Reform Runs Out of Gas

Last week I attended a presentation by Bob Pozen, author of "Too Big to Save." Bob is Chair of MFS Investment Management, former Chair of Fidelity Management & Research, and lecturer at the Harvard Business School. Bob is an attorney by profession and Robert Shiller, the Yale economist, is his co-author of the book. I came with a lot of optimism, but left with a sense, at least from the slides, that reform of the financial markets has now been, as the Brits say, "crocked." That is to say, the plate has been thrown down on the floor and broken into shards of crockery. Reform now means a lot of incremental procedural changes that altogether don't add up to much.

Pozen says that there is too much focus on bank lending to business as being the key to economic expansion. He notes that bank lending was about 26% of total credit creation in 2006. Much more important, he says, is the task of reinvigorating the securitization market. He says that current volume, if I heard it correctly, is about $20 billion annually versus $1.2 trillion in 2006.
One reason that the market imploded, among many, was the fact that issuers were not required to hold a retained interest in the securitizations, and I would presume that establishing this as a norm would be one of the enhancements discussed in the book.

I felt that he glossed over the role of S&P, Moody's and Fitch in the whole debacle. The capabilities, business models, and governance of these institutions have not changed. Pozen's answer is to have these and other credit rating agencies, submit bids to an SEC master who would pick the best one for each issue. This seems like a procedural step that leaves all the significant issues behind the failure of the agencies untouched. It's another "check the box" procedure, a la Sarbanes-Oxley.

He rightly points out the popularly misunderstood nature of the extent of financial institutional bailouts. Out of about 650 financial companies that have been recapitalized, there are 290 small banks. Many of the companies don't hold deposits, but received TARP money anyway. The program was rolled out without any limits or rationale. That was, and is, reflective of management incompetence on the part of the Government. Remarkably, he notes that the Government got 15% warrant coverage on its deals whereas Warren Buffett demanded and received 100% warrant coverage for his Goldman deal! Don't want to ruffle any CEO feathers, especially with the taxpayers' money.

Repealing Glass-Steagall was clearly a humongous mistake. Pozen says reinstating a separation of commercial and investment banking is not desirable. It may not be, but his argument escaped me. He says that underwriting securities is not the problem. That may be true, but principal trading of all manner of convoluted instruments surely is the problem, and it takes place on the same trading desks. There was an obligatory comment about financial innovation, but who needs the kind of "innovation" that got us here? Finally, he rightly points out that if other nations don't follow, then US banks would be at a disadvantage. But, wouldn't the UK and the other G's want to coordinate this kind of policy?

On the subject of executive compensation, he noted the failure of the whole system for regulating the banks that took TARP money. We've always pointed out that this was a blunt instrument, and that focusing on the back-end compensation without getting at the philosophical issues about economic rents and short-termism in corporate objectives would be a futile exercise. He noted that Wells Fargo responded to the guidelines by stripping down the options-related compensation of its terrific CEO, whom I have always admired for his focus and consistency. Unfortunately, his base salary went from $900,000 to $5.6 million, and his restricted stock grants more than made up for any "loss" of option-related potential gains. Pozen said that this is not the kind of "reform" that was intended, but that it was a rational and predictable response to the foolish rules-based structure.

Pozen mentions that there is no data to support the notion that procedural-based SOX led to better stock price performance or less malfeasance or bad governance. Again, our systems are based on rules and bright lines, and Europeans tend to favor principle-based systems. Ultimately, it's the people in charge of Governments and the corporations, along with an informed citizenry that make a system fair and reasonably efficient.

I'm sure that there's lots of good ideas in the book and some good analysis of the historical origins of the crisis from Robert Shiller. After all this time, though, I would have expected more penetrating ideas for reform.