Friday, July 23, 2010

Financial Regulation...What It Means to You and America

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

As expected, financial regulation recently was passed in Congress and President Obama has signed that into law. As I discussed in Politicians Run Amuck… Again, my overall view is that something is better than nothing, but this bill is far, far from perfect. Historically, sweeping reform often comes with unintended consequences and this bill, just like health care reform will have its fair share.

To be clear, I have not read the almost 2000 page bill. My conclusions are drawn from a variety of research and commentary from both sides of the political aisle. I don’t want to rehash most of what I already wrote about, but there will be a few repetitive comments. First and most importantly, shame on Congress for totally and unequivocally kicking the can down the road on Fannie Mae and Freddie Mac. That is appalling! Two of the main ingredients in the financial crisis are passed over? Is Congress kidding, scared of what they may find or helpless?

President Obama pounded the table that “too big to fail” is over and we will NEVER again use taxpayer money to bailout failing institutions. Does anyone really believe that to be the case? You mean to tell me that if J.P. Morgan was on the brink of failure and needed a government backstop, the administration wouldn’t step up? That’s beyond naive to accept. We all know that Uncle Sam, whichever party is in control, would kick and scream but still come to the rescue.

I know what’s in the bill, giving the Fed and FDIC new and extraordinary powers to orderly unwind a failing institution (something I totally favor), but I just don’t buy it in times of crisis. There is no way, in my opinion, that anyone in government could have safely unwound Lehman Brothers to protect the system. And while a “bailout fund” may be created from this bill, who do you really think will end up paying for it? The banks may cut the checks, but that will certainly result from higher fees and charges to us!

The bill does address derivatives, by requiring banks to spin off certain groups under their control and move some trading to exchanges and clearing houses. Longer-term, I have to agree with this as it removes one element of potential financial Armageddon. But it does not come without cost. By spinning off these departments, banks will be required to capitalize (inject money) the new entities, further straining their own capital and reducing the amount of money to lend. That is called credit contraction, something we’ve been unsuccessfully fighting for three years. Less and tighter credit in the system will negatively impact economic growth in the short-term until the banks replenish their capital base.

The bill also limits banks from investing more than 3% of their capital in hedge funds and private equity. This provision was interesting as it suggests that somehow the hedge funds and private equity shops were a cause or accelerant in the crisis, something that is simply not true. I don’t really care if this is law, but like most major changes, it should be phased in over a period of years. I do believe it will end up hurting bank earnings.

FDIC insurance was raised to $250,000, something that I applaud and makes perfect sense. That should help keep or increase customer deposits in banks (CDs, money markets, etc.), adding revenue and strengthening their base.

A new consumer protection agency/department is being created under the Fed as I understand it. Folks, we have enough governmental agencies, units and departments to last 100 lifetimes. We need another one like the Pacific Ocean needs more water! This country will never fully recover from our economic malaise until government begins to shrink and the private sector starts expanding. Interestingly, although auto dealers originate 80% of auto loans, they were exempted from this bill. That’s somewhat dubious from my seat!

I was surprised that few people talked about one of the root causes of the crisis, leverage. Over the years, the banking and mortgage industry have created all sorts of non conventional, fancy, outside the box products that few, if any, really understood or knew how to use. If Congress really wanted to prevent another housing bubble and fix the current problem for the long-term, they should have considered requiring 20% down on all mortgages. Yes, I know that many people could not afford it, but that’s exactly what used to be the norm before we decided that owning a house was part of our right of passage in this country.

In the short-term, it would further depress an already depressed sector, but it would also begin to create a very long-term, stable and constructive housing market for decades to come. Like addressing Fannie and Freddie, this would not be politically popular (so probably very smart!) and therefore not interest the vast majority of politicians only interested in reelection, pandering to the media and special interest.

As I said, overall, the bill is something and it’s probably better than nothing, but by no means the final answer. I believe it is deflationary in the short-term and will lead to further credit contraction and harm to the economy. Financial institutions are creative, cagey and shrewd, employing some of the smartest minds on earth. Longer-term, they will likely adapt and adjust, find loopholes to make up for lost profits. I just hope that we don’t drive too much business to other shores.

I am scheduled to be on CNBC’s Worldwide Exchange this Tuesday, July 27th, from 5:35am to 5:55am.

Feel free to email me with any questions or comments at

Until next time…

Paul Schatz
Heritage Capital LLC

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