held office (let alone a platform plank)? Because I just got off Westlaw, where there's a ton of financial institution and services regulations that I haven't heard anyone talk about removing, even the most wild-eyed libertarian (which is hardly the orientation of the current GOP).

Or maybe you meant "Republicans don't support regulating as extensively or as much as I want"? If you dialed back the hyperbole, I could appreciate your arguments more.

The hyperbole seems especially pointless considering much more heavily regulated economies in Europe had similar or even worse housing booms and worse financial results. And I'm sure you've read much more than I about how our regulations and policies in some ways worsened this crisis by providing bad incentives. Talking more or less regulation is worthless, really. It's smart regulation vs. bad regulation.

Steven Pearlstein: Republicans actually talk all the time about deregulating and about how burdensome regulation is and how it costs jobs and crushes innovation. Look at the Chamber propaganda, just as an example. They are always careful to say, of course, we understand there is need for some regulation, but then when you peel back the onion, the only kind of regulation they like is usually the kind of regulation industry itself likes, which is the kind that protects business or certain business interests. If you ask, for example, what part of the OSHA law the Chamber likes, it likes much of it in principle but opposes any new regulation or initiative that OSHA proposes. Or take consumer protection in financial products. Oh, sure, they say, we're for that in principle, but when you mention a specific credit card regulation, they're against it. They are against having an independent agency. They are against that agency having an independent source of funding that can't be stopped if the industry puts pressure on Congress. They are against giving enforcement powers to make sure the regulations are adhered to. But they are for consumer protection. Get the picture.

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Richmond, Va.: Does the new proposal allow the executive branch to shut down a financial company without going through bankruptcy court?

I happen to think the idea that the bankruptcy courts are too slow or cumbersome to deal with large financial institutions is an excuse for those in the Treasury or Federal Reserve who don't want to have the transparency that a court filing would require them to provide.

For all the talk about how we couldn't put GM through bankruptcy before we did it, once push came to shove, a prepackaged bankruptcy ended up being a pretty decent option (which I believe you advocated at the time). I happen to believe that the same process would have been a better solution for AIG as well and would have solved a lot of the current problems with the bailout approach such as the bonuses.

Steven Pearlstein: It's an alternative bankruptcy-like process better suited to winding down, liquidating or selling a financial institution that is so large or so intertwined with the financial system that the regular bankruptcy process would probably be inappropriate and overly disruptive.

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Ernst & Young: As with the late Arthur Andersen (the company), the Lehman report reveals that Ernst & Young was knee-deep in the fraud. You think anything will come of it? Why is it getting no play in the legacy media?

Steven Pearlstein: What will come of it will be one big fat shareholder law suit that will be settled, without admitting or denying anything, for the maximum amount of money under E & Y's liability insurance, with most of the money going to the lawyers.

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Kensington, Md.: Not a lawyer, but an economist who has been in the room with Fed economists and lawyers listening to arguments for not enforcing financial regulations. "You're obligated to enforce the law" always took a back seat to "that wouldn't be efficient" (see Greenspan, Alan). (Lawyers shrug and go back to keeping themselves busy).

Seriously, the Fed really doesn't have the person-power to enforce the regulations it's responsible for. Very poor staffing decisions, IMO.

Steven Pearlstein: Sorry, I shouldn't have been so flip.

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Washington, D.C.: I picked up "The Big Short" by Lewis on Monday, and I'm about halfway through it. I'll be done with it tomorrow. I read "Liar's Poker," "Money Ball," and "The Blind Side," but "Big Short" is the best. The problem, though, is that Big Short is the most frightening, because it portrays the collapse of the financial underpinnings of our country - AND PEOPLE IN POWER WERE TOO STUPID TO UNDERSTAND THE IMPLICATIONS OF WALL STREET'S FAILURE TO UNDERSTAND THE NATURE OF THE COMING ECONOMIC COLLAPSE. If you want, I'll let you read my copy of the book. I'll bring it to the Post building.

Steven Pearlstein: I reviewed the book in Sunday's Outlook/Book section. I've got two already, thanks.

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Richmond, Va.: What's your take on the potential downgrading of U.S. Government debt?

Steven Pearlstein: I think its silly.

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washingtonpost.com: Steve had to take off. Thanks to all for joining us, and please come back next week.

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