So-called financial reform will cause deflation

Eric Singer Contributor
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Congress will break this weekend not quite done on “financial reform.” A defeat of this bill would help avoid a double dip recession. The bill is dishonest because it does not deal with Fannie or Freddie, the main engines of our collapse. The bill’s deafening silence on these two institutions means it is posturing, not helping. In the short term, which is what you would think Congress cares about, the bill is deflationary because it takes precious capital from the banking industry while cutting alternatives available to consumers. It is not a coincidence that the stock market is breathing heavily and making new lows as the prospects for this “overhaul” have brightened.

Some of the main features of this bill and its draw backs appear to be:

1. Moving financial derivatives on to exchanges. This will have the net effect of driving some of this business from New York to Chicago, and some overseas to places like Hong Kong, with a net loss to the United States.

2. Banks will be limited in proprietary trading to 3% of their assets. This implementation still has too much risk for the taste of Secretary Volcker, who wanted a complete ban. The thought that it is a good idea to limit risk by limiting proprietary trading while still leaving Fannie and Freddie to continue unfettered after they lost us over a trillion dollars is ludicrous.

3. Requiring most derivatives parties to post sizable collateral. While government has a role in managing risk, once private parties have done their deal, the usual unintended consequences of imposing NEW contract terms from the outside are to cause the NEXT party to hesitate. One consequence of this will be that a lot of assets will be frozen or liquidated or just idled to provide “safety” at a time when our biggest danger is that the velocity of money has slowed to a crawl, making deflation more likely.

4. Now that the Health Care legislation process has established that we have to pass laws to find out what’s in them, it is unclear whether end users of derivatives like Boeing may be required to post a trillion dollars of collateral. Who really knows at this moment? Do we really want to roll the dice on this?

5. New wind down procedures will be put in place that essentially codify the ad hoc seizure of banks like  Washington Mutual that left shareholders with nothing when under normal procedures they might have gotten something. This will apply to arguably solvent banks too. Once burned, twice shy investors will not come running to invest in bank equity knowing that Fed seizure has become easier.

6. Raising capital requirements for banks in accordance with Basel 3 and disallowing most Trust Preferreds as capital. The less free capital they have, the less they can lend to consumers and small business job creators.

7. Speaking of the consumer, the new “watchdog” will limit the products they can grab onto when they’re in real trouble. Suppose the only lender who will lend to you is a payday lender, but you need the money to keep your car insurance in force. If the Feds make that choice disappear, an accident can put you into bankruptcy. Why limit choices?

8. The Fed will referee the fight between merchants and banks on credit card fees, with an eye towards getting merchants more of the pie than before. Given all the pressure on their profits from this and other provisions, banks may make it up by charging for bank accounts. So now the consumer will earn no interest on their checking accounts but get charged for keeping their cash with banks. Huh? It looks like savers will be penalized and spendthrifts rewarded. Many savers, angered by the fees, may simply pull their deposits out of banks and put their money under the mattress, sort of like the Great Depression.

9. National mortgage standards will apply so that banks will have to figure out if a new mortgage loan will be repaid. What? Isn’t that what banks used to do before Fannie and Freddie led them down the garden path by buying almost every mortgage in sight? Congress should just let banks fail that continue to lend to people who don’t repay. The banks will figure it out. One national standard is more likely to create systemic failure than the diversity of hundreds of local standards.

10. Credit rating agencies would have two more years of monopoly power, finishing with an SEC study of their calls. Let the market make the calls and get the credit agencies out of public shelter for their oligopoly.

Sadly, this is not even a comprehensive list. In theory, the bill is not all bad, just mostly bad, in a fragile economy that needs animal spirits more than anything else. In the short term, it will be highly deflationary. In the long term, it may become more inflationary as it increases the politicization of the Fed. No wonder we’re starting to feel bipolar. Congress needs to break its cycle of addiction to legislation, and take the summer off without pausing to fire another shot into the belly of the economy. The nation could use a breather.

Eric singer is the portfolio manager for the Congressional Effect Fund (CEFFX).