Senator Dodd Doubles Down on a Losing Bet

Watching the devolution of the bank reform bill in the U.S. Senate has been painful. Banking Chairman Chris Dodd's
original proposal unveiled last year had numerous strengths, most
significantly the removal of bank supervisory authority from the Federal Reserve.
Dodd had decided that the Fed had done such a lousy job ignoring the
housing bubble and failing to crack down on predatory lending in the
mortgage market that it shouldn't be given a second chance.

But a second chance for this unpopular and failed institution is
currently in the works. In an effort to please Republicans and achieve
a bipartisan bill, Dodd is not only going to let the Fed keep its bank
supervision and rule making authority, he wants to give it authority
over the proposed Consumer Financial Projection Agency (CFPA).

How would this work exactly? The CFPA issues strong rules cracking
down on credit card abuses one week and the Fed issues contrary rules
the next? Moreover, if I were the Fed chairman, I would insist on veto
power over any agency under my jurisdiction.

This ill-conceived idea may be enough to kill public support for the
financial reform proposal in the Senate. The bill has always been more
remarkable for what it lacked than what it contained. This point was
made clear by an astounding interview with a Wall Street insider in a
little-known trade publication called Welling@Weeden.

Long before the 2008 financial crisis, the blueprint for the crisis
was laid by the Fed's weak-kneed response to another derivative-fueled
disaster involving a massive hedge fund called Long Term Capital
Management (LTCM), whose collapse in 1998 threatened the entire
financial system. The Fed organized a massive private bailout, but did
not take concrete action to address the underlying causes. The failure
of the government to crack down on derivative abuses lead directly to
the current crisis. Today, the former lawyer for LTCM says that by once
again not getting to the heart of the matter, Congress is busily laying
the groundwork for the next catastrophe.

"What strikes me now, looking back, is how nothing was changed; no
lessons were applied. Even though the lessons were obvious in 1998,"
says James Rickards, former LTCM lawyer who negotiated the firm's
emergency bailout. Risk models needed to be fixed; leverage needed to
be slashed; derivatives had to be pulled out of the shadow market and
cleared through clearing houses and regulation needed to be ramped up.
But the government "did just the opposite" says Rickards, launching
into a string of deregulatory moves that made banks bigger and ensured
that derivatives would remain unregulated. According to Rickards, "the
U.S. stared near-catastrophe in the eye, with LTCM, and decided to
double down.""

Today, Rickard says the risks are even greater. Globalization has
"scaled up" the financial system and the level of risk, "so now when
[the system] fails, it fails catastrophically on a much greater scale
than we have ever seen before." If anything, there is greater
concentration on Wall Street, and the only difference is that "the Fed
has printed so much money, and Treasury has spent so much money, that
they have papered over the problem temporarily."

What is needed? While the current Senate bill does kick the can to
regulators to set higher capital requirements and lower leverage
ratios, it lacks critical elements. In Rickard's opinion, we need to
break up the big banks by reinstating Glass-Steagall
protections and the Volcker rule, let them be investment or commercial,
but not both; fix the conflict of interest in the ratings agencies and
create competition for them; liquidate Fannie Mae and Freddie Mac
and get back to a private housing market; and most importantly, make
sure that every derivative is regulated and traded in a clearing house.

The Dodd bill does none of these things. Not one. Once again, the
Senate is doubling down on a bad bet and the blueprint for the next
crisis is being laid as Dodd busily negotiates away the bill's best
provisions to achieve bipartisan support.

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