If Trump is planning on attempting to remove CFPB Director Richard Cordray "for cause" he's hardly going about it in a smart way. The Trump administration keeps generating more and more evidence that any for-cause removal would be purely pretextual, which strengthens Corday's hand were he to litigate the removal order (as he surely would).
I have an op-ed in American Banker about proposals to convert the CFPB into a commission structure. Basically, the idea that a commission structure increases accountability and policy stability and reduces arbitrary or abusive actions by an agency just doesn't hold water upon examination.
Not included in the piece is a brief history of independent agency structure. The reason that so many independent agencies are structured as commissions has absolutely nothing to do with a perceived superiority of the commission structure from any sort of good governance perspective. You'll be hard pressed to find any Congressional debate about single director versus multi-member commission structures. The prevalence of multi-member commissions is a matter of path dependency and Congressional desire to maximize patronage opportunities, not any considered debate.
It's that time of year again! Time to revisit and perhaps rebalance the investments in your retirement portfolio. While it is a sad fact that many people lack significant retirement savings, it is nonetheless useful for those interested in consumer finance (and investment companies, pensions, etc.) to think about how retirement savings plans work and to be able to offer some advice, for example, to debtors emerging from bankruptcy with their clean slate. William Birdthistle, of Chicago-Kent law school, has recently released Empire of the Fund, a magnificent new work on the most common vehicle that carries individuals' retirement savings in the US: mutual funds.
I have heard that Birdthistle, who teaches across town from me, is legendary in the classroom. Having read his new book, I'm not at all surprised. While his fairly esoteric subject matter made me hesitate to nominate his book in response to Katie's post, Birdthistle has really pulled one off here by managing to make a book about the structure and pitfalls of mutual funds and retirement savings ... extremely entertaining! It is masterfully written, with both erudite references to relevant comments by literary and historical figures, along with laugh-out-loud allusions to modern culture ("OMG! Friends, right! Mutual funds are lame!"). This book is an absolutely brilliant example of how to make a work on an otherwise dry financial subject not only accessible to the general public, but a real pleasure to read. It is no wonder the New York Times calls this "a lively new book."
Do financial institutions care about bigotry? I don't ask that facetiously. I want to be clear that I am not raising the question of whether financial institutions themselves want to discriminate based on race, gender, national origin, religion, sexual orientation, etc. (or "have a taste for discrimination" in Gary Becker's terminology). Instead, what I am asking is whether they care about bigotry and discrimination in society writ large? That is, do financial institutions believe they have some sort of social responsibility? Do they, as corporate entities believe in diversity and inclusion, and human rights? Or even if they don't, do they believe that bigotry and discrimination in society are bad for their bottom line?
Certainly that's what they have told us in the past. Large banks have repeatedly made statements about how diversity and inclusion help them to be better businesses and to better serve their customers. Indeed, many large financial institutions have statements of corporate values that typically include things like diversity and inclusion and human rights. These institutions also sponsor charity events that advocate for these values. But how much of this is just lip service and token payments to improve community relations? We're about to find out. The major financial services trade associations just got a letter from the Ranking Democratic Members of the Senate Banking and House Financial Services Committee, as well as from Senator Elizabeth Warren and Rep. Keith Ellison. The letter outlines concerns about Stephen Bannon's appointment to a senior White House position and asks the trade associations to publicly oppose Bannon's appointment. Will the trade associations (and the banks that fund them) take a stand against bigotry, even if it costs them political capital with the incoming administration? If they don't, what sort of message are they sending about their commitment to comply with fair lending laws? About equal opportunity employment? About hostile workplace environments? It'll be interesting to see what happens. Obviously the trade associations aren't quite the same as their members, and cannot be seen as speaking for any particular member institution, but this is a case in which silence counts as action, and if the trade associations are silent, then it's on the members to speak up if that silence does not represent them. As the letter says, "This moment is a test of the moral leadership of the banking and finance community."
Banking is not an industry; banking is not the real economy. The big banks especially are economic and political behemoths that remain unpopular and poorly understood in the popular imagination. Opinion polls show voters favor breaking them up, and some shareholders do too. While Wall Streeters may bemoan the fact that banks are no longer hot growth stocks, I suspect most voters who chose either candidate would not be saddened to see banks become public utilities. The Republican agenda to roll back Dodd-Frank, if this means unshackling the megabanks from speculating with public and taxpayer funds, will be the first betrayal by the incoming administration of its voter base.
Banks are now basically franchisees of the government's, i.e. the taxpayers', full faith and credit, as recently and eloquently explained by Professors Saule Omarova and Robert Hockett Banks create and allocate capital because the government recognizes bank loans as money and puts taxpayers' full faith and credit behind bank IOUs. The conventional story that banks convert privately-accumulated savings into loans to borrowers is a myth. Because banks are public-private partnerships to create and allocate capital, the public can and should play a central role in insuring that the financial system serves the needs of the real economy, not just the financial economy.
So here is the first test for our new federal leaders. Are you tools of Wall Street, doing its bidding by undoing financial reform, or will you turn banks into the public utilities they ought to be?
