May 2010 Archives

by Roy C. Smith

After a yearlong effort to get it right, the U.S. Senate passed a financial overhaul bill last week that actually weakens the government's ability to manage the next financial crisis. The House version passed last December is better, but not much.

Neither measure effectively addresses the problem of the 10 to 15 too-big-to-fail U.S. financial companies, which in the past occasionally have required bailouts to prevent their collapse and a consequent panic in financial markets.

Nothing in either bill requires banks to become smaller, or discourages them from becoming even bigger. Undoubtedly, many institutions will grow larger. After all, regulators already encouraged JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. to acquire large failing financial companies during the recent economic crisis. Very large banks have difficulty managing all the different risks they carry, and periodically one or another of them fails at it.

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Senate Bill and Hedge Funds

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The Senate bill requires hedge funds to register with the SEC as investment advisers and raises the assets threshold for federal regulation of investment advisers from $25 million to $100 million, a move expected to increase the number of advisors under state supervision by 28%. According to the Senate bill, the SEC may require any investment adviser registered with the SEC to maintain such records and file such reports as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Agency for Financial Stability. This data will be shared with the Agency for Financial Stability. The records and reports required to be filed with the SEC shall include a description of: 1) the amount of assets under management and the use of leverage; 2) counterparty credit risk exposure; 3) trading and investment positions; 4) valuation methodologies of the fund; 5) types of assets held; 6) side arrangements whereby certain investors in a fund obtain more favorable rights or entitlements than other investors; 7) trading practices; and, 8) such other information as the SEC, in consultation with the Agency for Financial Stability, deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk. Further, the SEC shall conduct periodic inspections and other inspections prescribed as necessary by the SEC of all records maintained by an investment adviser registered with the SEC.

by Philipp Schnabl and Marcin Kacperczyk

Money market funds are the stepchild of finance. Even though they manage more than $4 trillion in assets, you won't find them in the Senate's financial reform bill from last Thursday . Is this justified?

If you analyze the track record of money market funds up to 2007, you would think that the Senate bill got it right. Apart from a small hiccup in the early 1990s, not a single fund ever got into trouble. However, in August 2008, a large money market fund, the Reserve Primary Fund, went bankrupt. As a result of the Reserve Primary Fund's troubles, investors started pulling their money from the entire industry.

Faced with a panic, the government decided to act promptly. Three days after the start of the run, it announced that all money market funds would be guaranteed. This announcement successfully stopped the run, but it also meant that going forward investors expect to get bailed out again.

We therefore believe that the government has to explicitly acknowledge that money market funds will receive government support during times of crisis. Even though this may be unpopular in policy circles, this is an honest thing to do. How should the government do this? This blog post has the answer.

On Thursday the Senate passed its version of the financial reform bill, and the reconciliation process with the previously passed House bill will now begin. What are the implications for consumer protection? The similarities between the two bills in the area of consumer protection and more notable than their differences, but there are some distinctions to keep in mind and some troubling issues common to both bills. Consumer protection is a worthy goal, especially given some of the documented abuses leading up to and during the financial crisis, but bad regulation may be worse than under-regulation.

The Senate's passage of its version of the financial regulatory reform bill, like its House of Representatives' counterpart (H.R. 4173), presents a mixed bag of reforms for the role of the credit rating agencies in the debt markets of the U.S.  Both bills instruct financial regulators to cease relying on ratings in their prudential regulation of banks and other financial institutions.  This is all to the good.  It is the near-deification of the three large rating agencies, as a consequence of over 70 years of such regulatory reliance on ratings, that greatly magnified the disastrous consequences of their over-optimism with respect to the creditworthiness of subprime residential mortgage based securities.

But both bills also pile on new regulatory requirements on rating agencies, which will surely add to the costs of being a credit rating agency and will discourage entry and thus discourage new ideas, new methodologies, new technologies, and new business models.  Because the large incumbents are better able to absorb these costs, an ironic consequence of these requirements is that the three incumbents could well become more important, not less.  Do the authors of these provisions realize this?

