Zombie Regulation

Public Policy chaos is hard to miss these days. One moment it’s which health plan will make its way through the blue dogs in the Senate and the liberals in the house. The next moment it’s escalation of military actions in Afghanistan; probably where the original quagmire reference was developed at the dawn of time. Look this way!!! No look that way!!! Then there’s the forgotten war against financial risk excess. I could create a pretty good argument that much of the chaos might be to distract us from the rumblings still coming from the Wall Street fault line. Good thing the Europeans are looking, because it seems that we’re certainly not. That means they’ll be at least one safe place to put your money, eventually. Unfortunately, it won’t be here.

The Chief Executive of the Vampire squid was in Germany this week telling the Europeans exactly what they wanted to hear (h/t to myiq2xu). This should’ve elicited the “D’oh” heard round the world. Problem is, no one in the U.S. is listening. We have yet to see any serious proposal to regulate and standardize the types of complex financial derivatives that nearly brought the world economy to it’s knees less than a year ago.

Lloyd Blankfein, chief executive of Goldman Sachs, on Wednesday admitted that banks lost control of the exotic products they sold in the run-up to the financial crisis, and said that some of the instruments lacked social or economic value.

In a speech to the Handelsblatt banking conference in Frankfurt, he also repeated an attack, first made in the spring, on Wall Street compensation practices, calling the furore over bankers’ pay “understandable and appropriate”.

The startling message from the head of the world’s most high-profile investment bank echoes comments by Lord Turner, chairman of the Financial Services Authority, the UK regulator, who provoked controversy last month when he questioned the social value of much investment banking activity.

Mr Blankfein said: “The industry let the growth and complexity in new instruments outstrip their economic and social utility as well as the operational capacity to manage them.”

This is so true. When it takes an army of lawyers to work on one tranche and the contracts it involves, when it takes math that requires physicists turned financiers to price the silly things, and when the resolution process is so whacked that it can take months to figure out who owns what, you’ve got control problems. Even more true is the fact that investments in these products doesn’t really create anything of value. It ties capital up in arbitrage and speculation rather than placing it the hands of entrepreneurs that actually create products and services. Top it off with cash out flows via bonuses from stock holders to what amounts to a professional gambling class and you’re bound to create a major clusterfuck eventually. So, given the clusterfuck last year, why aren’t we rewriting financial law?

Acknowledging that some products had become too complex, Mr Blankfein said: “We have a responsibility to the financial system which demands that we should not favour non-standard products when a client’s objective and the market’s interests can be met through a standardised product traded on an exchange”.

Although Mr Blankfein stressed that derivatives had an “important economic and social purpose” and argued that banning complex, customised derivatives altogether would hurt economic growth, he conceded that such products should rightly attract “more rigorous capital requirements”.

The Goldman boss, who himself received total compensation of more than $70m in 2007, said multi-year bonuses should be outlawed and senior staff should receive large proportions of pay in stock, rather than cash.

In recent months Goldman has faced a spate of bad publicity as lawmakers, corporate governance experts and the media have attacked its bonus accruals – amounting to $11.4bn in the first half of the year – and criticised its role in the financial crisis.

Mr Blankfein’s support for the thrust of global regulatory reform – including a recommendation that there should be a “robust sharing of information” between regulators – is likely to be influential among peers and welcomed by politicians.

I consider the statement “robust sharing of information” to be the year’s understatement. Especially, given this particular piece that popped up at Bloomberg today about crash catalyst Lehman and the resulting clusterfuck in the money markets. If you’ve either got money in money market accounts (MMAs)or are forced into them through your pension or 401k plan, like I am, read that article while you’re sitting down. Oh, and consider monitoring your blood pressure .It outlines what was going on a year ago when everything was coming apart at the seams and the underlying value of MMAs went south.

It was commercial paper and the $3.6 trillion money market industry that traded the notes that came close to sinking the global economy — not a breakdown in credit-default swaps or bank-to-bank lending. The bankers were focused on saving themselves, and commercial paper, as invisible as the air they breathed, never came up at the meetings, according to one of the two dozen executives invited to the New York Fed by its president, Timothy F. Geithner, 48, and Paulson.

Again, we have this massive transfer of wealth from the “real” economy of making things and creating jobs, to the shadowlands of finance. If you read the article, this sentence screams at you.

On commercial paper desks all over Wall Street that Monday morning, phones that normally buzzed with employees renewing overnight loans were hushed.

Anyone that has ever worked a money desk, and I have, knows that this is epic. According to the article, not even Walmart went unscathed. It had short term money sitting with one of the MMAs that it couldn’t withdraw. Funds were stuck that were supposed to be available for working capital. There’s a detailed account for several MMAs that basically went to gridlock and negative positions in the blink of an eye. What I want to emphasize, and this ties back to the original intent of my thread, is that most of this happened because our financial regulations and laws do not reflect reality on the ground any more. Here’s your basic punchline.

Money market funds flew under Paulson’s radar because they were considered cautious, said David Nason, assistant Treasury secretary for financial institutions at the time.

As long as they invested in debt with the highest credit ratings that matured in less than nine months, the rules for money funds as outlined in the Investment Company Act of 1940, regulators left the funds alone, said Nason, now a managing director of Promontory Financial Group, a financial-services consulting firm in Washington.

“The commercial paper market is largely unregulated,” Nason said. “It’s a nebulous area of credit that isn’t under the umbrella.”

The deal is that we’ve actually had folks look at this and there’s been suggestions. I guess you can guess the status of the action taken to date. Yup folks, hear those crickets!

“The widespread run on money market mutual funds has underscored the dangers of institutions with no capital, no supervision and no safety net,” the Group of 30, a financial advisory organization that includes former Fed Chairman Paul A. Volcker, said in a January report.

Money funds undermine the strength of the U.S. financial system and should be regulated more like banks, Volcker said in an August interview. They should submit to the same “regulatory burden,” he said.

The SEC recommended that funds hold a certain percentage of their assets in cash, so they can make payments in times of stress. Regulators also proposed upgrading the quality of the assets that funds can own and limiting them to securities with shorter maturity dates.

When are we actually going to get around to taking care of this? It’s not like we haven’t mapped the fault lines. Where’s the forward momentum on the regulation before we get more aftershocks?

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