Obama Bulks Up `Too Big to Fail’ With Steroids: Caroline Baum

Commentary by Caroline Baum

-- Back when Bob Rubin and Larry Summers were running Treasury and financial crises were confined to developing countries, international-government types would opine about revamping the “global financial architecture.”

One attempt at architectural redesign and integration was Basel II, a standardized system for assessing banks’ capital adequacy based on underlying risks. Banks deftly circumvented the regulation by shifting risky assets off the balance sheet.

Next?

The Obama administration’s architects went back to the drawing board and last week produced a blueprint for regulating financial institutions. One controversial aspect of the plan is the creation of a systemic risk regulator, the Federal Reserve, with the power to oversee any financial firm, not just a bank holding company, “whose combination of size, leverage and interconnectedness could pose a threat to financial stability if it failed.”

In other words, the same folks who missed, or did nothing to prevent, the worst crisis since the Great Depression will definitely, absolutely, positively be able to anticipate the next one. Uh-huh.

It gets worse. Instead of eliminating the doctrine of “too big to fail,” which encourages risky behavior because of perceived government backing, the Obama plan defines, institutionalizes and expands on it.

“All systemically important companies will be subject to enhanced regulation,” says Peter Wallison, senior fellow at the American Enterprise Institute, a conservative Washington think tank. “What could that possibly mean? It means they are too big to fail.”

Charter Club Members

Previously the determination of who was and wasn’t TBTF was in the eye of the beholder: It had to be inferred.

This past year, the federal government took the guesswork out by designating Fannie Mae and Freddie Mac, 19 of the biggest banks, two car companies and one insurance company acting like a hedge fund as charter members.

“We need to get rid of too big to fail,” says Allan Meltzer, professor of political economy at Carnegie Mellon University in Pittsburgh. “It perpetuates a system where bankers make profits and the public takes losses. We want to put responsibility back on bankers.”

Bigness wouldn’t be the only prerequisite for failure exemption. The 88-page White Paper released last week expands the standard to include too leveraged and too interconnected without ever quantifying “too,” Wallison says.

Incorrect Diagnosis

Institutions that are perceived as TBTF can borrow at lower interest rates, using their funding advantage to muscle out smaller lenders. No wonder small banks are voicing reservations about the plan, which has the potential “to destroy competition in every corner of the economy where you identify too big to fail,” Wallison says.

Some economists criticized Obama’s “New Foundation: Rebuilding Financial Supervision and Regulation” for being built on shaky ground. The administration’s analysis of the roots of the crisis reads “as if the problems were caused by unregulated firms,” writes Arnold Kling, a member of the financial markets working group at George Mason University’s Mercatus Center, in a June 17 blog post. “The holders of credit risk were regulated institutions, especially Fannie Mae, Freddie Mac and the banks. They took on excessive risks right under the noses of the regulators.”

Proper diagnosis is key to implementing a treatment plan. Without it, the effort to re-regulate the financial system will be a politicized effort that will cause more harm than good.

Politicized Princesses

Speaking of Fannie Mae and Freddie Mac, Meltzer says the other main problem with the Obama plan is its failure to deal with the two government-sponsored (now owned) enterprises.

“We should take Fannie and Freddie and close them down, make Congress put the subsidies on the budget and eliminate their function,” he says.

If Congress wants to subsidize low-income housing, fine. Write that subsidy into the budget so it’s transparent.

In addition to the proposal for a systemic risk regulator, the plan would eliminate the Office of Thrift Supervision, create an agency to protect consumers from abusive lending practices, regulate over-the-counter derivatives and curtail the Fed’s emergency lending powers.

Loan originators and securitizers would be required to retain 5 percent of their pooled assets, creating a modest incentive to perform due diligence.

“I’d make the retention 20 percent,” says Bush administration Treasury Secretary Paul O’Neill, who would mandate a 20 percent down payment on every mortgage, a relic from another era. “Why not ensure that housing finance never gets us into trouble again,” especially since it was lax mortgage underwriting standards that brought the U.S. and world economy to its knees?

White Paper Discolored

Answer: Because it’s politically unpopular.

Already politicians are appealing to Fannie and Freddie to relax standards on mortgages for new condominiums, according to yesterday’s Wall Street Journal. House Financial Services Committee Chairman Barney Frank, Democrat of Massachusetts and long-time enabler of the GSEs, wrote to the chief executives of both companies asking them to lighten up on recently tightened terms, the Journal says.

You can see where this is going, and Congress hasn’t even had a chance to get its fingerprints on the White Paper.