Dealers occupy an important position in financial markets, essentially serving as central nodes that match buyers and sellers of all types of instruments. Sometimes the dealer itself will serve as the ultimate buyer or seller, but frequently they are running (or attempting to run) matched books of buyers and sellers. In short, dealers are really just matchmakers. So here's the thing: we've seen how human matchmaking can be entirely replaced by (1) algorithms and (2) apps. For algorithms, that's just stuff like Match.com or eHarmony. And for apps, well, there's Tinder, etc. I assume that someone has even combined algorithms with an app, so users don't have to browse for dates, but just log on and are automatically matched. This model seems entirely applicable to many types of financial contracts. If I'm a hedge fund looking to go short on some debt obligation, I need to find someone who will sell me CDS. I could go to a dealer (and pay a nice bit for this), but why not just use an app that will match me with all of the funds that are looking to go long? We could have Tinder for CDS--let's call it CinDerS. If there are apps that can match dominants and submissives, why not protection buyers and protection sellers? And nothing limits this to CDS. It really works for any type of financial instrument. I'm sure there are a bunch of regulatory and business issues lurking here, but it strikes me that the old dealer model is facing an imminent technological challenge.
It doesn't take a genius to figure out that incentive-based compensation like the type featured in Wells Fargo's current and previous consent orders has the potential to encourage fraud and steering of consumers into inappropriate products in order to make sales numbers. Here's the thing: there's little regulation of retail banking employee compensation. Instead, banks are relied upon to self-regulate, to have the good sense not to have unduly coercive incentive compensation and to have internal controls to catch the problems incentive compensation can create. But when a leading bank like Wells Fargo repeatedly fails to have good sense and to have sufficient internal controls, it suggests that it might be time for more directed regulation that will create clearer lines that facilitate compliance.
The CFPB already regulates the compensation of mortgage originators (loan officers and brokers), limiting compensation based on loan terms to 10% of total compensation. But this regulation applies only to mortgage loans. There's no regulation of retail banking employee compensation generally. And there are some big wholes in the CFPB mortgage loan officer compensation regulation. In particular, the CFPB's regulation does not cover compensation based on the number of loans made or the size of the loans, only on the terms of the loans. That leaves the door open for banks to set up compensation schemes that pressure employees to engage in fraud to meet quotas and get bonuses.
So what can be done going forward?
Perhaps as a result of GM, I've been thinking about notice issues in connection with insolvency. Thus, I was a bit surprised to see these three notices, all related to Lehman cases pending in Hong Kong (and schemes of arrangement in those cases), which appeared in this morning's Financial Times.
Note that in the title the notice is addressed to the "Scheme Creditors," as "defined below." Yet below, we are told that Scheme Creditors are "as defined in the Scheme." So unless you are an insolvency fanatic – I plead guilty – and going to run down the documents and read them, this published notice has told you absolutely nothing.
They might as well run an add that says "A company is insolvent. You might be a creditor. Or maybe not. Good luck."
I'm testifying before House Financial Services tomorrow regarding the "CHOICE Act," the Republican Dodd-Frank alternative. My testimony is here. It's lengthy, but it doesn't even cover everything in the CHOICE Act--there are just too many bad provisions, starting with the idea of letting megabanks out of Dodd-Frank's heightened prudential standards in exchange for more capital, then moving on to a total gutting of consumer financial protection, and ending with a very poorly conceived good bank/bad bank resolution system executed through a new bankruptcy subchapter. The only good thing about the Bad CHOICE Act is that it has little chance of becoming law any time soon.
The CFPB's proposed payday rule making is out. There's a nice summary here.
I'm going to reserve comment other than to note a critical implication of a rare area of agreement between the supporters and opponents of the payday rule: it will result in a lot of payday lenders closing up shop. That might be just what the industry needs.
Payday lending differs materially from bank lending in (among things) that there are very low barriers to entry. Bank regulators restrict the number of bank charters in order to reduce interbank competition. (What was that about free markets, Jamie Dimon?) That mode of regulation does not exist in payday, and it results in a self-cannibalization of the industry. Most storefront lenders have very few actual customers--a few hundred per store per year. Often stores average less than one customer per day (offset only partially by the fact that these customers tend to take out multiple loans). That means that payday lenders have to amortize their fixed and semi-fixed costs over a small borrower base, which in turn results in very high priced loans even without outsized profit margins. (This also suggests that bank payday lending, like Postal payday proposals, is economically more feasible because of a broader base over which to spread fixed costs.) In other words, too much competition is actually pushing up prices.
The situation is somewhat analogous to a population of deer (or wolves) that grows too large for the sustenance base. The resulting overgrazing (or overpredation) can ultimately result in a catastrophic collapse. The typical wildlife husbandry solution is to cull the herd in order to ensure that the survivors are stronger and healthier. Regulations that have the effect of reducing the number of lenders can be thought of as functioning in a similar way. In banking, this is done through control over chartering. Insurance does this through rate regulation (preventing destructive rate races). The CFPB's rulemaking is likely to achieve something similar in payday lending.
