There hasn’t been a piece of legislation so debated, maligned and blamed for negative consequences prior to most of the underlying elements of it going into affect since, well since the Obama Heath Care reform, the 2010 Patient Protection and Affordable Care Act, or PPACA.  

Implementation of many Dodd-Frank provisions has been delayed until the end of the year and legislation has been passed that would push implementation further out. But here we are in mid-2011 and most of the reforms passed by Congress to address regulatory failures have not been enacted. With 2012 being an election year — when major progress rarely gets done — it is possible that relatively few changes will be made in our financial structure despite the 2008 meltdown.

It is a sign of a sick political culture. While it is fair to criticize parts of any legislation, which we have done here, the idea that we could go a whole four-year cycle without significant progress after a meltdown the size and scope of the credit crisis is down right sad. That is true whether you blame the legislation itself or opposition to it. This was the type of event that called for action. That called for the ordinary political posturing to be laid down and leaders to address the core problems that led to this disaster.  Or at least to the bailout. Perhaps a simpler solution would have been to force a breakup of all the so called “too big to fail” institutions, ensuring no institution would be too important to have to face the consequences of their poor decisions.

Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler stated today in testimony before the Senate Banking Committee, “The 2008 financial crisis occurred because the financial system failed the American public. The financial regulatory system failed as well.” 

I have a feeling he likes to remind that to folks who are keen to overturn or defang Dodd-Frank. It is good to remember what happened.

Perhaps the problem is that most of the really bad things that could have occurred did not. Kind of like the current debt ceiling crisis. So after the dust settles and the banks got bailed out, perhaps some folks wondered what was the big deal?

Unfortunately, the decision makers are the ones that failed and they are listening to the people who were bailed out. For them there were some tense moments but the banks are back in the black, thanks to government and Federal Reserve largesse, though the rest of the economy is faltering. These folks are far removed from the current economic wreckage caused by the crisis.

The banks immediate needs were met and now they are spending considerable money to prevent changes to the way they do business.

It is an ominous thought as we slip closer to the Aug. 2 debt ceiling deadline, but anger over the bailout could cause folks to ignore the warnings of impending disaster. No bailout should have been passed without a plan to prevent it in the future. Dodd-Frank probably attempted to do too much.

This comes on the heels of a possible Moody’s downgrade announcement a day prior. “Moody’s Investors Service has placed the Aaa bond rating of the government of the United States on review for possible downgrade given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on U.S. Treasury debt obligations.”

S&Ps CreditWatch indicates a substantial likelihood of taking rating action in the next 90 days.

It is ironic because what brought this to a head is the credit crisis and resulting great recession, which is ongoing despite technically being out of it for more than a year. And while there were many culprits, right at the top of the list has to be the aforementioned credit ratings agencies. It was them who chose to slap AAA ratings on massive amount of collateralized debt obligations (CDOs) and other mortgage backed securities. It is them who were compensated by the very investment banks that were creating these products as quickly as mortgage lenders could write bad loans and sell them off to be bundled in various mortgage backed securities. The shocking conflicts of interest of how these ratings agencies operate is arguably public enemy #1 in the crisis.

The very nature of most of these products—subprime mortgages—meant they were higher risk products. Nothing wrong with that if they were labeled as such but they were not, and they were not because the banks who created the products needed the AAA ratings to sell their CDOs to the widest group of investors, many of whom are restricted from investing in things not rated as investment grade.

Bottom line is the banks paid for the ratings.

As noted here at the onset of the crisis all the way back in August 2007, the fact that high risk investments were rated as low risk investments is extremely dangerous because entities used these products as collateral and leveraged off of them as if they were AAA government debt.  

In an upcoming Futures interview with Securities and Exchange Commission (SEC) Chairman Mary Schapiro, the SEC chief talks about the conflicts of interests with ratings agencies and steps she is taking to address it.

Frankly, given there complicity in the crisis, I am surprised the ratings agencies are still around.

This is not to say the Federal government should not get debt under control. The growth path of entitlement programs made the conversation we are having today  on debt inevitable, the financial crisis just moved things forward a bit. However, in the last week I have seen stories from ratings agencies and the heads of several investment banks talking about what the government needs to do. These are the folks that got us into this mess and seemingly got off scot-free.

Don’t know why the government doesn’t just  do what the banks did and pay for their ratings.

We found this disturbing and pointed out how the report acknowledged some of the fundamental factors behind the recent surge in commodity prices but then ignored them in seeking solutions.

The report talks about the surge in demand in emerging and emerged economies. The report also talks about how the use of food based commodities in biofuels has affected price and how government mandates that subsidize that use, have affected price. Oddly the UNCTAD report recommends more government mandates for a problem partially caused by government mandates.

The report also acknowledges the role of a weakening dollar on commodity prices and the fact that commodities have always been seen as a hedge against inflation.

But while acknowledging these real fundamental factors the report suggests that they alone do not explain the price surge and look to the financialization of commodities and the increasing number and impact of speculators. It seems odd to decouple the two because it is these fundamental factors that the speculators are reacting to.

