Holy Cow! We’re Going to Have Financial Reform

A few hours ago, the Senate did something truly amazing: it clobbered Wall Street and the banking industry, defying armies of overpaid lobbyists and passing genuine reforms for our run-amok financial system. Voting 59 to 39, the Senate passed Senator Chris Dodd’s sprawling bill to clamp down on the Wall Street excesses that nearly destroyed capitalism.

Here is my initial quick take in the Fiscal Times. But let me amplify a bit here. For all its compromises and omissions and special exceptions, this is a strong bill that will make life a lot less free-wheeling and lucrative for the big banks and, with a little perserverence, a lot safer for consumers and the economy as a whole. This is a victory for the good guys.

Go ahead and call me naive. Critics of the banks like Simon Johnson and James Kwak of Baseline Scenario will undoubtedly complain that the Senate capitulated to Wall Street because it didn’t try to break up the giant banks or properly clip their wings in areas like derivatives. And to some degree, Johnson and Kwak are right. One of the underlying causes of the crisis was that institutions like Goldman Sachs (GS) and Citigroup (C) had become too big to fail, and many of them took reckless risks because they assumed on some level that the government would bail them out. Neither the Senate nor House bills would really reduce the number of too-big-to-fail institutions. Instead, they create a new “resolution” mechanism to shut them down in an orderly way if they do fail.

But before all the armchair pundits begin carping and tut-tutting, let us first appreciate how much the Senate bill actually does accomplish and how difficult it is to do anything at all when the full force of the financial industry is against you. Remember also that Dodd and the other Democrats had to contend with the hardball intransigence of the Republican Party, whose leaders tried to obstruct or gut just about every meaningful reform in the bill without proposing any of their own. This was not, repeat not, a philosphical disagreement between those who believe in the wisdom of government regulation and those who believe in the wisdom of free markets. However sincere Alabama’s Dick Shelby might be in his fear of overbearing government, this fight was about denying Demorats a “victory.” It was all straight from Mitch McConnell’s playbook for political success: just say no, no, a thousand times no — no matter how venal it makes you look.

Against that backdrop, it’s astonishing that the Senate bill actually became stronger as the process dragged on. The proposed consumer financial protection agency is stronger and I believe more independent than it would have been in the original Senate bill (more on that in a moment). The multi-trillion market in financial derivatives, which is almost unregulated right now, would for the most part have to be take place on exchanges or at least through clearinghouses — either of which require greater transparency and more pfront capital by the players. Banks, whose deposits are federally insured, would be prohibited from trading derivatives. And as an added surprise bonus, from none other that freshman Senator Al Franken, the bill includes a very smart reform to fix the corrupt busines model of credit-rating agencies.

You can argue that some of these reforms will backfire, and some probably will. But you cannot argue that the reforms amount to little or nothing. These are big changes.

Don’t take my word on this. Listen to Heather Booth, executive director of Americans for Financial Reform, a steering group for a coalition of consumer groups, labor unions, community activities and senior citizens lobbying groups (including AARP). Booth and her members have doggedly tracked every eye-glazing nuance of this zillion-word bill. These are exactly the kind of liberal-;left advocates who are often so quick to accuse Congress of caving in to business.

But here is what Booth emailed me shortly after the Senate voted to cut off debate this afternoon and move to a final vote:

“Ed, this is a historic step forward to hold the big banks accountable, who cost us 8 million jobs and brought the economy to the brink of collapse. We still need fight the attempts to weaken this by the Wall Street interests and those who represent them in Congress…But this is the most significant reform for consumer financial protection and reining in the casino economy that we have had in fifty years.”

Mind you, Booth was strongly defending the bill even when it was still possible that Republicans would win a few final votes on some big issues like derivative regulation. “What people need to understand is that this is a strong bill,” she had told me on Wednesday. “That story isn’t getting out.”

There are a number of reasons I think Booth is correct, but here are just two examples. Despite absolutely relentless opposition from the banking industry, as well as from the Chamber of Commerce and other business groups, the bill would create a remarkably powerful new consumer financial protection agency. It would have the power to regulate mortgages, credit card fees, payday loans, car loans and most other big areas of consumer lending. It will also have examiners who are authorized to delve into bank operations.

This is absolutely crucial, given how all the existing “prudential”’ bank regulatory agencies utterly failed to halt subprime liar’s loans or the even more evil pay-option adjustable rate mortgages, all of which were almost hot-wired to default when the housing market cooled down. Consumer protection is important not only for consumers but, as we learned the hard way, for the economy as a whole. The banks fought hard to park the new consumer authority inside one of the bank regulators, because those regulators are mainly concerned about the bank’s financial strength.

It’s true that the Senate bill would turn the new agency into a “bureau” inside the Federal Reserve, which sounds bad. But the agency’s director will be appointed by the president and won’t have to answer to the Fed chairman. Much more important, but almost unnoticed, the new agency’s funding would be far more secure than it would be if came from annual congressional appropriations. Instead, its money will come out of the Fed’s annual profits, and the Fed has very little latitude to quarrel about how much the agency’s director says the agency will need.

Here’s a second example of why this bill is strong. The Al Franken amendment, which for some reason Dodd apparently opposed, strikes a huge blow for reform of the credit rating agencies — Moody’s, Standard & Poor’s. These were the firms that assigned AAA ratings to about $2 trillion worth of bonds and CDO’s backed by explicitly nasty mortgages. That the agencies had been corrupted is beyond dispute, and the way in which they were corrupted isn’t much of a mystery. They were earning a fortune from the firms selling all those securities, and they chased that business by finding ways to give the Wall Street issuers the ratings they wanted.

It’s hard to fix the incentives, because somebody has to pay the agencies for their work and investors don’t want to pony up the money.

Franken’s amendment is simple and brilliant. It requires the Securities and Exchange to make up a list of approved rating agencies, and then to hand out rating assignments to each of the agencies on a rotating basis. The Wall Street issuers would still pay the agencies for their ratings, but the agencies would no longer in a race to lower their standards. In fact, the agencies would have new incentives to set themselves apart by competing on the accuracy of their ratings. Best of all, the system would encourage new rivals to jump into the business because it would be much easier to win assignments.

To be sure, this is a monster-sized piece of legislation that undoubtedly contains some nasty provisions. I plan to look for them, and I welcome tips from the legions of people who are much smarter than I am about the intricacies of financial regulation. It’s also a given that this legislation will have unpleasant consequences. Tighter lending restrictions mean that certain types of loans will become harder to get and/or more expensive. Higher capital requirements on banks may actually slow the pace of economic growth. And some well-intentioned reforms will turn to be terribly misguided in the real world.

But given what the world has been through the last few years, I would rather take the risk of over-regulating or badly regulating than the risk of letting Wall Street continue on its merry way toward the next big thing.

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