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1Wednesday, June 17, 2009

The Grayson-Glass-Steagall Act of 2009 - A Proposal for a Regulatory Overhaul of the FinancialSystem, or “The Compartmentalization of Decay in Financial Institutions”by John Bougearel

(*Note: This is my own proposal, and not one that would necessarily be endorsed by Mr. Alan Graysondown the line. The reason for selecting Mr. Grayson in the title is that as a Congressman he is much closerto being an advocate for the taxpayer than a proponent for the big banks)

On June 12, Bloomberg News reported that the Federal Reserve is likely to emerge as the most powerfulregulatory agency in the Obama administration’s plan for overhauling financial market oversight. Theplan for the Obama administration has been crafted by Treasury Secretary Tim Geithner and NationalEconomic Council advisor Larry Summers. On June 9, Treasury Secretary Geithner told the FederalReserve Chairman Ben Bernanke that the Obama administration’s regulatory overhaul would call for theFed to be“the regulator of firms deemed too big to fail.”And, according to the Obama administration’sJune 17 09 white paper, if any large firm deemed to be too big to fail (TBTF) appears to actually befailing, the Treasury would be given the power“to appoint a conservator or receiver to stabilize it.”On Wednesday June 17, Obama declared that the financial crisis“was a failure of the entire system.”Thisindictment included not just Wall Street firms but the US Treasury, Federal Reserve and other regulatoryagencies.“An absence of oversight engendered systematic, and systemic, abuse”said Obama.Up through the first half of 2009, the Office of Thrift Supervision (OTS), Comptroller of the Currency, the FederalReserve Board, the FDIC, and state bank regulators have been our bank regulators.Obama’s proposed regulatory framework overhaul for financial system would eliminate the OTS agency,but otherwise much of the current regulatory system will be left in place. This led RepublicanRepresentative Scott Garrett of New Jersey and member of the Financial Services committee to voice hisconcern that the president’s plan “stays at square one on the big issues. It creates a cycle of more bailouts.It perpetuates what we’ve had in the past.” Scott Garrett’s point is valid, given that all state and federal regulatory agencies, with the notableexception of Sheila Bair’s FDIC, of the financial system have failed the US. Leaving the existingframework intact and giving even more authority to these agencies, which have already failed us, isfraught with risks to the US taxpayers.

Just What is Too Big Too Fail?

A legal definition of TBTF still does not exist. The doctrine of TBTF is little more than an article of faith.The Obama administrations white paper defines TBTF as any firm“whose combination of size, leverage,and interconnectedness could pose a threat to financial stability if it failed.”The combination of size,leverage, and interconnectedness is left undefined by the administration. TBTF thus becomes simply amatter of public trust for the administration. They know a TBTF entity when they see it and it hassomething to do with “systemic risk.” For the public, TBTF becomes an article of faith once theadministration has arbitrarily conferred a TBTF status upon an entity.

2In my estimation, “Too Big to Fail” is a myth that began with the bailout of Continental Illinois in themid- 80s and needs to be deconstructed to save the financial system from its own demise. I will go a stepfurther and uncategorically state that systemic risk in the financial system spreads and deepens preciselywhen lawmakers and policymakers confer upon certain financial institutions a “too big to fail” status.Unfortunately, a deconstruction of the TBTF myth is not on the table amongst legislators as yet. I wouldlike to see that change, but I am not hopeful.On June 3

, I attended Barry Ritholtz’s June Financial Conference at the NYAC. One of the paneldiscussions addressed the “Too Big To Fail” topic. This panel discussion was led by Nassim Taleb, authorof the

Black Swan,

and Florida Democratic Representative Alan Grayson. Mr. Grayson, by the way, isreally to be applauded not only for his investigations into the financial mess that Wall Street created, butmore importantly, for his willingness to participate in Financial Conference panel discussions hosted byfolks like Barry Ritholtz, who are independent and not captured by Wall Street and Capitol Hill.Alan Grayson did attempt to define TBTF at Ritholtz’s financial conference but fell a tad short. Mr.Grayson took the position however that unlike unicorns, such TBTF institutions do exist. And if TBTF’sexist, they must be regulated. This is essentially the same position put forth by the Obama administration’splan to have the Fed oversee all TBTF firms.“These firms should not be able to escape oversight of theirrisky activities by manipulating their legal structure,”the White Paper said. Through higher capitalrequirements and stronger regulatory scrutiny “our proposals would compel these firms to internalize thecosts they could impose on society in the event of failure.”Higher capital requirements (now at 25 to 1 or 4% tangible common equity I believe) would be aminimum step. Doubling it to 12 to 1 or even 10 to 1 would be helpful. And yes, compelling these firms toprivatize rather than socialize their losses in the event of a financial firm’s failure would also be essential.However, the latter proposition seemingly contradicts the essence of what is meant by being TBTF.By definition, TBTF means government guaranteeing, backstopping, and subsidizing these financialinstitutions with taxpayer dollars when these firms fail. The government saves TBTF firms preciselybecause these parts are deemed to be essential entities to the financial system. Regulating these institutionstherefore entails guaranteeing and subsidizing them with taxpayer dollars as and when needed in afinancial crisis. This socializing of private losses is poppycock thinking.