Finally, the Senate bill contains the "Franken Amendment", which instructs the SEC to create a clearinghouse board to which issuers of RMBS that sought a rating would apply.  Though the issuer would continue to pay for the rating, the "shopping around" by the subprime RMBS issuers would be eliminated, since the clearinghouse would select the rater.  If this provision survives the reconciliation of the two versions of the bill, it will be crucial for the clearinghouse to maintain high standards of rating quality and to be open to innovation in ways of determining the creditworthiness of bonds.

The Senate's financial regulatory reform bill was passed by the Senate on Thursday evening.  The devil will surely be in the details -- both with respect to how the reconciliation with the House of Representatives' similar bill (H.R. 4173) is worked out and then how the implementing regulations are developed by the Fed, the SEC, the FDIC, etc.

But there are 2 elephants in the room about whom there will be no details worked out: Fannie Mae and Freddie Mac.  Both bills are completely silent with respect to any reform of these two dominant entities in the residential mortgage secondary markets.  How anyone on Capitol Hill can claim that these bills represent "fundamental reform", when these 2 mortgage giants -- who will probably represent the largest net cost from the federal government's "bailouts" of the financial sector -- remain unaddressed, remains a deep mystery.

Micro-Managing Again!

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You might think that the Senate has enough to do attempting to save the country from another financial crisis. Measuring and regulating systemic risk, orderly liquidation of failing financial institutions, Freddie and Fannie, rating agencies--the list of critical issues is long and the problems are complex. However, significant regulatory reform is apparently not enough to keep our diligent Senators busy. A couple of weeks ago Senator Tom Harkin took the time out to propose capping ATM fees, and this past week the Senate approved an amendment put forward by Senator Richard Durbin to reduce the "swipe fees" that banks and other companies charge on credit and debit card transactions.

Restrictions on ATM Fees -- Another Bad Idea

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Apparently some people in the Senate think that price controls are the appropriate tool for consumer protection. Ideas have been floated in the past to regulate interest rates on payday loans and credit card fees, and the latest target is ATM fees. Senator Tom Harkin seems to believe that restricting ATM fees to "a reasonable upper limit of 50 cents per transaction" will actually benefit consumers. Unfortunately, the logic underlying such a proposal shows a fundamental misunderstanding of, or perhaps disregard for, economics.

Edward Altman, professor of finance at New York University's Stern School of Business, talked yesterday with Bloomberg's Paul Gordon about junk bonds. Altman, who spoke in Hong Kong, also discusses the likelihood Greece will default on its debt.

Watch the video at

Euro Is in Fiscal No Man's Land

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by Jonathan Story and Ingo Walter

The new agreement by European Union members to stand together with the International Monetary Fund in support of Greece's effort to stave off fiscal calamity marks a turning point in a grand experiment that stood the relationship between politics and high finance on its head.

Unlike the U.S. after 1865 or Germany after 1989, where political unity created monetary unification, the launch of the euro in 1999 was just a monetary event and presumed that a political merger of EU states would come along eventually.

This has never been accomplished before, and it hasn't worked out as planned. The recession of the last year laid bare the structural divide that has existed and widened in the EU. It has provided a key lesson during the Greek debt crisis, which at more than $146 billion will be the most costly bailout ever.

Greece and its Club Med partners -- Portugal, Spain and Italy -- haven't come close to keeping pace with the German manufacturing industry in driving down relative unit-labor costs. The gap continues to widen. Year by year, the frugal Germans have won market share in the EU, which now absorbs more than 65 percent of their exports compared with about 45 percent in the mid-1990s, but Germany's key consumers are running out of purchasing power to keep its export champions humming. Long-term overproduction lies at one end of the chain, overconsumption lies at the other end, with growing and ultimately unsustainable debt linking the two. A single currency and monetary policy join them at the hip.

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The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors