There You Go Again

Congress passed financial reform legislation in July, and history repeated itself.

In 1998 the large hedge fund Long-Term Capital Management was “rescued” by a group of large banks at the urging of the Federal Reserve. No taxpayer funds were involved, but the event cast into the public eye the same issues involved in the recent meltdown — excessive leverage, systemic risk, over-the-counter derivatives, unstable markets and hedge fund activities. Congress requested reports and held hearings.

Congressmen lamented the systemic implications of the LTCM event and vowed to address the risks. Despite these public lamentations Congress passed the Gramm-Leach-Bliley Act a year later and the Commodity Futures Modernization Act in 2000. These game-changing laws eliminated the isolation of investment banking’s trading intensity from commercial banking’s federal deposit guarantee and ensured that over-the-counter derivatives wouldn’t be regulated.

Fast forwarding to 2010, we have more of the same. Congress vowed never to allow another taxpayer-funded bailout of a large financial institution and assured the public that the financial reform bill will create an “orderly resolution” of failing financial behemoths.
The Dodd-Frank financial reform bill will not deliver on any of those promises. Again, regulation has been the weak link, yet Dodd-Frank delivered even more of it. Regulators will never have the staff, skill levels or sophistication to be ahead of innovations by profit-driven financial institutions. They are the last to discover a systemic problem, finding out only when the wave is washing over them.

“Orderly resolution” of a single systemically-significant institution is impossible because of their size and involvement with over-the-counter (OTC) derivatives. OTC derivatives trading created new structural ties among the world’s biggest banks.

The biggest banks are much larger than in 1998. Top Federal Reserve officials believed that LTCM presented systemic risk in 1998. LTCM controlled only $125 billion in assets. The largest bank holding companies, several being $2 trillion in size, are now at least ten times the size of LTCM. That’s not inflation. They were allowed to become that large.

If one of these big banks fails, which part gets “resolved” first — the small investors, the broker-dealer clients, the large derivatives counterparties, the hedge funds, the foreign counterparties? The list of their customers and clients is long and varied. The only certainty is that the biggest clients will be treated best, leaving the little guy yet again holding the short straw.

Systemic risk still exists. The biggest banks would all require bailouts if one starts to fail. That means taxpayers are still on the hook no matter what Congress vows.