We've seen this happen before. In 2010 Colorado undertook a major regulation of its in-state payday industry (this after an unsuccessful round of regulation in 2007). Pew has nicely analyzed the results. The result of the regulation was that the number of in-state payday lenders fell by half (-53%). Demand slackened only a little (-7%; why would it disappear?), however, so the number of customers per storefront almost doubled (up 99%). The terms borrowers received were much better under the Colorado reform, and the revenue per store increased (+26%).
What the Colorado experience suggests is that it's possible to have both better loan terms for consumers, and a healthier payday lending industry, but only if there is a contraction in the number of lenders. Put another way, some lenders have to go out of business in order for others to do better and for consumers to get better terms. It's rather counterintuitive--normally we think of competition as an important force for consumer protection, but at a certain point, it seems, too much competition actually results in price increases. But it goes to show that the free market may not always produce the socially efficient result. (Obviously this isn't Pareto efficient, but it could well be Kaldor-Hicks efficient.) Curious to hear thoughts.
Does the Obama White House truly stand for consumer financial protection, or will it support Wall Street when it thinks no one is looking? That's the question that the Supreme Court served up today. The Supreme Court is considering whether to hear an appeal in a critical consumer protection case called Midland Funding v. Madden. This is one of the most important consumer financial protection case the Supreme Court has considered in years. (See here for my previous post about it.)
The Court will only take the appeal if at least four Justices are in favor of hearing it. Today the Supreme Court requested the opinion of the Solicitor General about whether to take the case. That's a good indication that there's currently no more than three Justices who want to hear the appeal and another one or more who are unsure (it will take five to overturn the lower court decision in the case). If four Justices wanted to hear the case, there'd be no reason to ping the Solicitor General.
The request for the Solicitor General to weigh in on the case puts the White House in the position of having to decide whether it wants to stand up for consumer financial protection or to fight for Wall Street.
Now for a break from Puerto Rico.
Some housing finance commentators (here and here, e.g.) have been very excited by a 9th Circuit ruling that Fannie Mae is not a governmental entity for purposes of the federal False Claim Act (FCA) because they believe that basically decides the issue of whether Delaware law applies to the controversial Net Worth Sweep undertaken by Treasury as part of its support of Fannie and Freddie. Unfortunately, this excitement reflects a misunderstanding of some legal concepts and issues. The 9th Circuit opinion is a big nothing for the Delaware Net Worth Sweep litigation. It does matter for those who try to bring FCA claims against sellers to Fannie and Freddie, but that's a different kettle of fish.
Some thoughts on the new rules for broker-dealer OLA cases, over at Dealb%k.
The primary objection being made by those opposed to this amendment is that Congress needs to hold extensive hearings. But this is just a correction to a recent misinterpretation of the statute – not a wholesale revision of the Trust Indenture Act.
That's just not right. This isn't just a "clarifying amendment". The proposed amendment neuters the Trust Indenture Act as a protection for bondholders.
A large number of bankruptcy and corporate finance scholars, including several Slipsters, signed on to a letter to Congressional leadership regarding the proposed omnibus appropriations bill rider to amend the Trust Indenture Act. We don't all agree on how to interpret the Trust Indenture Act, on whether it should be amended, or on what amendments should look like, but we are all agreed that it shouldn't be done through this sort of backroom process. As Professor Douglas Baird of Chicago put it, "This is no way to run a railroad." Any amendment of the Trust Indenture Act should proceed with the customary procedural checks of legislative hearings and opportunity for public comment. The Trust Indenture Act is simply too important a statute to amend on the fly.
One of the many creatures attempting to crawl its way onto the back of the omnibus appropriations bill is an amendment to the Trust Indenture Act. The Trust Indenture Act is the 1939 securities law that is the major protection for bondholders. Among other things, the Trust Indenture Act prohibits any action to "impair or affect" the right of bondholders to payment or to institute suit for nonpayment absent the individual bondholder's consent. This legislation was passed in the wake of extensive study by the SEC of the unfair and abusive practices in bond restructurings in the 1920s and '30s, when ma and pa retail bondholders were regularly fleeced in corporate reorganizations.
The amendment in question is being pushed by the private equity firms that own Caesar's Entertainment Corporation (CEC), which is attempting to unburden itself from the guaranty of $7 billion of bond debt issued by its (now bankrupt) subsidiary, Caesar's Entertainment Operating Company (CEOC).
There are several problems with the proposed Trust Indenture Act Amendment, ranging from political unseemliness to ineffective drafting to unintended consequences on capital markets. There might be good reason to amend the Trust Indenture Act, but not through a slapdash job intended to bail out some private equity firms from their own sharp dealings.
It's appropriations season and efforts to harass the CFPB seem to be going into overdrive. The latest scheme: hit the CFPB with financial reporting requirements unparalleled for any government agency. This little nugget of petty harassment is found in section 504 of the House Financial Services Appropriations bill being considered for inclusion in the final budget package.
