Like generals fighting the last war and failing to protect against current threats, our Congress in its consideration of financial regulation bills is not recognizing what has caused our recent financial upheaval and what needs to be addressed to avoid its recurrence. Too much of the pending legislation appears to be retribution against Wall Street and does little to protect America against new crises.
Our economic problems were caused mainly by incurrence of far too much debt by individuals and firms, and secondarily, by ill-conceived investments in securities comprised of such debt. All of our problems come back to these factors. By definition, foreclosures result from excessive debt. Much of this debt resulted from the express efforts of Fannie Mae and Freddie Mac and the Community Reinvestment Act to promote homeownership, and some resulted from weak underwriting on the commercial side. Financial institution failures and bailouts - from Washington Mutual to Lehman Brothers and numerous less-visible firms - resulted either from origination of too many bad loans or the purchase of too many securities comprised of them and not worth close to their price and thereby impaired capital.
Any successful changes in law need to reduce the likelihood of such events, especially the flawed loan-origination process. This can be done either directly by prescribing lending standards - although this may damp demand when we can least afford to do so - or indirectly by changing corporate governance standards to require proper oversight of lending activity.
However, what we see in Congress largely ignores such matters. For example:
c In response to the alleged depredations of Goldman Sachs, Sen. Carl Levin, Michigan Democrat, seeks to prevent overreaching of customers - primarily institutional - by investment banks not disclosing conflicts of interest when originating securities. We already have securities laws to deal with such nondisclosures, and they have nothing to do with imprudent lending and investing. Our broader economic problems had nothing to do with financial institutions overreaching and everything to do with too much lending and borrowing.
c Sen. Blanche Lincoln, Arkansas Democrat, and Paul Volcker seek to limit or prohibit banks from investing in derivative securities. While this may have some modest impact on the “ripple effect” from securities based upon poor-quality loans, it does nothing to prevent the making of such loans and the subsequent foreclosures and repossessions that are currently causing problems. It will also drastically limit legitimate, genuinely risk-reducing currency and commodity hedging by financial institutions and users of physical commodities such as airlines and food producers.
c Several bills seek to cause loan originators to keep “skin in the game” by forcing them to keep some ownership slice even for securitized products. But as recently explained in these pages, securitizers already have liability for fraudulent underwriting through their representations and warranties.
c The administration and others seek to create a Consumer Financial Protection Agency to protect consumers from complicated products and language allegedly foisted upon them by large financial institutions. Professor Elizabeth Warren of Harvard Law School and the Congressional Oversight Panel is especially vocal as to the depredations of credit-card issuers. However, complication has nothing to do with debt amounts, which are the ultimate problem. Witness the current problems in the commercial real estate area where borrowers were sophisticated (or at least had access to counsel) and the documented failure of administration efforts to assist consumers by merely reducing mortgage interest rates. A recent survey by Fitch Ratings indicated that more than 11 percent of securitized commercial loans are expected to be at least 60 days past due by the end of 2010. The problem is too much debt and not confusing interest rate provisions.
To the extent that the effort to force lenders and borrowers to contract under “plain vanilla” products that they would not otherwise utilize, have any effect, they are likely to reduce lending by removing options that both parties find beneficial regarding allocation of risk of interest-rate changes. At present, the last thing we should be doing is reducing lending.
c Sen. Christopher Dodd, Connecticut Democrat, proposes to change the definition of “accredited investor” to make it harder for individuals to invest in sophisticated, privately placed securities. Existing Securities and Exchange Commission rules already require high income ($200,000) and/or net worth ($1 million) for this purpose, but Mr. Dodd would further increase these levels. There is no evidence that such investments by individuals played any role in our financial meltdown and we should not discourage any kind of investment.
None of the bills impose direct liability on anyone for the results of their bad lending decisions. Corporate law is highly process-oriented, which is to say that as long as officers and directors jump through the right hoops in making their decisions, they are not liable even for catastrophic consequences. By addressing “resolution authority” for failing firms, pending bills only divert the focus from holding responsible those making the decisions requiring resolution and encourage more bad decisions. Similarly, nothing in pending bills does anything to reverse the flawed mission of the Community Reinvestment Act and Fannie Mae/Freddie Mac.
Perhaps this is wishful thinking, but Congress needs to stop trying to punish Wall Street and help America avoid another Great Recession.
Martin B. Robins, a corporate attorney, is an adjunct law professor at Northwestern and DePaul universities.