Obama’s Regulatory Proposals — Smarter or Just More?

Good Evening: U.S. stocks finished mixed Wednesday after a morning dip and afternoon rally both failed. Some less than cheery news from FedEx and some bank downgrades set the tone for the early weakness, while a successful test of the 200 day moving average by the S&P 500 helped prices rebound in the afternoon. And it is also quite possible that stocks were ready to bounce a bit after a few down days, but I’ll focus more on market direction tomorrow. Instead I will review President Obama’s proposal for changing the regulatory landscape of the financial industry. The issues that brought us the financial crisis are not small, but I wonder if some of the President’s many, many ideas on the subject are correctly sized in relation to the problem. More is not always better, especially when it comes to a complex industry like modern finance.

Stocks overseas were on the weak side overnight, extending a trend that began late last week. U.S. stock index futures were also a bit lower, though the news out of FedEx may have been a contributing factor (see below). FDX announced an earnings beat, but then went on to say the economy deteriorated during the most recent quarter and put an exclamation point on this observation by halving its earnings guidance for the current quarter. Since what is shipped by FDX is the very stuff that makes our economy go, hearing its management say — whether from 30,000 feet or on the ground — that the green shoots are not visibly sprouting gave many investors pause in the early going.

The economic data was not much of a factor, since the tame CPI figures reported today tell us little about the inflation risks down the road. So, too, with the current account deficit; it narrowed in Q1 due to factors that have already started to reverse (see below). The banks, however, were a story with a little more teeth this morning. In the final story you will find below, S&P downgraded 18 banks — despite all the stress test results and capital raises in recent weeks. It would have been an even bigger story had the ratings agencies not trashed their reputations in the 2003-2007 time frame.

Given this news flow, stocks could have been forgiven for opening 1% lower, but they instead opened nearly unchanged before declining by the aforementioned amount 90 minutes into the trading day. The S&P 500 even managed to penetrate its 200 day moving average for a brief spell before that index followed NASDAQ higher. After rallying until they were up approximately 1%, the major averages settled back to close mixed. Bonds were firm in the morning, but they also reversed to finish mixed. Yields on the short end fell a couple of bps, while those on the long end rose in equal measure. At least the dollar and commodities were fairly consistent, though. The former fell and stayed down, while the latter followed oil and precious metals higher for most of the session. The CRB index closed 0.4% higher.

I’ve written quite a bit about how the U.S. can more intelligently regulate our financial system. Back in May, I cited Barry Ritholtz’s suggestions for financial reform, which he posted in this article on his site, The Big Picture . In addition to Barry’s list, I proposed the following suggestions in a commentary posted later the same day (comment) . I then added these ideas to this growing laundry list on June 9 in this piece. The philosophy behind these proposals is to create a regulatory boundary fence inside which financial firms can then more or less freely operate. Detail-loving micromanagers need not apply for a position in this framework-oriented approach.

In response to all of the free advice available above and elsewhere, the Obama administration put forth in the Monday edition of the Washington Post the following preview of the President’s proposal. This early glimpse was heartening to the extent that it addressed many of the issues that Barry and I have written about. But, as always, the mischief of regulatory reform is in the details. President Obama’s actual proposal broadly follows the outline laid out by Mr. Geithner and Mr. Summers, but it goes quite a bit further — and, perhaps, too far (Obama’s Draft Proposal). Let me clearly state that I have yet to read every one of the 85 pages, but the pages I have read seem to indicate that when choosing between “smarter” regulation and simply “more” regulation, the President’s draft proposal seems to favor a “more regulation is better” approach.

The first piece of evidence I offer in support of my assertion of an unwelcome drift toward “more” as opposed to “smarter” regulation is the size of the proposal itself. “Change” mean many things, but 85 pages are more indicative of too much micromanagement rather than a statement of principals and intents to be debated during the legislative process. The blueprints for the type of “boundary fence” regulation I’ve often proposed would require a few pages; regulating the behavior of financial institutions while inside the boundaries is what takes so much explaining.

Another indication that the “more is better” philosophy of regulation might be transcendent in the President’s draft is an entire section (# 3) has as its goal to “protect consumers and investors from financial abuse”. Like 99% of the American population, I’m against financial abuse in all its forms, but it’s a fool’s errand to try to set up a vast infrastructure of rules to deal with it. The smarter approach would tell all investors and consumers to take responsibility themselves for any dealings to which they are a party. “Caveat emptor” would be my first, if inelegant, suggestion.

To those two simple words I would also offer ways for consumers and investors have easy access (800#, website, etc.) to both FINRA and the enforcement division of the SEC. FINRA could handle most of the brokerage-related complaints (think: my advisor did unauthorized trades in my account), and the SEC could handle the larger problems surrounding organizational practices (think: Stanford or Madoff). Both FINRA and the SEC already have the power to police, fine and/or prosecute perpetrators of financial misdeeds, so let’s just make it easy for folks to find help at these two regulatory bodies and then just ask the agencies to do their jobs.

See? My version of section # 3 alone would take only two paragraphs to explain, will cost next to nothing to implement, and will likely be more effective than any attempt to legislate even more “do’s” and “don’ts” than already exist. Sarbanes-Oxley is only one example of a confusing tangle of regs that has utterly failed to address the abuses it was intended to prevent. Conscientious objectors of the potentially higher staffing costs my idea might bring needn’t worry too much, since the extra funding the SEC might need could be found in eliminating certain departments (e.g. “Economic Analysis”).

Before anyone takes umbrage at what they may think is a political attack on the administration, let me say there is plenty to like about Mr. Obama’s proposal. I support 1) the overall approach to taking systemic risk into consideration instead of focusing only on individual institutions, 2) the imposition of leverage caps on these firms, 3) the move toward more transparency, 4) the desire to better coordinate the various regulatory bodies and their roles, 5) the attempt to finally rein in OTC derivatives, and 5) the goal of working toward international standards on all of the above. Done well, these changes will be quite welcome in that they will help lower the systemic risk embedded in our current system.

I’m less than enthralled, however, about 1) giving the Fed more power, 2) attempting to detail the ways we can now “protect” consumers and investors, 3) requiring hedge funds and “other pools of capital” to register with the SEC, and 4) skating past the moral hazard issues created by all the 2007-2009 bailouts. In short, Mr. Obama’s proposal is a start — one which I hope will emphasize intelligent attempts at regulation, but one I fear will end up just being more governmental ways to micromanage. This draft obviously will be subjected to considerable tinkering during the legislative process. Financial firms are huge campaign donors, especially in the Senate, so I’m guessing whatever our President eventually signs into law could be quite different than what he laid out today. Let’s hope Mr. Obama’s 85 pages of what looks like “more” get whittled down until we can proudly call them “smart”.

— Jack McHugh

FedEx Falls as Forecast Trails Estimates on Economy
U.S. Economy: Consumer Costs Fall Most in Six Decades
S&P Cuts U.S. Banks, Citing Regulation, Volatility

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