The bill would require the CFPB to submit quarterly reports to Congress that detail its obligations by object class, office and activity; an estimate of the same information for the coming quarter; the number of full-time equivalents in each office the previous quarter and an estimate for the coming quarter; and actions taken to achieve the goals, objectives and performance measures of each office. This level of reporting detail required is unprecedented for other agencies, as is the reporting timeline: two weeks after the close of each quarter.
It's hard to see what the point of section 504 is other than to harass the CFPB, tie up the agency in bureaucratic redtape, and distract from its mission.
Now you might note that the CFPB IS required under section 1017(a)(4)(A) of the Dodd-Frank Act to make quarterly budget reports to OMB and under section 1017(e)(4) to submit annual reports to the appropriations committee. But these reports do not require the level of detail mandated by section 504 and do not have a specific deadline, much less a two-week turnaround. There's also an annual Comptroller General audit and report to Congress. All of which is to say, the CFPB is subject to standard financial controls and oversight. There haven't been any budget scandals, etc. that merit closer scrutiny. It's hard to see any reason for the additional level of scrutiny in section 504 other than animus toward the CFPB's mission.
The Seventh Circuit Court of Appeals recently slammed Cook County Sheriff Thomas Dart for his actions trying to get Mastercard and Visa to stop processing payments for Backpage, an advertising website whose ads include various adult services (some legal, some not). The Backpage decisions has been taken as an indication of the strength of the legal case by some payday lenders against the FDIC, OCC, and Fed over Operation Choke Point.
Unfortunately, Judge Posner got it wrong in Backpage because he incorrectly assumed facts not in the record. But even if he got it right, there's a lot that differentiates Operation Choke Point (whose name does, unfortunately, sound like it might be from an adult ad on Backpage).
The financial wonkosphere just doesn't get it about Glass-Steagall. Pieces like this one by Matt O'Brien concentrate on the questions of whether Glass-Steagall would have prevented the last crisis or whether it is better than other approaches to reducing systemic risk. That misses the point entirely about why a return to Glass-Steagall is so important. No one argues that Glass-Steagall is, in itself, a cure-all. Instead, the importance of a return to Glass-Steagall is political. But totally absent in much of the wonkospheric discussion is any awareness of the political impact of busting up the big banks.
Let's be clear about why Glass-Steagall matters: the route to campaign finance reform runs through Glass-Steagall.
There’s an interesting new article out on the celebrated Massachusetts U.S. Bank v. Ibanez case that suggests that the defendant, Antonio Ibanez, was at the center of a property fraud ring. It's not clear to me that there was anything illegal about Ibanez's activities, but even if there were, I don't think it much matters.
It’s easy for Progressives to get excited about the idea of postal banking: a public option for banking! What’s not to love?
I’m glad to see the idea of public options in financial services getting some play of late; it’s something I’ve championed for a while in payments and housing finance. But I think it’s necessary to recognize some of the limits to postal banking. In particular, it's not at all clear to me why we would want to involve the Post Office in the public provision of financial services. What the Post Office offers is a way to recreate a brick-and-mortar branch bank network. This really doesn't make a lot of sense for 21st century banking. Additionally, postal banking is often pitched as an alternative to payday and title lenders. Before we go running down that path, we should think about what it means to have the government in the payday lending business.
It was like eight nights of Chanukkah in one for me watching the Democratic debate last night. There was a Glass-Steagall lovefest going on. But here's the thing: no one seems to get why Glass-Steagall was important or the connection between Glass-Steagal and the financial crisis. The importance of Glass-Steagall was not as a financial firewall between speculative investment activities and safe deposits. It was as a political Berlin Wall keeping the different sectors of the financial industry from uniting in their lobbying efforts and disturbing the peace of the nation.
Until and unless we realize that the importance of Glass-Steagall was political, we're going to continue wasting our time debating insufficient half-measures of financial regulation like the Volcker Rule, which has the financial, but not the political benefits of Glass-Steagall. More critically, we're going to pass regulations like the Volcker Rule and then wonder slack-jawed why they don't work, as the financial industry undermines them through the regulatory implementation and legislative amendments. Financial regulation is just not that complex technically, even if if has a lot of technical rules (it's the capital, stupid!). The problem we face is not technical, but political.
A new book out by University of Minnesota Law Professors Claire Hill and Richard Painter proposes a really intriguing proposal for disciplining wayward financial services firms: "covenant banking." The problem, as Hill and Painter observe, is that when things go badly at a financial institution, the burden is borne by shareholders, not by the managers, who have portable human capital and whose compensation is not typically subject to clawback. In essence the problem, as Hill and Painter see it, is that bankers lack "skin in the game." And Hill and Painter have a plan to fix it.
Both sides in the interchange fee debate have pointed to a recent Richmond Fed study as evidence supporting their position (here and here). Frankly, it's hard to tell without agreeing on a baseline for analysis: pre-Durbin interchange fees or what the fees would have been but for Durbin or the anticipated post-Durbin drop in fees? The finding that most merchants didn't notice a change in their merchant fees (which, of course, aren't the same as interchange fees) means very different things depending on the baseline used: that Durbin is pointless, that Durbin saves merchants money, or that Durbin isn't working as intended because of a defective rulemaking by the Fed.
