Senator Dodd Doubles Down on a Losing Bet

Watching the devolution of the bank reform bill in the U.S. Senate has been painful. Banking Chairman Chris Dodd’s original proposal unveiled last year had numerous strengths, most significantly the removal of bank supervisory authority from the Federal Reserve. Dodd decided that the Fed had done such a lousy job ignoring the housing bubble and failing to crack down on predatory lending in the mortgage market that it shouldn’t be given a second chance.

But a second chance for this unpopular and failed institution is currently in the works. In an effort to please Republicans and achieve a bipartisan bill, Dodd is not only going to let the Fed keep its bank supervision and rulemaking authority, he wants to give it authority over the proposed Consumer Financial Protection Agency (CFPA).

How would this work, exactly? The CFPA issues strong rules cracking down on credit card abuses one week and the Fed issues contrary rules the next? Moreover, if I were the Fed chairman, I would insist on veto power over any agency under my jurisdiction.

This ill-conceived idea may be enough to kill public support for the financial reform proposal in the Senate. The bill has always been more remarkable for what it lacked than what it contained. This point was made clear by an astounding interview with a Wall Street insider in a little-known trade publication called Welling@Weeden.

Long before the 2008 financial crisis, the blueprint for the crisis was laid by the Fed’s weak-kneed response to another derivative-fueled disaster involving a massive hedge fund called Long Term Capital Management (LTCM), whose collapse in 1998 threatened the entire financial system. The Fed organized a massive private bailout, but did not take concrete action to address the underlying causes. The failure of the government to crack down on derivative abuses lead directly to the current crisis. Today, the former lawyer for LTCM says that by once again not getting to the heart of the matter, Congress is busily laying the groundwork for the next catastrophe.

“What strikes me now, looking back, is how nothing was changed; no lessons were applied. Even though the lessons were obvious in 1998,” says James Rickards, former LTCM lawyer who negotiated the firm’s emergency bailout. Risk models needed to be fixed; leverage needed to be slashed; derivatives had to be pulled out of the shadow market and cleared through clearing houses and regulation needed to be ramped up. But the government "did just the opposite" says Rickards, launching into a string of deregulatory moves that made banks bigger and ensured that derivatives would remain unregulated. According to Rickards, "the U.S. stared near-catastrophe in the eye, with LTCM, and decided to double down.”"

Today, Rickard says the risks are even greater. Globalization has "scaled up" the financial system and the level of risk, "so now when [the system] fails, it fails catastrophically on a much greater scale than we have ever seen before." If anything, there is greater concentration on Wall Street, and the only difference is that "the Fed has printed so much money, and Treasury has spent so much money, that they have papered over the problem temporarily.”

What is needed? While the current Senate bill does kick the can to regulators to set higher capital requirements and lower leverage ratios, it lacks critical elements. In Rickard's opinion, we need to break up the big banks by reinstating Glass-Steagall protections and the Volcker rule, let them be investment or commercial, but not both; fix the conflict of interest in the ratings agencies and create competition for them; liquidate Fannie Mae and Freddie Mac and get back to a private housing market; and most importantly, make sure that every derivative is regulated and traded in a clearing house.

The Dodd bill does none of these things. Not one. Once again, the Senate is doubling down on a bad bet and the blueprint for the next crisis is being laid as Dodd busily negotiates away the bill's best provisions to achieve bipartisan support.