The report’s analysis reminds me of the old philosophical riddle, “If a tree falls in a forest and no one is around to hear it, does it make a sound?”

However we must change the riddle a bit.

If nobody used commodity markets to hedge against inflation and the depreciation of the dollar, would commodities still go up in the face of rising inflation and a falling dollar?

If you follow the UN and the rest of the blame speculators crowd’s logic, the answer is no. They acknowledge that growth in Asian economies is leading to greater demand for meat and the grain to feed cattle and that commodities react inversely to a falling dollar and are used as a hedge against inflation but argue that those obvious fundamentals do not explain in full the rise in commodity prices. For that they blame excessive speculation or the financialization of commodities. However, it is exactly those fundamentals speculators are following. It is why they are speculating that prices will rise.

My favorite line from the executive summary of the report is: “The analysis clearly shows that information flows play a vital role in commodity price developments. The market distortions described above are closely related to the fact that market participants make decisions under conditions of substantial uncertainty (emphasis mine).”

They just described trading.

Futures markets provide certainty for hedgers in that they can lock in the price of a commodity, the future price of which is uncertain. A speculator speculates on the uncertain price of a commodity. Without “substantial uncertainty” there would be no need for these markets. Markets by their nature are substantially uncertain.

Be weary of anyone or any institution that believes they can change that fundamental truth.

It didn’t get the term flash crash for no reason, the entire event happened in a matter of minutes and shook investors to the core. Below is a short audio recording of that period from the S&P 500 futures pits. After listening to this, it’s easy to remember why investors and regulators were scrambling in the months following.

As dramatic as this sounds, it’s important to remeber that this was a market that worked properly, unlike some equities that traded down to a penny. It’s now been a year and regulators have rolled out a number of changes to try and improve investor confidence in the markets. Where do you stand? Have the changes been beneficial or merely a Band-Aid over a much larger problem?

I thought of this when reading a report in Crain’s this week of how, surprisingly, Citadel CEO Ken Griffin came out in support of Dodd-Frank. The problem is Griffin came out in support of Dodd-Frank months ago, a point we made at the time. And he is not the only one. Other managers and investment professionals have supported putting more restrictions on markets, particularly over-the-counter markets.

This illustrates a problem in modern reporting and perception. We can see a couple of industry leaders or lobbying groups speak out in support or against a new law or policy and jump to a conclusion that said law or policy is universally supported or opposed. We all are guilty of jumping to such conclusions, which are insipid because that is what certain groups want us to believe.

For example, keep on saying that a vast majority of Americans are against health care reform and soon people will believe you.

This really should have no place in reporting but too often it does. Whether it is about legislation, regulation or elections to often the “horse race” story prevails rather than analysis of the details of what is involved. We simply take a survey, and not a very scientific one at that.

I don’t mean to pick on Crain’s here, as their story acknowledges that the remarks were similar to those he made last September, but I think this is a good example of how those pushing an agenda can distort reality and create a false perception. The Chicago Fed event last September was a big deal. And a large and prominent hedge fund supporting a controversial regulatory overhaul was also a big deal. But despite this, it assumes universal opposition by large institutions and free market supporters.

Interactive Brokers boss Tom Peterffy spoket to this in our Top 50 Brokers feature when he stated that the large investment banks were trying to delay implementation of Dodd-Frank until they could gain political support and protect their profits. Peterffy stated in a speech to the World Federation of Exchanges: “The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers’ orders at prices that leave the banks with undisclosed but huge profits.”

He goes on to say that at times the banks convince counterparties it is in their best interest.

 “How do they do this? What dark arts do they employ to maintain the status quo? I think their magic consists of such mundane things as million dollar paychecks to the salesmen, golf outings, tickets to games, dinners, Cuban cigars and probably some other blandishments that should not be discussed in polite company. And of course, the fact that most OTC derivatives “customers” are not playing with their own money. The customers are finance or investment staff that work for large corporations, state or municipal governments, pension funds and insurance companies. These end-user employees get to drink the fine wines, but it is the shareholders or taxpayers that pay for the overpriced derivatives.”

This is a vicious circle and the ones making the huge profits are able to convince the media that everyone involved supports the status quo.

Of course Citadel is on the other end of these OTC trades with investment banks, which is why Griffin would like to see a more level playing field. But there and parts of Dodd-Frank for most hedge funds to dislike, so it is easy to get the impression that the industry as a whole is against it in its entirety.

 We all need to pay a little closer attention.

A point sharply made in an op ed piece in the New York Times by the retiring Barofsky and a point made here last December.

The wildest most universal and undisputable conclusion was that “Too big to fail institutions” remained; in fact they have only grown and have an uneven playing field, which will ensure that they continue to grow and continue to be too big to fail. Meaning our leaders have failed in the most important mission following the bailout—to ensure it doesn’t happen again.

