Sen. Dodd’s Financial Reform Bill: The Problem of Leverage

Trying to keep up with all the changes in U.S. Sen. Chris Dodd’s (D-Conn.) financial reform bill has been a daunting task. Two weeks ago, it was described in the press as “the 1100-page bill.” Last week, it became “the 1400-page bill.” And within a day or two—voila!—we were reading about “the 1600-page bill.” The Dodd bill has been morphing at a rapid rate. Shades of health-insurance reform!

Most Americans support a government attempt to regulate exotic, esoteric, unregulated, and nontransparent financial derivatives. Warren Buffett calls such exotica “financial weapons of mass destruction.”

Derivatives shook the country’s financial system to its foundations in 1998, when Long-Term Capital Management’s derivatives pyramid imploded, and then again in 2008-9 with AIG’s portfolio. Despite these near-death experiences, published guestimates of the total notional value of derivatives held by U.S. banks remain in the $200-trillion range. (Total U.S. GDP is only about $14 trillion.)

The Dodd bill aims to reduce risk by placing stricter limits on financial leverage. The irony—and, I believe, the danger—of the bill is that, while seeking to reduce financial leverage, it seems designed to increase political leverage; that is, the government’s power and control over financial firms.

President Obama, Sen. Dodd, and other supporters of the bill say that the bill will protect Americans from the financial fallout of major bankruptcies by authorizing federal regulations to shut down financial institutions in an orderly fashion when they start to fail. In theory, that sounds commonsensical and innocuous. In practice, it could be problematical.

Who decides when a firm is starting to fail? Like the heavenly emissary in the movie “Heaven Can Wait,” who took a man’s soul prematurely, only to later discover that the man would have survived and shouldn’t have died, financial regulators may pull the plug on institutions that could find ways to come back from the precipice of failure.

Worse, think of the leverage that regulators could wield over private companies if they held life-and-death power over them: “Listen, Ms. CEO, the guys at Treasury think you should do A, B, and C. Do what you want, but if you don’t do them, they may pull the plug on you.” The Dodd bill could make vassals and serfs out of all financial institutions. A president could effectively cartelize the industry.

Another provision of the bill desired by President Obama and Sen. Dodd is for the SEC to be given increased influence in elections for corporate boards of directors. The SEC already is a politicized agency. Many of us suspect that the SEC’s recent charges against Goldman Sachs were not based on solid legal grounds, but were announced when they were to drum up support for the Dodd bill. I’m no fan of Goldman Sachs, but neither do I believe that a politicized attack dog like the SEC should gain more leverage over private companies.

Lastly, there is the question as to whether this alleged financial reform halts or codifies taxpayer-funded bailouts of financial institutions.

President Obama flatly denies that the Dodd bill includes bailout provisions. Speaking in New York on April 22, he said, “a vote for reform is a vote to put a stop to taxpayer-funded bailouts. That is the truth.”

Contradicting the president are two members of Congress from the president’s own party. Sen. Ted Kaufman (D-Del.) worries that the bill expands “the safety net … to cover ever-larger and more complex institutions heavily engaged in speculative activities,” thereby “sowing the seeds for an even bigger crisis.” Rep. Brad Sherman (D-Calif.) categorically states, “The bill contains permanent bailout authority.”

You decide for yourself who is telling the truth. The Congressional Budget Office seems to side with Kaufman and Sherman. CBO examined the budgetary impact of the bill’s $50-billion resolution fund for large insurance and securities companies, hedge funds, and other nonbank firms deemed “systemically important.”

This language raises serious questions: Which firms, exactly, will be deemed “systemically important?” Will they be told ahead of time, thereby increasing moral hazard? Are there specific guidelines that will be transparent and available to all so that they know where they stand, or will the requirements for “systemically important” status be kept secret? Would regulators be constrained by fixed rules, or would they be free to arbitrarily decide which firms are the ones anointed for rescue?

Judging by his track record so far, President Obama likes to play Big Brother to private businesses, rewarding his friends while stiffing others. The Dodd financial reform could bring us more of the same.