The 2000 page bill on financial reform is pretty much finished. However, it will require about 500 more pages of yet to be written regulations and an international increase in capital requirements on banks that may not be completed for years. Like the health care bill we will not know what is in it and how it will work until an army of lawyers tell us over the years. Lawyers and regulators have replaced markets.

The purpose of financial reform, according to President Obama, is "to prevent a crisis like this from ever happening again". That will not happen. All crises are different, but crises cannot be legislated out of existence. ( You might want to read my article "The Elephant In The Room" on, if you haven't already, to get a more complete understanding of the causes of the crises we faced and the recession that ensued.)

The following is a look at the causes and cures of the last crisis. The bold print indicates the cause, followed by the ability of the new legislation to deal with it:

The Community Reinvestment Act
The federal government compelled banks to lend to less than qualified customers in order to promote increased home ownership. This was the beginning of institutionalizing sub-prime mortgages into the system. Today, the FHA, Fanny Mae, and Freddie Mac, are doing exactly the same thing. The policy is an attempt to keep people in their homes whether they can afford them or not; and to entice others to buy homes on more favorable terms than the free market would allow. So, nothing has changed, here.

Fannie and Freddie
Fanny and Freddie have been totally left out of the financial "fix" and are mounting up deficits in the billions at taxpayer’s expense on a daily basis. These two institutions had to be taken over by the government, they failed so badly. They are now totally in charge of most mortgages in America. Again, no change, no help, no resolution.

Lax credit agency ratings
The rating agencies amount to a cartel that you must deal with by government decree. There are only a handful of them and they are protected from competition, hence their great incompetence. What needs to be done is to eliminate the protective legislation and allow hundreds of rating agencies to compete. Or better yet, outlaw them and force everyone to actually do due diligence on what they are buying. This new regulatory bill will discipline the protected agencies if they show incompetence in the future. At least it’s an attempt at improving the level of competency of the rating giants. But the best rating agency is the free market itself. It rates all trading vehicles on a daily basis.

Lack of regulation and enforcement by government agencies and markets
Perhaps one of the biggest contributors of the crisis was the breakdown of enforcement of the anti-fraud laws on the books. Watchdog agencies such as the SEC failed to catch even the gravest of frauds going on right under their noses. Madoff's Ponzi scheme is a case in point even though he was audited by regulators quarterly. And the market participants relied too much on ratings, and securitized mortgages they never took the time to understand. This bill does address these shortcomings, but will not be as effective in preventing the next episode as will the memories of the last crisis fresh in the minds of investors. It will be a long time before investors will trust without verifying.

SEC deregulation of leverage
The bill recognizes that excess leverage was at the heart of the crisis and attempts to address the problem by increasing capital requirements of banks and limit leverage used by financial institutions. The bill attempts to prevent the use of any leverage with monies coming from taxpayer funds. All and any government guarantees are being scrutinized and limited. This is one of the strongest measures in the new bill.

Mandating a mark to market rule
It is recognized by most private economists that enacting a mark to market rule in the middle of a crisis serves only to exasperate a panic and a crisis. That is exactly what happened last time. The very day they repealed the law the stock market stopped its slide and rallied 500 points. This bill does nothing to prevent a recurrence of that mistake. In fact the government is ready to re-instate a new M to M rule and broaden it to include all credit card and consumer loans. If enacted look for this to immediately push us toward a new crisis as massive liquidations are forced on to the market by law. The market itself marks everything that trades to market minute by minute. Mortgages and consumer loans do not trade and should not be priced as if they do.

Elimination of the Uptick Rule
The uptick rule served to regulate short selling. It was establish in the 30's as a device to contain panic, very much like the circuit breakers imposed on markets today. It was eliminated just as the market began to cave. Like M to M it was about as ill timed as is possible to imagine. The uptick rule has not been reinstated in this bill. Yet everyone is investigating the "flash crash" recently, at great time and expense. (Don't you just love regulators?)

Refusal to save Lehman Bros.
The refusal of the Federal Reserve Board to save Lehman Bros. was the biggest mistake of the crisis. In fact, it helped enhance the crisis and many believe, that had the fed stepped in, we never would have had the domino effect that began the following Monday. Or the recession that followed. Many books and documentaries have cited this view. The fed acknowledges it as their biggest mistake. This bill gives the fed resolution authority to take over any company that is going broke and they believe could be a threat to the financial system as a whole, and liquidate it in an orderly way. This does not eliminate the "too big to fail" problem, but it does set up a framework to oversee troubled companies and seize them and liquidate them at no expense to the taxpayer. A bank of last resort should be, and usually has been able to prevent a systemic melt down. It should have last time. This is a good provision.

The Fed's tight monetary policy and artificially high interest rates
One of the causes that contributed to the credit implosion was the feds tight monetary policy a year in advance of the melt down. Even as market interest rates were falling, the fed held the fed funds rate at 5.25% and kept the money supply at minus zero for a year. This was a big mistake. The fed needs to follow market rates and set the money supply at a range of plus 3 to 5% and leave it. Today, the fed funds rate is .25%, but 30 day rates are .06% and the money supply growth has been nil for a year. The broader money supply is again falling. Once again we see the signs of deflation. The fed should be increasing the money supply at a low and stable rate. And if they allow the fed funds rate to float, they might find that it falls to the 30 day rate or less. We are, unfortunately replaying the days that led up to the fall of 2008. This bill does nothing to resolve Federal Reserve errors that contribute to a crisis.