Compartmentalizing Systemic Risk: The Living Tree System as a New Model forcompartmentalizing Systemic Risk in the Financial System.

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Before becoming a Commodity Trading Advisor in 1995, I was a certified, licensed arborist. One of theamazing protective features I learned about tree systems are their ability to compartmentalize “wounds”and or “decay.” Key to tree systems: they do not heal or save their wounded, diseased or decayingbranches.Dr. Alex Shigo was the first person to study this phenomenon in trees. This phenomenon in tree systems isas close to a perfect model on which to build a system for compartmentalizing decay in our financialinstitutions. Dr. Shigo called this phenomenon the “Compartmentalization of Decay in Trees” or

CODIT.

Borrowing from the CODIT model, we could create a model called the “Compartmentalization of Decayin Financial Institutions” or

CODIFI.

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Trees do not heal themselves when parts of their system become wounded, infected, or diseased. Ratherthey compartmentalize the damage instead. And, when and where possible, they continue growing aroundand over the damage. Compartmentalizing protects the tree system itself against the spread of decay toother healthy parts of the tree. Trees compartmentalize by sealing off and laying down barrier walls thatprevent decay around the wound from spreading in all four directions, up, down, in and out.By the same token, we should not expect the mega-large financial institutions with rotting assets on theirbalance sheets to heal themselves. They have mortally wounded themselves with the products held bothon and off their balance sheets. To prevent these mortally wounded firms from infecting the rest of thefinancial system, these firms need to be ring-fenced and compartmentalized, walled off from the rest of the financial system for the sake of the financial system itself. This would, by definition put size limits not just on financial institutions, but also on how much of any one product they can have on either theirbalance sheets or off balance sheets. Size and margin limits are imposed upon market participants withrespect to futures products, positions size limits need to be placed on the products held by financial firms.If they exceed their size and margin limits, compliance and risk management freezes the account andreduces their balance sheet position to be in accord with regulations.Under such a regulatory regime the combination of size and leverage would never allow any one financialinstitution to become too big to fail. In the words of Nixon’s Treasury Secretary George Shultz discussingFannie Mae and Freddie Mac

“If they are

too big to fail, make them smaller

.”

Speaking of SecretaryTreasury’s and taxpayer protection, where can taxpayers go to find a George Shultz type now? All therecommendations and policies from our more recent Secretaries of the Treasury are aimed at subsidizingthe big banks and making them larger.

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More amazingly about trees, the outer barrier is so strong that many trees continue to grow healthy outercambium layers despite a hollow, decayed interior. By proxy, our financial system should be able tocontinue to maintain its overall health and grow in spite of any one wounded branch. By walling off mortally wounded firms and their toxic waste from the rest of the financial system, the rest of the financialsystem itself should be able to function healthily and continue growing, despite the presence of decayedand hollowed out entities such as AIG Citigroup, and Bank of America. With propercompartmentalization, AIG would never have been allowed to become the slush fund of taxpayer moniesthat it has since Hank Paulson rescued the company from bankruptcy. That such a mechanism tocompartmentalize is not in place more than a year after the failure of Bear Stearns is appalling.

Pruning and Branch Collars

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Pruning. Decaying branches in our financial system need to be pruned from the trunk of the financialsystem. In tree systems, every branch attachment to the tree trunk has what is called a “branch collar.”These branch collars work effectively as a tree’s defense system when a branch has decayed or otherwisebeen wounded. Branch collars prevent the decay from spreading into the rest of the tree system. Withoutbranch collars, the decay from a wounded branch could infect and spread into the rest of the tree system.Likewise, effective branch collars need to be in place for every branch within our financial system.Without them, the toxic decay on the balance sheets of our failed financial institutions can spreadthroughout the rest of the financial system and kill it. Decaying branches in our financial system must becarefully pruned from the financial system. The role of branch collars is similar to “ring-fencing”