The Dumbest Financial Laws Of All Time

The Dumbest Financial Laws Of All Time
Maureen Farrell and Brett Nelson, 06.23.10, 07:10 PM EDT

Think the new financial reform bill is suspect? Try these legislative gaffes.

How worried should the world be about the new regulatory reform bill wending its way through the U.S. Congress? Given the country's track record on looking after the financial services industry, the answer is: plenty worried.

Even the staunchest believers in free enterprise would agree that a modicum of regulation is necessary for a functioning economy. The new bill, which Congress aims to get on President Obama's desk before the July recess, looks to be chock full of ways to ward off yet another financial crisis. These include: audits of the Federal Reserve; the dismantling of lucrative banking divisions devoted to crafting and trading complex securities called derivatives; an agency that would take quick control of troubled financial institutions; and the so-called Volcker rule, after former Federal Reserve chairman Paul Volcker, that would prohibit banks from making speculative trades with depositors' money.


Whatever ideas end up on the books, three things are certain.

First, regulation--no matter how well intended--comes with a whole heap of unintended consequences. Some laws have invited, or at least exacerbated, full-blown financial crises. (For a round-up of the most ill-fated legislation, "Regulations are fixed in time and can't adapt," says David Weiman, a professor of economics history at Barnard College.

The second certainty: No matter what the rules are, the financial industry will figure out how to innovate around them. "New regulations often let people find ways within the letter of the law to do whatever they wanted to do in the first place," says Edward Kane, a professor of finance at Boston College. To wit: After the Enron scandal, the Financial Accounting Standards Board drafted rules intended to make companies confess to dicey assets held in separate entities that weren't consolidated on their balance sheets for all eyes to clearly see. Those defenses didn't exactly hold.


Third, politicians will look to ease as much pain at the polls as possible, even at the expense of future generations. The Volcker rule, for example, would allow banks to make bets on mortgage securities issued by Fannie Mae ( FNM - news - people ) and Freddie Mac ( FRE - news - people )--the very entities that taxpayers have had to bail out, to the tune of $140 billion (and counting), because these companies were given leeway to buy and guarantee billions worth of busted mortgages taken out by those who couldn't afford the monthly payments.

When it comes to financial crises and what caused them, the past is all too easy to forget. Here are five of the most painful, yet important reminders.

1930: The Smoot Hawley Tariff Act

Mandate: Congress levies tariffs on 20,000 goods.

Pernicious result: Ushered in an era of worldwide protectionism. U.S. trading partners retaliated with high tariffs of their own. Global trade declined by two-thirds between 1929 and 1934, deepening the Great Depression.

1936: Amendment to the National Banking Act of 1935

Mandate: The Comptroller of the Currency handed three ratings agencies an oligopoly when it decreed that Federal Reserve member banks could invest only in bonds considered investment-grade by four "recognized" ratings agencies: Standard, Poor's, Moody’s and Fitch.

Pernicious result: A horrendous conflict of interest, as the ratings agencies were paid by the companies they were rating. Overly generous ratings on securities backed by risky mortgages fueled the housing crisis in 2008.

1982: Garn-St Germain Depository Institutions Act

Mandate: This law gave thrifts license to invest in more non-residential mortgages and codified quirky accounting provisions, such as amortizing losses on sales over 10 years rather than booking them all at once. The Federal Home Loan Bank Board, the thrift regulator, could offer promissory notes, adding to the government's tab.

Pernicious result: "Zombie" thrifts suddenly were considered profitable, or at least solvent. Further gambles ultimately cost taxpayers some $120 billion and bankrupted the The Federal Savings and Loan Insurance Corporation. The Resolution Trust Corporation eventually unloaded assets of 747 S&Ls in a fire-sale.

1992: The Federal Housing Enterprises Financial Safety and Soundness Act

Mandate: Established the Office of Federal Housing Enterprise Oversight to ensure the "safety and soundness" of Fannie Mae and Freddie Mac, the government-backed yet publicly traded entities that buy and guarantee home mortgages. OFHEO had a small staff and limited power. The law also lowered Fan and Fred's capital requirements to half of what banks needed to set aside.

Pernicious result: Moral hazard. When defaults shot up in 2008, the government took over both entities. As of this writing taxpayers had pumped in about $140 billion to keep them afloat, with no cap in sight.

2004: Approval of "Consolidated Supervised Entities"

Mandate: The Securities and Exchange Commission agreed to lower capital requirements for the top five investment banks--then Lehman Brothers, Bear Stearns, Merrill Lynch, JPMorgan and Morgan Stanley --if they agreed to be regulated as Consolidated Supervised Entities (CSEs), with defined capital requirements.

Pernicious result: Ushered in the era of "too big to fail" by letting the banks use their own models to determine their capital ratios. With the SEC fielding a team of just 13 regulators, this was like the fox guarding the hen house. When Bear Stearns failed in 2008, it had a back-breaking $33 of debt for every $1 of equity.

Gallery Of Pain: The Eight Worst Financial Laws Of All Time

How will this 2,000 page bill work?
One of it's authors is quoted as saying:

"It's a great moment. I'm proud to have been here. No one will know until this is actually in place how it works. But we believe we've done something that has been needed for a long time. It took a crisis to bring us to the point where we could actually get this job done."


"No one will know until this is actually in place how it works.!!!"

That's exactly the economic disruption and uncertainty which continues to freeze business activity and hiring.

Edited by Rogerdodger, 26 June 2010 - 11:10 AM.