Wall Street and the City of London can relax and learn to love financial-regulatory “reform.” Sure, Western governments vow to rein in bankers and speculators. But the politicians also offer a way for Wall Street to evade new rules that would restrict their profits. As long as financiers employ their creativity to help governments conceal and expand public-sector obligations, rather than use that creativity to expose those obligations as untenable, they’ll be OK.
The blueprint is in Sen. Chris Dodd’s reg-reform bill. The bill promises to “restore America’s financial stability.” A new Financial Stability Oversight Council (FSOC) would scan transactions and accounts for potential threats.
Yet the bill signals the FSOC: don’t look for risk in government securities markets. Consider the section that governs banks’ trading. It directs regulators to prohibit banks and their holding companies from proprietary trading and equity-fund sponsorship. But there’s an exception. Banks could trade in “obligations of the United States” and GNMA and Fannie Mae securities, as well as in state, city, and local public-authority debt.
The bill gives other financial firms a pass on government debt, too. Dodd wants regulators to set debt limits on systemically risky companies that aren’t banks. But, the bill says, “the rules … shall not apply” for proprietary trades in federal, mortgage-agency, or state and local government debt.
The same principle holds for securitization. The bill would require underwriters to retain risk in the debt-backed securities they sell. But it offers “a total or partial exemption of any securitization, as may be appropriate in the public interest” (hint: mortgages).
The pols want “financial stability,” then, but only if it doesn’t affect the capacity of government — and favoured constituencies like homeowners — to borrow profligately and cheaply. To ensure institutional demand for its debt and for the debt of cash-strapped cities, states, and homeowners, Washington would disproportionately encourage banks and other institutions to use such debt as trading-profit fodder.
Ironically, these exemptions would add to systemic risk. Trading in government and mortgage securities is tricky, especially if interest rates become volatile. Trading exclusively in such securities – since the feds would have made other investments either off-limits or more expensive – is even riskier.
The “Orderly Liquidation Fund” that the Dodd bill would create to pay for future bailouts wouldn’t be of much help in a government-debt crisis, either. The bill would require the FDIC to invest the fund’s $50 billion in … government debt.
Systemic risk would multiply for another reason. Big financial firms would quickly learn that the government wants its target markets to move in only one direction.
That is, Washington would let bankers and big speculators profit from their innovations as long as those innovations were helping the government to issue debt. Proprietary trading to bet on rising Treasury and muni-bond prices and low interest rates: good. Prop trading to bet against Treasuries, muni bonds, and the Fed: bad, and probably unpatriotic, too.
Europe’s experience demonstrates this truth. European leaders are up in arms about credit-default swaps and “exotic” derivatives – because speculators have started using these instruments to bet against Greece and the euro. The European pols didn’t mind, though, when financial innovators were using the same instruments to help Greece borrow impossible amounts, making the debt seem less risky than it was through illusory hedges.
And today, Europe’s leaders look benignly on another financial innovation: the City’s new pension-longevity derivatives. Pension derivatives could help hide governments hide another untenable risk: unaffordable pension liabilities. Under the few deals done so far, pension-fund managers have paid financial institutions a fee in return for “insurance” that retirees will outlive their pension plan’s money.
Without capital and trading rules, the “insurers” in capital-markets pension derivatives may someday find themselves unable pay hundreds of billions of dollars in liabilities, just as AIG, in 2008, couldn’t make good on its monolithic mortgage bet.
But Europe doesn’t seem too worried now. Look for the U.S. to be just as calm when this innovation reaches our shores. Once state and local politicians figure out that the big, bad banks can help them lop a few billion dollars’ worth off their pension liabilities, they won’t want Washington interfering with this gift – and so it won’t.
Successful regulatory “reform,” then, in Washington’s view, would focus financial innovation on increasing and hiding government liabilities, crowding out real market signals and private investment. Wall Street and the City quickly would learn that all the West wants is help suspending its disbelief about how much it owes for as long as possible.
It’s absurd in the last measure. But it could go on for a long time – as Washington and the rest of the West employ regulatory forbearance to support the financial instruments of self-preservation.
Nicole Gelinas, author of After The Fall: Saving Capitalism From Wall Street – and Washington, is a Chartered Financial Analyst (CFA) charterholder and contributing editor to the Manhattan Institute’s City Journal.
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