The financial crisis and the US financial reform

Financial crisis and the US financial reform

ONE: retrospect of US financial crisis

With the debate about US financial reform finally, it appears, about to end, should we all feel safer and more confident that a crisis will not recurn? After all, the root causes of this crisis (including derivatives) have been identified and addressed. Measures have been taken to prevent system-wide bail-outs.

We agree wholeheartedly with the need for financial reform and support many of the derivatives provisions in the bill. But have we addressed what actually happened in the financial crisis? Or have we left the real culprit lurking, ready to resurface and create more instability in the financial system?

It's clear today – and it was clear three years ago – that the culprit is real estate exposure. Bad lending, driven by poor underwriting standards and awful risk management, created and drove the crisis.

Derivatives, of course, played a role. These financial instruments were and are a means of hedging and taking on risk. Some market participants used them to take on real estate risk. But history shows it's not the product itself that causes crisis. It's the underlying risk discipline. The savings and loan crisis of 1989-90, the Japanese property bubble of the 1980s, and events such as the Panic of 1837 occurred at different times in different places. But what they and other crisis have in common is a weakening in risk management standards and practices regarding real estate value and exposure.

Looking at the 2007-09 financial crisis, a similar pattern emerges. The casualties had one big factor in common –real estate exposure –

which they took on in different ways. First, consider AIG. While a large portion of its risk was taken via derivatives, there is no doubt that what turned bad was the underlying real estate risk. It also took large positions in the cash subprime market and its cash losses may well exceed whatever losses it suffers on its derivatives position.

What about the other casualties? The biggest are Fannie Mae and Freddie Mac. It has just been reported that their losses so far top $160bn and they could go much higher.

Then there are the two banks that had to get a second bite of government support. Both were very active creating collateralised debt obligations out of subprime mortgages and got stuck holding the bag when the music stopped. Let's also not forget Washington Mutual and Wachovia, victims of residential mortgage problems, which no longer exist as independent entities.

The investment banking industry was also feeding at the trough of the real estate lending boom. Bear Stearns was rescued but nearly $30bn of real estate exposure was left at the Fed. Lehman failed and its failure was a result of soured real estate.

There are dozens of other banks with more than $1bn of assets that failed because of real estate problems.

TWO: the limitations of American financial reform “The American people will never again be asked to foot the bill for Wall Street’s mistakes,” the president said.

The action on financial reform now switches to the US Treasury and regulatory agencies, which will have to decide which companies should be designated as “systemically significant” and face higher standards of capital and supervision.

Republicans and bankers have complained that the law perpetuates uncertainty, given the amount of work still to be completed by the

regulators. “It creates vast new bureaucracies with little accountability and seriously undermines the competitiveness of the American economy,” said Richard Shel by, the senior Republican on the banking committee.

the broad lines of the legislation are clear. Derivatives trading will be brought on exchange, and the regulatory and capital treatment generally tightened up, investment banks will have the ghost of Paul Volcker haunting their trading floors, and there will be new and tough oversight of retail markets by a consumer protection body.

The SEC and CFTC remain separate, and the “overlapping” jurisdictions that the Treasury paper described, and which have led to so many dysfunctional turf wars, remain in place. It proved impossible to build the political consensus needed for structural change; indeed, the Treasury barely tried, in spite of its clearly stated preference. The relevant Congressional committees guarded their territories jealously. The US remains the only country in the world where cash securities and derivatives sit at separate regulatory tables. As the Treasury said in 2008, “the realities of the current marketplace for securities and futures products make it increasingly difficult to rationalise a separate regulatory regime”.

There has also been no progress on the insurance front. Again, American exceptionalism prevails. The US will still be the only country without a national insurance regulator, a gap that was strongly felt in the AIG case, where the New York state insurance commissioner was in charge. A consolidated federal supervisor of the whole group would surely have taken a closer interest in the risks it was running in its financial products business, and would have been better able to liaise with the Federal Reserve.

The Paulson Blueprint concluded with some stirring phrases: “If

private sector institutions don't change, they become obsolete. Our regulatory structure also needs to change and evolve to one which will stand the test of time . . . we need to begin the serious work of modernising and reforming the structure.”

That work, it seems, has barely been started. Messrs Dodd and Frank may think it's all over, as the saying goes, but that is far from the case. Just another 2,300 pages of legislation and real progress might be visible.

Conclution:although the financial crisis bought the US economy into disasters, the financial reform which is the main measures taken by US government to cope with the crisis have no rooted impact to the financial industry