In the midst of the race to claim vindication based on the study, however, no one seems to have noticed that a least some of the data used in the study—which comes from a merchant survey conducted by Javelin Strategy and Research—seems a little screwy.
I'm testifying tomorrow before Senate Judiciary Committee's Subcommittee on The Constitution (yes, that's the official capitalization), about the constitutionality of the Dodd-Frank Act.
Short version: nothing to see here folks.
Slightly longer version: really nothing to see here.
Even longer version: the plaintiffs in State National Bank of Big Spring v. Lew have a totally non-Originalist interpretation of the Bankruptcy Clause, namely that "uniform laws" apparently requires equal treatment of all similar creditors, so title II Orderly Liquidation Authority is unconstitutional. Yes, that's the sound of me shaking my head.
My written testimony is available here.
I agree with Adam about all that post-Starr hyperventilation. No, it does not mean that bailouts are over, that the Fed has been slapped down, or any of that lurid stuff. (Though tabloidness does feel strangely gratifying in financial journalism.) Nevertheless, we should be careful not to dismiss the AIG decision as a realist vignette. Its implications for crisis management will become clearer over time, and may well turn out to be important.
At first blush, Starr feels like a stock crisis move by the Court of Claims, evoking the Gold Clause cases in 1935, where the U.S. Supreme Court held that the Congress violated the 14th amendment when it stripped gold clauses from U.S. Government debt, but denied Court of Claims jurisdiction because the creditors suffered no damages. Had they gotten the gold, they would have had to hand it right over to the Feds. And if you measured the creditors' suffering in purchasing power terms, getting their nominal dollars back still put them way ahead of where they had been in 1918 thanks to all the deflation.
Putting this history together with Starr, I wonder about two implications. First, it would have to be awfully hard for a firm getting federal rescue funds in a systemic crisis to prove damages. See also the car bailout stuff. By definition, the firm's best case is the gray zone between illiquidity and insolvency (I called it "illiquency" back then). If you accept that a court is unlikely to enjoin a caper like AIG in the middle of a crisis, this gives the government a fair amount of scope to act, even if it turns out to be off on authority after the fact.
Second, the Greek mess makes me think that the real concern in crisis is not with ex ante constraints on bailouts working as planned, but rather with accidental institutional malfunction. At some point (not yet), all the sand in the wheels will create enough friction that policy makers will not be able to respond to a tail event in a sensible way. No institution would have the authority to do "whatever it takes," and no decision-maker would be willing to take the risk. Maybe this is as it should be, but it does give me pause.
Over at Dealb%k I talk about the confusing state of affairs regarding Dodd-Frank Orderly Liquidation Authority and the FDIC's new "single point of entry" (SPOE) approach to OLA.
In short, since OLA expressly excludes depository banks, it is not clear that a SIFI can be placed into OLA based on the failure of its insured bank. One way around that problem might be to use the "source of strength" doctrine to trigger a default at the parent-company level.
Trick is that the the regulators have done nothing to develop the source of strength power Dodd-Frank gives them, and doing so is also in tension with their general disapproval of parent company guarantees and cross-default provisions. They argue that guarantees and cross-default provisions will undermine SPOE.
Lately I have been teaching courses with names such as "Global and Economic Justice" and "History, Impacts and Regulation of Consumer Credit" instead of "Bankruptcy," "Secured Transactions" and "Chapter 11 Reorganizations." So I have been reading different books and listening to different speakers. A lecture I attended recently by Xav Briggs here brought to my mind a couple of books that I use in one of my courses, “Borrow” and “Debtor Nation” both written by Louis Hyman. In many ways Hyman's books remind me of "Credit Card Nation" the outstanding and "ahead of its time" book by Robert Manning which I used extensively when I created my consumer credit course in 2002.
Part of the wisdom I find in each of these books is the caveat that you cannot understand consumer protection without understanding the nature of American capitalism or the drive for an above-market return. This was never clearer or more of a "blow to the side of the head" than during the frenzy in the early 2000's, and perhaps nothing demonstrates it more crassly than the rating agencies covering their eyes as they rated subprime securitizations allegedly in order to "keep the business."
Our former co-blogger, Senator Elizabeth Warren, delivered an incredibly important speech yesterday laying out the work still to be done on financial reform. This speech is a bigger deal than Senator Warren's Antonio Weiss speech or her famous Citibank speech. This speech is a blueprint for Dodd-Frank 2.0. It lays out a detailed vision of the challenges for reform work going forward:
There are three remarkable things about this speech. First, what is truly groundbreaking is that Senator Warren recognizes that the problems in the financial regulatory space are not just technocratic ones but political, and that technocratic fixes will never work until and unless the political structure of financial regulation is reformed. Senator Warren's speech says exactly what needs to be said: the power of large financial institutions not only threatens our economy, it threatens our democracy. Senator Warren has picked up the mantle of Teddy Roosevelt.
