Island Investing: Financial Reform

My column in today’s Keys Weekly.

Q. What’s going on with financial reform in Congress?

A. As you have probably heard by now, there is a significant financial reform bill currently making its way through Congress. The House passed its proposed reform bill at the end of last year, and the Senate will take up its own version at the end of this month. Prepare for heavy spin.

As one Senator memorably said a year ago in the midst of the credit crisis, “The banks are still the most powerful lobby on Capitol Hill. And frankly, they own the place.” So I think it’s notable that some fairly serious reform efforts have survived thus far.

The reform of our financial system is an issue that should be bigger than politics. The massive bailouts of “too big to fail” Wall Street banks were deeply offensive to just about everyone, regardless of political beliefs. They demonstrated at a shocking level the unholy alliance that has grown between politics and finance over the last few decades. In what may be one of the great ironies of our time, it turned out that Wall Street banks were bad for free markets.

I think it’s also important to understand that Wall Street banks didn’t get to be so big because of their economic advantages – they got there because of subtle political ones. What also should be kept in mind, however, is that regulation can unequivocally make the risk in the system worse. And it doesn’t make any sense to leave financial reform up to the same regulators who just failed us all so miserably.

I think Teddy Roosevelt had it right. The big banks should be broken up – not because that alone will guarantee our financial system will be safer, but because it will end this dangerous mix of politics and finance that nearly led to the collapse of the most advanced economy in history. One year later, the surviving Wall Street banks that helped cause the crisis are even bigger and more powerful. And until we address “too big to fail,” we’re really just kicking the can down the road.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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6 Responses to Island Investing: Financial Reform

  1. PlanMaestro says:

    well said… but can we speak softly when we are not carrying a stick?

    • Cale Cale says:

      I’m wondering if the SEC announcement about Goldman on Friday might be that stick, Plan.

      I can’t imagine the threat of new regulations really concerns the banks too much. It’s relatively easy for the language to be neutered before anything is passed, and to eventually get around any new rules that do make it through. But the threat of being accused of securities fraud by the US government is a huge stick. It hits ’em right in the breadbasket. I gotta think that every client of every Wall Street bank has probably spent this weekend wondering how they’re getting screwed. That’s the sort of pressure that will actually get to the banks.

      Here’s the other thought floating around in my head…in theory, this sort of thing could force the banks to eventually break themselves up. If these sorts of cases become more common – and there appear to be at least a few others out there – then at some point it becomes in the bank’s own interest to separate deposit-taking and/or investment banking from trading, just to prove to their clients that there are in fact no conflicts. You might even say that those banks who did break up would have an advantage over the other banks. The market would reward them.

      That idea probably gives bureaucrats and bank managers too much credit for foresight, but it’s interesting to think about the political strategy behind the scenes here, in any case. Think it also goes back to what I told my investors in January…the big extraneous variable in the market’s returns this year is likely going to be the war between Wall Street and DC. And there’s a long time to go until November.

  2. Kirk Kinder says:

    Cale,

    Good stuff. Totally on board with separating politics and business. We need to get rid of the corporatist practices in the US. If you can’t beat your competitor through head-to-head competition then you should fail. You shouldn’t be able to get a politician to put the odds in your favor.

    However, I don’t agree that too big to fail is bad. The size has nothing to do with the failure. It was the leverage and political clout, as you mentioned. Many small banks are failing due to poor lending standards and too much leverage. The Great Depression was an enormous banking crisis without having too big to fail banks. So it is leverage and lending decisions that ultimately decide success or failure.

    • Cale Cale says:

      Yep, a bank doesn’t have to be big to fail. Capping the amount of leverage they can use has absolutely gotta be part of reform, but I don’t think it will really be effective without breaking up the banks first. If history is any guide, these guys will find a way around whatever capital ratio rules or leverage restraints are thrown at them – whether derivatives, SIVs, accounting rules or through political pressure. I think reform has gotta be done assuming that any new regulations that are introduced will eventually be worked around by the banks. If they’re smaller, it both reduces the odds that politics will enable banks to skirt the rules, and the ultimate damage if it does.

      You nailed the relevant difference…the system can absorb many small bank failures with relatively minimal disruption and at less-than-obscene cost. The size of a bank may or may not be related to the odds of its eventual failure, but if it’s a big bank that fails, it comes at far too high a cost to the taxpayer and the entire economy. And right now they’re incentivized to get even bigger through the explicit guarantee of support they’ve all been given, meaning another huge bailout at some point seems all but inevitable. It won’t be due to subprime mortgages next time, but I am troubled by how much Wall Street really, really likes the idea of cap-and-trade.

      So I think it’s time to go Bull Moose on ’em. Hard to see how anything less will really be effective in the long-term.

  3. PlanMaestro says:

    Crossing my fingers on GS being arrogant and stupid so they fight this “vigorously”. I do not think the SEC has found yet a consistant patern of fraud, only an individual small case. If GS throws Fab under the bus, and he has no more incriminatory evidence against GS for the investigators, that would probably be the end of it.

    If they do not, maybe GS helps us by being as stupid as other smart but arrogant firms: Drexel, Salomon, Anderssen

    PD: I like Kirk’s distinction. This is not about too big to fail, it is about too big for a well functioning democracy