Sunday, April 18, 2010

Financial Regulatory Reform

A great deal is going on in Washington, D. C. and New York City these days relating to the country's financial system and its major financial institutions, as well as with their oversight and regulation by the federal government. Many books and scholarly articles will be written about this. Even a big movie or two may deal with the situation and what happens. Most Americans no doubt find the subject very complicated, uninteresting and perhaps also boring. Nevertheless, how everything ends up, while currently difficult to predict accurately, is extremely important.

In the limited space a post provides, I'll try to fairly briefly cover the main points and share some of my personal viewpoints.

For a variety of reasons still being investigated, the U. S. economy fell into a deep recession beginning in December 2007 that most economists consider the most serious since the Great Depression of the early 1930's. It was triggered by many factors, including a substantial liquidity shortfall in our banking system, probably largely caused by excessive and imprudent mortgage and commercial real estate lending by the major commercial banks and other financial institutions like Washington Mutual, Countrywide Financial, and IndyMac Bank.

To make a great deal of money on this lending activity, and the related housing bubble, several of our largest investment banks, led by giant Goldman Sachs, created marketable securities, known as collateral debt obligations (CDO's), backed by huge volumes of the mortgages, a large percentage of which were subprime, and sold them to substantial investors in the U. S. and abroad. They also created complex derivative products to enable supposedly sophisticated market players to bet on future prices of these securities. When the housing bubble burst and housing values fell dramatically in 2007, 2008, and into 2009, the securities and mortgage loans themselves greatly declined in value, causing large losses to both the lenders and the investors in the securities.

As most of us know, the end result of this and other related developments was that banks substantially restricted availability of credit, harming individuals and businesses, as well as many municipalities, millions of people were laid off, many of them lost their homes through foreclosure, many banks and other businesses have gone bankrupt, and the federal government felt compelled to step in with a very large financial stimulus package last year and extensions to unemployment compensation payments this year.

One of the big things going on now in Washington is that former California treasurer, Phil Angelides, is chairing the bipartisan Financial Crisis Inquiry Commission, holding a number of hearings, to determine exactly what happened to have caused this crisis and what needs to be done to prevent a similar future event. A report to the Congress and President Obama is due this December.

However, in an action that was considered a surprise and shock to our financial markets, the Securities and Exchange Commission (SEC) last week filed a high profile lawsuit against Goldman Sachs, accusing the company of fraud in misleading investors in one of their complex transactions. More similar filings are expected.

Another big thing going on in Washington is that the Senate's Permanent Sub-Committee on Investigations, chaired by Senator Carl Levin of Michigan, is conducting their own hearings to assist the Senate in its work in coming up with an appropriate financial regulatory reform bill, which is high on Obama's legislative priorities for the next several months. Because the stakes involved are so high, lawyers, accountants, board members, lobbyists and advisors in New York and Washington for all the institutions and governmental agencies are working hard to assist their clients and colleagues prepare for and achieve the best outcomes possible.

Like with the recently approved major healthcare reform legislation, the ongoing debate in Congress on financial regulatory reform unfortunately has been highly partisan. The Democrats, urged on by President Obama, for the most part support a comprehensive bill, while virtually all Republicans appear to be strongly opposed to the bill in its current form, claiming primarily that it imposes too much and unnecessary government intervention in our financial markets.

As someone who spent a career in corporate, government, international and investment banking, what do I think?

I think a relatively comprehensive reform bill will eventually be approved with a few changes from the current draft to convince a small number of moderate Republicans to vote in favor. However, a lot will depend on the outcome of the pending SEC lawsuit against Goldman Sachs. It seems to me that the SEC will have difficulty proving fraud in a court of law, although it's likely that jurors and the presiding judge will conclude Goldman did not behave ethically in how they handled their activities cited in the case.

In view of the high costs and distractions of a possibly lengthy trial and the negative publicity likely to come out, it would not be at all surprising if the SEC and Goldman settle before a trial. In such a settlement Goldman no doubt would have to pay a substantial fine (which they can easily afford) and acknowledge that, while they felt strongly they were not guilty of outright fraud, they in retrospect should have handled the transaction involved differently, with more transparency. The Obama Administration and SEC would most probably prefer a trial, if they felt very confident they could win in court and also that it could be concluded in a reasonably short period of time, but I suspect that's not what they will conclude.

In the end I think Goldman will come out OK and continue to be a dominant player in our financial markets, we will have a reform bill approved into law, and the lawyers, accountants and associated lobbyists representing all the players will make out like bandits.

Angelides' Financial Crisis Inquiry Commission will deliver their report in December and it will be highly critical of Wall Street and the senior management and boards of directors of the major commercial banks and other financial institutions who were active in real estate lending over the past several years. Furthermore, a high and disturbing level of blatant partisanship in Congress will continue and average Americans will continue to feel very unhappy with both Wall Street and the majority of our elected politicians.

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