Fighting the Wrong Fight on Financial Reform

April 26th, 2010 at 6:30 am David Frum | 27 Comments |

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Here are Hernando de Soto’s criteria for effective reform of derivatives regulation:

- All documents and the assets and transactions they represent or are derived from must be recorded in publicly accessible registries. It is only by recording and continually updating such factual knowledge that we can detect the kind of overly creative financial and contractual instruments that plunged us into this recession.

- The law has to take into account the “externalities” or side effects of all financial transactions according to the legal principle of erga omnes (“toward all”), which was originally developed to protect third parties from the negative consequences of secret deals carried out by aristocracies accountable to no one but themselves.

- Every financial deal must be firmly tethered to the real performance of the asset from which it originated. By aligning debts to assets, we can create simple and understandable benchmarks for quickly detecting whether a financial transaction has been created to help production or to bet on the performance of distant “underlying assets.”

- Governments should never forget that production always takes priority over finance. As Adam Smith and Karl Marx both recognized, finance supports wealth creation, but in itself creates no value.

- Governments can encourage assets to be leveraged, transformed, combined, recombined and repackaged into any number of tranches, provided the process intends to improve the value of the original asset. This has been the rule for awarding property since the beginning of time.

- Governments can no longer tolerate the use of opaque and confusing language in drafting financial instruments. Clarity and precision are indispensable for the creation of credit and capital through paper. Western politicians must not forget what their greatest thinkers have been saying for centuries: All obligations and commitments that stick are derived from words recorded on paper with great precision.

Above all, governments should stop clinging to the hope that the existing market will eventually sort things out. “Let the market do its work” has come to mean, “let the shadow economy do its work.” But modern markets only work if the paper is reliable.

These ideas from one of our greatest free-market thinkers more or less align with the section of the financial reform bill that deals with derivatives.

That does not mean that the bill is fine. Democrats have tethered derivatives regulation to another project, the creation of a new agency to regulate and protect consumer credit. That’s a seriously bad idea that will tend to constrict the flow of credit to households and small businesses. Yet it’s the new consumer-protection agency that seems to be the least controversial element of the Democrats’ proposal. Meanwhile it’s the elements of the bill that address Hernando’s concerns that are the most controversial with Republicans and the right. Curious, huh.

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27 Comments so far ↓

  • TerryF98

    Well David there are such people as predatory lenders.

    As a very rich man you would have no knowledge of such “businesses” and the ways they destroy people lives.

    Add in the way the credit card industry hikes rates and abuses their customers and there is definitely a need for some consumer protection.

    Why with interest rates at almost zero are theses people charging 25% rates and above?

  • Slide

    DF said, “That’s a seriously bad idea that will tend to constrict the flow of credit to households and small businesses. ”

    And that is necessarily a bad thing? One of the main reasons we had the financial meltdown was because people were given loans that they never should have qualified for. We all saw the ads: “no money down, no credit check, no work verification, etc. etc. Don’t you think that perhaps some of THAT credit should have been “constricted”?

    The originators of the loan had no risk because the loans ultimately got bundled into bonds and sold removing all risk from the lender. They were rewarded in making loans to anyone that had a pulse. There was no down side. The lenders used all kinds of “tricks” to game the models that the rating agencies used to rate the bonds masking the toxic nature of the sub-prime bonds to unknowing purchasers. Result – everyone got a loan if they applied. The housing bubble expanded. Everyone’s house price went up. People were encouraged to take second mortgages on their expanding equity. Things were great. Until the bubble burst that is and the whole house of cards came crashing down.

    With such a recent history of predatory lending behavior described above and after witnessing the destructive results of that behavior it is amazing that someone would suggest that we don’t need oversight in this area. The market will correct itself right David? With the help of hundreds and hundreds of billions of taxpayers dollars that is.

  • kensilber

    Recommended reading: Nicole Gelinas explains why a consumer protedction agency won’t work, in “The Financial Reform Fiasco.”

    http://www.researchmag.com/Issues/2010/April-1-2010/Pages/The-Financial-Reform-Fiasco.aspx

  • Slide

    kensiber, with all due respect, researchmag.com is not exactly an objective disinterested party now is it?