Second, as a political matter this speech announces a reform offensive. Since the high-water mark of Dodd-Frank's passage in 2010 we have seen a steady push for deregulation. For Senator Warren to take the offensive here, particularly when her party is in the minority in both houses of Congress shows real moxie. That this speech is credible in such political circumstances is also a testiment to its substantive strength.
Third, this speech presents the only vision for financial reform in the policy space. (OK, I guess the "deregulate 'em all" approach is a vision of sorts, but come on...) There isn't a competing right or left alternative out there. No one else has a cohesive reform platform. I think that makes Senator Warren's speech all the more important because this is the speech that will shape the policy field going forward into 2016. This is the yardstick against which all presidential candidates, Democratic and Republican will be measured. It will be interesting to see which ones endorse what parts of Warren's vision and how enthusiastically. Silence will be particularly telling, as it is a vote for the dysfunctional status quo that leaves the Too-Big-To-Fail banks intact and growing.
Read the speech. This is important.
The New York Times carried an important story about the risky investment moves of life insurance companies. There's a lot of good stuff in the story, but it missed an important angle, namely the consumer harm that has already resulted from bank affiliation with captive reinsurers in the private mortgage insurance space, namely inflated and unecessary private mortgage insurance premiums because of illegal kickback arrangements.
The Wall Street Journal ran a story today about H. Rodgin Cohen, the Senior Chairman of Sullivan & Cromwell and "one of Wall Street's top lawyers" decrying "the myth of regulatory capture." All I can say is wow. That's some chutzpah.
For Rodgin Cohen to downplay regulatory capture is a like the scene in the Wizard of Oz when the Wizard says, "Pay no attention to that man behind the curtain." It's hard to think of an individual more at the center of the regulatory capture phenomenon than Rodgin Cohen. Cohen plays a particular and unique role in the regulatory capture problem. Cohen is not just "one of Wall Street's top laywers". He is the top bank lawyer. He's a node through which all sorts of connections happen. Cohen is the eminece grise of financial services law and is an institution unto himself. Think of him as a sort of super-consiglieri or Mr. Wolf. There's no one who quite plays the role of Cohen in the world of financial regulation, and he's rightly greatly respected.
I don't think of Cohen as an anti-regulatory ideologue (heck, regulation is how he earns a living), but he is deeply implicated in the regulatory capture problem because his strong suit is mediating between financial institutions and regulators. His job is to convinece regulators that they are on the same team as the banks and to get issues resolved quietly and out of the spotlight. Cohen, for example, was a drafter of the little noticed 1991 amendment to section 13(3) of the Federal Reserve Act that enabled the Fed to bailout non-banks like AIG and Goldman Sachs. Cohen's skill in persuading regulators to advance the financial services' industry's agenda is part of why Cohen is so respected and valued. But it also means that for him to admit that there's a capture problem of any sort would be to admit that financial institutions and regulators do not have aligned interests and to recognize that he's an advocate for financial institution clients, whose interests are not those of the public. And that would undercut the very sort of cozy relationship between banks and regulators that he aims to foster. Cohen's success is based in part on capture, so he's the last person who'd want it to go away.
I'm testifying before the House Financial Services Committee on Wednesday at a hearing entitled "Preserving Consumer Choice and Financial Independence." I'm the only non-industry witness (no surprise there). For those interested, my testimony is linked here. Here's the highlight:
Community banks face a serious structural impediment to being able to compete in the consumer finance marketplace because they lack the size necessary to leverage economies of scale. The CFPB has repeatedly acted to ease regulatory burdens on community banks in an attempt to offset this structural disadvantage. While community banks continue to face serious problems with their business model, their profits were up nearly 28% in the last quarter of 2014 over the preceding year, which strongly indicates that they are not being subjected to stifling regulatory burdens.
Ultimately, if Congress wants to help community banks, the answer is not to tinker with the details of CFPB regulations... Instead, if Congress cares about community banks it needs to take action to break up the too-big-to-fail banks that receive an implicit government guarantee and pose a serious threat to global financial stability. Until and unless Congress acts to break up the too-big-to-fail banks, community banks will never be able to compete on a level playing field.
I'm thrilled that Jay Westbrook has finally come into blogosphere with his posts on Single-Point-of-Entry. I've blogged a little on SPOE already, but I want to highlight what I still think are two critical problems with SPOE. In keeping with Jay's spirit, let's call them "Backdoor Bailouts" and "Funding Fantasies".
Senator Elizabeth Warren surprised a lot of people by laying into Federal Reserve Board Chair Janet Yellen as hard as she ever laid into Timothy Geithner. I think this was a really important exchange. But it's easy to miss exactly what's being communicated in it. Senator Warren's comments can basically be translated as follows:
"Janet, I like you, but let me level with you. You need to replace your General Counsel, pronto. He's not on the same page about regulatory reform, and it's a problem. There's really no place for obstruction by Fed staffers, even the General Counsel. It's time for him to go."