Applicant fraud
Loan officer fraud
Mortgage broker fraud
No Doc Loans
125% loans
Zero down loans and
Banks pushing adjustable rate loans at teaser rates...

have all gone by the wayside, mostly driven out by market forces. But it is the government’s job to prosecute fraud. It has been announced this week that thousands of mortgage bankers and employees have been indicted throughout the nation. This country participated in the greatest act of fraud in its history. It, more than anything else was responsible for the crisis. If the regulators had been doing their jobs in one of the most regulated industries in this country-- the banking industry -- we would not be where we are today. This should be kept in mind when considering the efficacy of 2 to possibly 3 thousand pages of new rules and regulations that are going to be imposed on us in the future. Good regulation needs enforcing. Unfortunately, as we've seen, it becomes more about the perpetuation of bureaucracy than regulation.

No counter party risk, no recourse:
One of the problems that came back to bite us in the crisis was that the originators of loans no longer kept them. They fraudulently put together "liar loans" and sold them to Wall St. We now are going to require that all originators "have some skin in the game". They must retain a portion of the liability. This is a good thing.

Creation of exotic new unregulated and non-transparent derivatives:
Many of these liar loans ended up in packages with both subprime loans (demanded by the government) and perfectly good loans taken out by the majority of home buyers. This was called "securitization". These derivatives were stamped triple A and sold all over the world. Derivatives got the blame, but it was the content of mortgage backed securities that were the real problem, not the vehicle. Collateralized debt obligations, fraudulent credit default swaps issued by AIG that had no backing, and all kinds of exotic new instruments sprung up, many of which we still don't completely understand. This bill will try to make derivatives more transparent, and trade them on exchanges and clear them when possible, and more importantly, subject them to higher capital requirements which will take the huge leverage on them down to more reasonable levels.

But with this market at 600 trillion and growing, and traded throughout the world, I do not expect the market to be controllable. I do expect that because of this legislation, credit availability will be reduced and costs of most things financial will increase. But, at least some will sleep better at night knowing that the regulators are on the job. (Now, let me many regulators does it take to monitor 600 trillion dollars of complicated derivatives throughout the world? How about if we just let the millions of those people buying them do that and concentrate on fraud and leverage abuse?)

Securitization by banks and Wall St investment firms:
As I have said , securitization was the vehicle for packages of multi-billions in fraudulent loans. This bill will help prevent this from occurring again, although the free market has already eliminated them long ago. After all, would you like to invest in a package of unknowable mortgages from places that are unidentified by debtors that were allowed to buy at no money down and had no proof they could pay the loan back? Amazingly, the whole world said "yes!" a couple of years ago.

Lowest long term interest rates in history due to world savings glut:
A lot of people think that the fed funds rate at 1% caused the real estate boom. But the fact is there were 27 real estate booms all over the world and most of them in high interest rate countries. The one thing in common that all the booms had is that long term rates fell to the lowest level in history, world-wide. Since money on mortgages are lent most often for thirty years, it is the long term interest rate that is most important, not the fed funds rate. The actual increase in central bank creation of money was minor. The world was flush with money due to the huge savings glut in China, India, and other emerging nations. Most nations’ basic money supplies were very low in the years of the real estate booms. There were fears of recession and deflation. The real estate market back then was the one bright spot in the economy.

It is important to view history and the present in context. A lot of people said when the fed, a few months ago ,exited the mortgage market and stopped buying government bonds that interest rates would rise. They fell. Today, we have the lowest 30 year mortgage rate in history. Yet, no one is buying homes. That is why "context" is so important. It is wrong to point to just one factor like the fed funds rate and conclude that it alone was responsible for the actions of millions of people. Whether the fed funds rate was at 1% or 5% would not have changed all the other factors we have just listed that led to the credit crisis. Today the fed funds rate is .25%. The lowest in history. And the fact that it is... is absolutely meaningless.

The Financial Regulation Bill came out of committee Thursday night. The bill will be voted on by Congress next week. It is a very mixed bag. Personally, I would not vote for it. The reason is that the unintended consequences of such sweeping regulation will most likely cause as many problems as it purports to solve.

And it will be expensive, restrictive, and cause great confusion and effort to comply with. The best intentions of regulation usually go awry. And in the end we are all responsible for ourselves. "Buyer beware" is the best regulation I know of -- and a good cop on the beat looking after me. In this last crisis the cops didn't do their jobs -- or most anyone for that matter. The nation went a little crazy. That usually is what causes crises.

To quote former SEC Chairman Harvey Pitt, who should know something about regulation, as a result of this bill "costs will be astronomical and eventually be passed on to people like you and me. I think it will impose heavy layers of bureaucracy and make the US competitively unable to compete with foreign countries". He says that the bill "requires so much additional regulation and makes the whole system so much more ponderous that every time a bank wants to do something, not only does it have to go through the regular channels but nine additional people which adds layers on to the review process which will increase the costs of lobbyists, lawyers, and the like." Add to that the concern that like the health care bill, taxes will go up an undetermined amount, mostly on small businesses and cost that are imposed on banks will be passed on the consumer. And many of the new regulations are said to have the potential to stifle small business, hiring, and innovation.

We could accomplish most of what everyone wants by simply, giving the fed the authority it needs to be effective as a bank of last resort; the assurance that those companies that need to fail, do, at no expense to the taxpayer; increase capital requirements and reduce leverage levels to historic levels on all financial institutions; and re-double our efforts to enforce existing laws against fraud. That is a one paragraph statement. It did not take 2000 pages. It is when you translate that into a 2000 plus page bill of hundreds of new rules and regulations that things begin to go very wrong. The Pandora's box of unintended consequences will be felt for years to come as individual responsibility is replaced with a legion of lawyers and bureaucrats. And mark my words, crises will still be with us.

Paul Nathan