  • kensilber

    Slide, I work at Research (part-time) and it’s a magazine for financial advisors. I’ve found financial advisors have a wide range of views about reform, not necessarily matching those of their bosses. I’ve also found financial industry publications vary on the subject as well, including ones within our company (Summit Business Media). So, while I wouldn’t say Research is “objective and disinterested,” I don’t see that there’s a good basis for dismissing the publication.

  • ottovbvs

    kensilber // Apr 26, 2010 at 8:22 am

    “So, while I wouldn’t say Research is “objective and disinterested,” I don’t see that there’s a good basis for dismissing the publication.”

    …….Of course it’s not…..but it is a reason to view it’s arguments with a large dose of scepticism

  • YuriPup

    David,

    When does it stop being “extending credit to households and small business” and become a means of extracting maximum profit? Is there a moral line crossed by company charging 400% interest on micro loans to the poor because the poor don’t have any other options? Is there a moral responsibility from us to ensure that both sides are getting a “fair” deal?

  • ottovbvs

    …….David there’s a very simple reason for the change of focus by Republicans in attacking this legislation…….the instructions they are receiving from Wall Street have changed……the big financial institutions have decided derivative regulation on the scale now being proposed which has gone far further than they expected (as a cursory examination of the Ag committee proposals reveals) represents a far more serious threat to their operations and profitablity than the consumer protection agency clauses in the bill………six month ago Republican obstructionism centered on the comsumer protection clauses now it’s derivatives…….either way it doesn’t matter much because there’s nothing the Democrats would like more than a knock down drag out fight over this but I don’t think they are necessarily going to get one particularly since the Republican’s Luntz inspired bs about bailouts is being so widely ridiculed……this legislation is going to get passed in the next two months max

  • balconesfault

    From the cited Researchmag.com article:

    The problem, though, is that a central bureaucracy can’t predict from on high what’s good for consumers, what’s slightly bad and what’s unacceptably toxic. Take, for example, a mortgage with a high fixed interest rate that a bank could offer to home buyers with bad credit. In offering such a loan, does a financial institution take advantage of someone with few other options for immediate home ownership? Or does the institution do the borrower a service by giving her an option to buy rather than keep renting — a choice that she otherwise would not have — while compensating its shareholders for the higher risk?

    Or consider a high-interest credit card. Is such a card an example of predatory lending? Or is it an opportunity for an entrepreneur who needs a few thousand dollars in ready cash to buy supplies for a new business, but can’t borrow from a bank? What about those tempting checks your credit-card company sends you at Christmastime? It seems pretty terrible for a card company to seduce borrowers into making purchases that they can’t afford. But a construction worker with no work in a cold snap could consider the checks to be a lifeline, as they could allow him to pay the rent as he awaits springtime work.

    What we need a central bureaucracy for is not necessarily to stop any one of these individual transactions – but to be monitoring the number of transactions that are taking place throughout society, and the threat it is creating for our entire credit system when those high risk loans are not the exception but the rule.

    Because our financial institutions have shown that when there is money to be made on speculation, today’s upside is well worth tomorrow’s potential downside. We’re infested with a generation of financiers who are all more focussed more on getting their millions and getting out before the market collapses than on the long term stability of even the institutions they run.

  • ottovbvs

    balconesfault // Apr 26, 2010 at 9:39 am

    “What about those tempting checks your credit-card company sends you at Christmastime? It seems pretty terrible for a card company to seduce borrowers into making purchases that they can’t afford. But a construction worker with no work in a cold snap could consider the checks to be a lifeline, as they could allow him to pay the rent as he awaits springtime work.”

    …….When opponents of the consumer protection agency are reduced to basing their case against it to the dangers of restricting usurious loans by credit card companies or paycheck bucket shops you know they are really scraping the bottom of the barrel.

  • chicago_guy

    What kind of Jew thinks that putting together laws to regulate (not abolish) usury is a bad idea? What kind of PERSON thinks that it should be legal to bleed the poor and most vulnerable of their income via overly-attractive lending pitches?

  • balconesfault

    What kind of Jew …

    WTF?