There was a further subtext, though, that I think should be highlighted, and that's "What you do about your GC is a shibboleth about whether you're serious on regulatory reform."
In an earlier post I described the FDIC’s proposed SPOE approach to resolution of SIFI banks and other financial institutions under Title II of Dodd-Frank. That post discussed two of the three components of SPOE: control of the process by the regulator and no bailout for management or owners. This post lays out the role of the third component, the “forlorn hope” debt.
That debt is unsecured debt owed to a bank holding company (BHC) and predestined to get little or nothing in case of the failure of the BHC. It serves in effect as a debt reserve to buffer the financial distress of the bank group. By being dumped, it would make the group as a whole solvent. By contrast, legislation already passed by the House would ignore the need for the reserve, thus setting up another bank bailout. The reserve debt component of SPOE awaits a strong rule from the Fed to make it a reality. This post discusses what the rule must do.
A Single Point of Entry (SPOE) sounds like the route of a returning astronaut or perhaps a building’s security plan or even a sex guide, but actually it is the FDIC’s proposal for saving the financial system when a giant financial institution strikes out on the derivatives market or discovers it has a school of London Whales. SPOE is important because the FDIC and the Bank of England have agreed on it as the best approach to a global resolution of a failing SIFI, the polite term for a TBTF bank. That agreement is crucial, because the largest banks can only be resolved on a global basis.
SPOE is a method of resolution of a SIFI in financial distress without having to choose between a government bailout or the collapse of the global financial system. By contrast, legislation passed by the House would privatize the SPOE process and likely result in future bailouts. The legislation is being marketed under the term SPOE, but bears little relationship to the FDIC proposal. The three key aspects of the FDIC plan are that a) the resolution process will be controlled by the regulator; b) there will be no bailout of the SIFI’s owners and management; and c) the creditors of the parent holding company will be tossed overboard, returning the bank group to solvency by erasing debt and lessening the need for government money to make the process work. This post discusses the first two points, control and no bailout, while a second post will talk about the debt dump.
MBS investors suffered a serious legal blow a couple of months back when the Second Circuit held that the Trust Indenture Act of 1939 doesn't apply to MBS.
The Second Circuit's decision hinges on treating a "mortgage" as a "security." That's rather counterintuitive. The Trust Indenture Act doesn't define "security," but refers to the Securities Act's definitions. The Securities Act defines "security" to include "any note" but the definition bears the caveat "unless the context otherwise requires." I'd think that the context would have pretty easily counseled for reading "note" not to include residential mortgages. What the Securities Act is trying to pick up are issuances of corporate notes.
Frankly, I think the Second Circuit's reading (and the resulting decision) are absurd. First, it is hard to see any context in which "note" should be read to include "residential mortgage" (especially in light of all of the other things that constitute a "security" under the Securities Act, when Congress could easily have included a "mortgage" in the definition). Second, the Second Circuit's reading arrives at an absurd policy result. It excludes from the Trust Indenture Act the very sort of securities (proto-MBS) that were the driving force behind the creation of the Trust Indenture Act of 1939 (and the NY state Trust Indenture Act of 1935 before that). The groundwork for the federal Trust Indenture Act was a 1936 SEC report authored by William O. Douglas, Jerome Frank, and Abe Fortas (among others) that documented in incredible detail the abusive role of trustees in mortgage bond reorganizations. (While bankruptcy scholars have tended to focus on the railroad reorganizations chapter of the report, the real estate chapter is just as important, and goes a long way to understanding why Douglas was such a champion of the absolute priority rule.)
The point here isn't to belabor a questionable decision by the Second Circuit (which did not mention the policy issues in its decision, but I don't know if they were argued), but to underscore the ruling's consequence. At least in the 2d Circuit, it's now clear that MBS investors are not protected by the Trust Indenture Act, and that's a bad thing. This decision means that there's very little (if anything) protecting investors from wrongdoing by MBS trustees, whether acts of omission (e.g., failing to police servicers) or commission (e.g., entering into sweetheart settlements of rep and warranty liability). This is exactly what the Trust Indenture Act was supposed to prevent. If Congress cares about investor protection, it's time to devise a 21st century Trust Indenture Act.
[Update: A state securities regulator emailed me to draw my attention to the Supreme Court's 1990 decision in Reves v. Ernst & Young. That decision expressly adopted an older 2d Circuit case's test regarding what is a security. That case excluded residential mortgage loans from the definition of "security" in the context of a securities fraud action. The 2d Circuit cited to its older decision (but not the Supreme Court's subsequent adoption of its test), but said that the context was different. Unfortunately, the 2d Circuit didn't think it was necessary to explain what about that context was sufficiently different to merit a different result. I can't see any plausible contextual distinction. There's really no context in which loans made for personal, family, or household purposes should ever be considered securities. They are subject to entirely different regulatory regimes, they are part of different markets, and no one would ever think to refer to such loans as securities. Except, apparently the 2d Circuit. It's one thing to arrive at the wrong conclusion after a serious analysis, but I am troubled that the 2d Circuit didn't bother to explain itself in this context.]
