Will the Dodd-Frank (Obama) Legislation Lead to Higher Cost Financial Failures?

One of the advantages that arm-chair generals have over commanders is that they are not burdened with a great deal of facts. Of the many frightening items about this bill, one is how opaque it is. JP Morgan Chase, who lobbied against many elements of the bill, is reported to have assigned 100 teams to understand all the implications of this 2300 page piece of legislation, requiring at least 243 unwritten regulations to be promulgated. My guess is that by the time all of the regulations and administrative orders are published we could be dealing with 10,000 pages of texts to fight over.

My Initial Thoughts

Citizens, business people, and investors can not wait until clarity is established, if that ever happens. To provide some guidance in the aftermath of the new law the following are my initial thoughts:

1. I agree with Henry Paulson and Harvey Pitt that the law will not prevent another large financial crisis. The former Treasury Secretary and former chairman of Goldman Sachs guesses that a crisis will happen within the next six to ten years. For a Washington-based politician, the time frame is instructive. As the one Marine officer serving on board an attack troop transport, I heard various officers of the day (in command of the ship until the Captain retook command), say that what was critical was that nothing happened that was bad “on my watch.” Today the common expression is to “kick the can down the road.” In both cases the approach is to avoid having to deal with a problem and to let the next officer deal with the problem, not try to solve the problem from occurring. Harvey Pitt a brilliant lawyer and former chairman and staff member of the SEC believes the new law does not address a badly broken regulatory system. Further, he sees a brain drain from our large sophisticated financial institutions that will take the creative business to new organizations or to overseas providers.
   
   
2. My concern is that Tim Geithner, as the President of the New York Federal Reserve Bank, saw the collapse of Bear Stearns and Lehman happening in real time and was very much aware that Merrill Lynch could also have disappeared that weekend. The markets in the US and perhaps more significantly in London had already made their judgments that the firms assets were mispriced, and would not provide the crucial liquidity needed. Because these were publicly traded vehicles, the “bear raids” were a critical alarm. The new Council of Regulators will be made up of people who should have known from their own review of the firms’ books, or heard the loud rumors of the firms’ troubles. If under the new legislation they anticipate the problem to avoid the “not on my watch” syndrome, the firm and their employees could be destroyed. If they move too late we are no better off than our recent history. What comes out of the bill is that the Secretary of Treasury is the dominant force in the future. (Think about past persons in that post and do you want to give them the keys to the kingdom?) By putting an unwinding mechanism in place are we creating a moral hazard that will let big players gamble with the public’s money in a provision that is not afforded to the smaller players?
   
   
3. The claim that “It won’t be the public's money” would fail a beginning economics course. Yes, the surviving banks would have to refund the bailout to the public purse. As we live in a closed economic cycle, what do you think the banks will do on this further demand on their capital? We are already seeing the early results of the Card Act of 2009. In this case banks and credit card companies are restricted from various charges. What we are beginning to see instead is that the banks are just charging for other services, some of which were formerly free or required little or no balances. What may be worse, because it is more difficult to quantify, is a decline in the level of service. On an overall basis if the market wants a particular service it will be paid for either directly or indirectly.
   
   
4. In some ways the most insidious element of the Administration-sponsored bill is the creation of the Office of Minority and Women Inclusion which is to be established in 29 government agencies. This office will require all those who are government contractors and subcontractors to file reports as to their employee rosters. This requirement goes all the way down to office cleaning services. The answers to these questions undoubtedly will push vendors into hiring and promoting various minorities and women. Assuming that businesses are already hiring the best people they can, they will be forced to hire less qualified people which will in turn raise their costs or worse, reduce the level of service provided.
   
   
5. There are other far ranging provisions in the law and probably more in the required regulation. I suspect that the implications for our society are much larger than what we expected. Just like the so called health care reform which is a classic case of "not on my watch" syndrome of first the change and then the pain.

Portfolio Implications

How do we translate the legislative analysis into our portfolios? I would suggest the following are worthy of your consideration;

1. When others play a short term focused game such as “not on my watch” or one year performance, I play for the long term. My focus for my family and managed accounts is the likely lifetime, therefore I am looking to future generations, including in one account, the future generations of professional football players.
   
   
2. I assume that history will repeat itself so we will see financial crises and frauds. Thus some level of reserves could be good as a cushion regardless of the interest income earned.
   
   
3. Minor league games can be more enjoyable to watch than the majors. Translation: a significant portion of one’s equity account should be small companies and those who have graduated to mid size. (In general, I would resist “fallen angels” whose market capitalization has dropped back into the mid and small cap range.)
   
   
4. One of the major lessons from the financial crisis is that it was brought on by the regulators finally waking up to the changes in technology that caused the markets to operate differently. My response is to invest in change or even disruptive elements. This means not only technological innovators, but also early lead adaptors change.
   
   
5. Since the US government is increasingly unfriendly to capital on both a corporate and on an individual basis, an increase in investing overseas is perhaps warranted. You may already be doing so with your investment in US traded securities. Some estimate that roughly half the revenues of the S&P 500 come from overseas. I believe that earnings growth for these companies will be predominately earned outside the US. At some point you may wish to invest roughly the same portion of the world’s GDP as the US does, or roughly one-third.

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