  • corringreen

    That was a nice demonstration that ignorance and racism is not SOLELY the province of the far Right. Too bad it entered into an online forum which is normally very thoughtful, but I’m sure we’ll recover.

  • khayes

    David, a strong independent consumer protection agency is absolutely necessary. I would have been against it 2 plus years ago as I (despite being a progressive liberal) reflexively loathe QUANGOs but it is obvious that the average Joe needs protection from the so-called FREE market – it turns out it was not so free to a great swath of consumers and to taxpayers. Elizabeth Warren, the primary proponent of the consumer protection agency is great on this. Ottovbs has it correct – Blanche Lincoln’s unexpectedly harsh derivative language has changed Wall Street’s focus. The Republicans are trapped here and have played the game poorly. They would be better to declare victory, vote for FinReg and move on.

  • Rabiner

    Chicago_guy made me laugh. I agree with those regulations proposed by Hernando de Soto. Unfortunately as Frum stated republicans are unwilling to support those ideas since it would cut profits out of the derivative market by making them all transparent.

  • LFC

    Democrats have tethered derivatives regulation to another project, the creation of a new agency to regulate and protect consumer credit. That’s a seriously bad idea that will tend to constrict the flow of credit to households and small businesses.

    I don’t quite understand how blocking credit flow with outrageous terms will constrict credit flow. I have a stellar credit rating. A few months back, Citibank tried to up my credit card rate with them to over 20%. (I told them that I don’t pay those rates for anything, and promptly canceled my card.) Why did they do this? Because they made a bunch of bad bets and, being a monstrously large company, decided they had the leverage to force their good customers to pay for their stupid bets.

    It seems to me that it was their lack of financial savvy is what is restricting credit.

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  • blowtorch_bob

    Quote of the day:

    “The talking point of the Wall Street apologists is that we can’t touch Wall Street because they are after all the life blood of the economy. The only blood in these parasites is what they have sucked out of Americans.”

  • rectonoverso

    Spare me!

    I sure as hell want to have watchdogs who will impose understandable credit card and mortgage contracts. It has nothing to do with small businesses. You would know that if you had ever run one.

  • ottovbvs

    chicago_guy // Apr 26, 2010 at 10:40 am

    “What kind of PERSON thinks that it should be legal to bleed the poor and most vulnerable of their income via overly-attractive lending pitches?”

    ……A Republican kind of person…..is this a secret?…….the bottom 50% of the population, or maybe more, need to be protected from themselves…….Paternalism?……sure……but at bottom I’m right…..typical Republicans however see these people as sheep to be sheared…..rather as people like Palin, Murdoch, Beck, O’Reilly and all their small time imitators see the Republican faithful as sheep to be sheared……I’ve no particular interest in protecting tea partiers from the depredations of this flock of vultures but the American middle and working class deserve some protection because basically they don’t in the main have the cultural or intellectual resources to look out for themselves…..Sad but true.

  • Go Dog Go!

    I find myself increasingly disillusioned with this party and conservatism as it is today. Financial reform is not only necessary to our national security, it is a political imperative. How on Earth could the GOP vote so loudly in favor of the same people who are bleeding our country dry?

    The outrage among moderate Republicans is getting louder. Will they listen? Ever? I’m beginning to doubt it.

  • balconesfault

    Go Dog Go: How on Earth could the GOP vote so loudly in favor of the same people who are bleeding our country dry?

    If it makes you feel any better, I’m convinced that a lot of the Republican votes aren’t so much in favor of Wall Street, as they’re against any potentially popular legislation passing that Obama could take credit for.

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  • sgath

    On your recent conversion back to a thinking, ideas, Conservatism. It would have helped a lot during the Bush years.

    “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
    —Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841

  • Go Dog Go!

    Balconesfault: Nope. That’s even more depressing. If the GOP want to sacrifice America’s very economic foundation for an ounce of political gain, then I want no more part of this party.

    Moderate voices must rise up and yank the Republican Party back to sensibility. Until GOP leadership can go to the bargaining table to get actual work done, not just score petty political points against Obama, our country will continue to suffer.

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