Darrell Issa, chairman of the House Committee on Oversight and Government Reform, showed slides illustrating the interest rate advantage the five largest banks, who control 50% of total banking assets, have over its competitors and Barofsky added that that didn’t include the perception of too big to fail. Wouldn’t you want your money in an institution that you knew would not be allowed to fail by the government?

This is not a political argument on free market solutions. There was one free market solution—let them fail, after that all bets were off and every effort should have been made to ensure minimal impact on the economy, which should have meant making massive loan modifications quickly so the foreclosure issue wouldn’t be hanging over the housing market like the sword of Damocles for the past two and a half years with no resolution in site. TARP, at least the way it was drawn up, bailed out the banks from the perceived failure of subprime loans. Now they appear to be collecting on them again, double dipping.

 An important point made by Barofsky was that TARP was only able to pass due to language that ensured that it would be in the words of the Fed, “conducted to…, restore the flow of credit to American families and businesses, and support economic recovery and job creation in the aftermath of the crisis.”

Barofsky notes, “These Main Street-oriented goals were not, as the Treasury Department is now suggesting, mere window dressing that needed only to be taken “into account.” Rather, they were a central part of the compromise [which convinced] reluctant members of Congress to cast a vote that in many cases proved to be political suicide.”

But shortly after it passed Treasury decided to fund banks directly rather than purchase toxic assets. But no conditions to meet the broader mandates of TARP were included. Why?

Before TARP was passed we pointed out that it was akin to buying deep out-of-the-money options but paying the price of deep in-the-money options. We asked what premium we were receiving for that cost. The answer was to restore the flow of credit to American families and businesses. It didn’t happen.

More to come.

It is astonishing to us that the CFTC has promulgated whole forests of rules related to Dodd-Frank and yet has not defined the entities and products that come under those rules. Seems backwards as noted here recently by our contributor and former CFTC Chairman Philip McBride Johnson.

We are sympathetic with the volume of work the Commission has had to undertake and realize that the definition phase is particularly cumbersome as it must be undertaken in cooperation with multiple other regulators, but it still makes no sense to save the definitions for last.

People and organizations are commenting on these myriad of rules unsure what particular bucket they and the products they offer and are accessing fall into.

A clear set of definitions as a first step could have helped streamline the whole process.

Now there is the chance that rules may be rendered meaningless as there is a real threat that Dodd-Frank could be neutered through a lack of funding. This type of uncertainly is bad for the markets. As is the prospect of defunding the regulators. Markets need clear rules or standards and their enforcement should be even, not based on a resource allocation decision within an agency.

If there are parts of the law people don’t like, work to remove them but don’t turn compliance into a voluntary exercise based on a cost benefit analysis estimating the regulators ability to monitor your activity.

“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again…. It falls to us to make different choices if we want different results.”

These are the words of the task force that wrote the Financial Crisis Inquiry Report released in January. These 10 commissioners were tasked by Congress to determine what caused the 2008 financial meltdown. After hearing about possible exemptions of certain firms from the Dodd-Frank Act by those in Congress, I read this report. It irks me that some of those responsible are the loudest naysayers of reform. Even the task force notes: “Some on Wall Street and in Washington with a stake in the status quo may be tempted to wipe from memory the events of this crisis….” So let’s have at it…what were the group’s main conclusions?

1) The financial crisis was avoidable. “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.” The main instigator? The Federal Reserve Bank and “its pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards.”

2) Widespread failure in financial regulation and supervision. “The sentries were not at their posts…more than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve Chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the financial industry at every turn, had stripped away key safeguards, which could have helped avoid the catastrophe.” Regulators highlighted for sleeping on the job: Securities and Exchange Commission, Federal Reserve Bank of New York and those keeping an eye on the mortgage industry. One suggestion on how it was weakened: The financial industry spent about $4 billion in lobbying and campaign contributions from 1999 to 2008.

3) Failure of corporate governance and risk management at key financial institutions. “Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding.” Further, compensation focusing on short-term gain added to the long-term problems.

4) A combination of excessive borrowing, risky investments and lack of transparency led to the crisis. Everyone was overleveraged, especially Fannie Mae and Freddie Mac. Both Wall Street and Main Street incurred debt levels unseen before.

5) The government was ill-prepared and its inconsistent response added to the uncertainty and panic. They rescued Bear Stearns, then put Fannie and Freddie into conservatorship, then let Lehman fail and then bailed out AIG.

6) There was a systematic breakdown in accountability and ethics. You think?

7) Contributing to the meltdown was a collapse of mortgage-lending standards, unchecked OTC derivatives and credit rating agencies that didn’t do their jobs.

My synopsis just skims the report; this group dug in and even got philosophical. “These conclusions must be viewed in the context of human nature and individual and societal responsibility…. It was a failure to account for human weakness that is relevant to this crisis.” It does hold accountable public officials, specifically in the Clinton and W. Bush administrations, and sort of blames us for allowing these officials to do what they did to the system. So what’s the takeaway? Learn from the past, heal thyself, and blame Alan Greenspan.