Community banks are ailing. Over the past decade many of them have failed or been gobbled up by larger banks. What's going on?
A new study by a fellow and a masters student at the Harvard Kennedy School of Government thinks it has found the culprits: Dodd-Frank! The CFPB! Regulation! Not surprisingly, this paper is already getting circulated by bank lobbyists as a prooftext for their anti-regulatory agenda.
Let me make no bones about this study. It is gussied up to look like serious academic research, with footnotes and working paper series cover page, but don't let looks fool you. The study doesn't conform with basic norms of scholarship, such as discussing contrary evidence and having conclusions flow from evidence. Instead, the study is really a mouthpiece for a big bank anti-regulatory agenda that pretends to really be looking out for community banks.
I'm not going to spend the time on a full-blown Fisking of this piece, but let me point out some serious problems and then talk about the real problem facing community banks and how big banks exploit community banks' problems to advance their own agenda.
Pretty darn dead. In 2014, there were all of 22 private-label RMBS deals. These deals provided $5.67 billion in financing for 7,342 mortgages. Let that sink in for a second. The private-label market financed fewer home mortgages than were made in the District of Columbia last year.
Perhaps the private-label market's defenders will finally accept that it is a seriously broken market and that fixing it isn't just a matter of interest rates moving a few basis points. This is a market that needs to take major steps to restore investor confidence, and that means, among other things, a total redesign of servicing/trustee compensation structures and roles and a major standardization of deal documentation so that investors won't have to worry about what language got snuck in on page 73 of a 120 page indenture.
There've been a bunch of post-mortems of the Antonio Weiss nomination in the press the last few days (see, e.g., here, here, and here). When I read them I often feel like I'm reading a story about a kid who went to a fancy eastern boarding school, where he was head of the literary society, lettered in three sports, and did lots of charity work, but didn't get into the Ivy League school where all of his family and family friends went. The result: shock and outrage that the kid was denied his birthright!
Being nominated for Undersecretary of the Treasury isn't quite like getting into Harvard (or even Yale). Yet reading Weiss's defenders' (and their all-too-willing jouralist abetters), one would think that's the story. And that underscores precisely what the problem was with the Weiss nomination, and what Weiss's defenders just don't get (or want to admit they get): the assumption that Wall Street success entitles someone to an important policy position for which they have no apparent qualifications.
In today's Short View Column, Dan McCrum examines falling oil prices and the futures market, and then concludes:
But the point of this story is not that some think they know what will happen next. Rather, it is that the price of one of the most widely used and heavily traded commodities has been able to halve in a matter of months.
The oil price is not some arcane derivative tied to dodgy mortgages, or a stake in an internet start up. It is the price of an industrial input paid by thousands of large and well-informed buyers. Low oil prices are not an unimaginable abstraction, merely something not seen for a while.
So, a question presents itself: if financial markets can be so wrong about the price of oil, what else are they missing?
Just in time for the new year, I've got a new article called Safe Banking up on SSRN. The article is a first principles reexamination of the industrial organization of financial services. It identifies the institutional combination of deposits and lending as the key problem in our financial system. We've developed an enormous financial regulatory state to attempt to hold these lending and deposits together, but it might be time to admit that bank regulation just doesn't work and can't. Our bank regulatory system is simply too complex and too politicized to work flawlessly as it must.
My solution is a radical, yet conservative structural change that has become possible because of recent technological and market changes: mandate the institutional separation of deposits from lending in both traditional and shadow banking markets, a reform I call "Pure Reserve Banking". Pure Reserve Banking means 100% reserve banking plus withdrawal of the entire panoply of government support and subsidization of shadow banking products. There's a host of financial stability and political economy benefits that would flow from such a change, but at core Pure Reserve Banking means ending the subsidization of a volatile growth economy in which gains are privatized and losses socialized and shifting to a more stable—and inherently equitable—growth economy.
The abstract is below the break:
Will we have an appropriations bill before a government shutdown? The fight over the 2015 Appropriations Bill is now focused on one of the non-appropriations measures stuck onto the bill by the House GOP. That provision would repeal section 716 of the Dodd-Frank Act, which prohibits bailouts of swap entities and pushes certain types of particularly risky swaps out of insured depositories. Section 716 might be thought of as the "Banks Aren't Casinos" provision of Dodd-Frank.
On the surface, the fight about section 716 looks like a partisan squabble. But the real issue is the internal Democratic Party struggle going on because if the Democratic leadership doesn't force party discipline in opposing the appropriations bill with this provision, the appropriations bill will likely pass. The outcome of the internal Democratic debate is frankly more important than whether section 716 gets rolled back. (I write that because I don't think the no-bailouts prohibition in section 716 is credible or that any prohibition on bailouts can be credible. When things get hairy, we'll bail, law be damned.) No, what matters here is how Democrats line up. The fight over section 716 is a struggle for the soul of the Democratic Party.
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