Front Runners

The drinks flow
People forget
The big wheel spins, the hair thins
People forget
Forget they're hiding
--The Who

Members of the bicameral 'financial reform' committee are congratulating themselves for coming to agreement on what is being billed as the biggest financial system overhaul since the 1930s. The Depressionary reference should tell you something.

The wording of the bill should also tell you something. The current title is the Restoring Financial Stability Act of 2010. When bills are worded as gerunds you know you have trouble that will be hard to shake. Moreover, the bill is being abbreviated the Dodd Frank bill, after two of the most damaging bureaucrats w.r.t. finance that Washington has ever subsidized (and that's saying something).

Toddo offers that 'we needed to do something' as he discusses some of the bill's marquee provisions related to derivatives and prop trading. Not sure I agree bro when the actions lead us closer to the abyss. The bill contains nice slabs of requisite pork as well, including provisions that protect 'low income, minority, and underserved communities' affected by failing financial firms (can you say moral hazard and taxpayer burden?), and mandatory affirmative action hiring practices of regulatory agencies.

Revenge of the SIGs. It's all sadly comical.

Bank panics and failures always relate to one issue: excessive leverage. Leverage entials borrowing funds in order to increase potential returns. Of course, leverage also increases risk, or the potential for loss, as well.

When markets go down, lower prices reduce the value of assets held by excessively leveraged firms below the value of their, creating conditions of insolvency. We know leverage is the core issue because conditions of insolvency are difficult, if not impossible, to achieve with no borrowed funds.

In other words, take away the leverage, take away the insolvency. No politicians, or their sponsoring SIGs, want to do that, though.

So how do firms get levered? Two things are necessary. One is an entity or entities willing to supply ample quantities of credit. The other is willingness to borrow, or appetite for risk, among the debtors. Absent either of these conditions, leverage cannot occur.

In unhampered markets these two conditions are regulated by fear of loss. Lenders dial back on credit issuance if they feel borrowers will not be able to pay them back. Borrows dial back on borrowing if they feel less able to repay what they owe.

The probability of 'excessive' leverage building in systems regulated by purely by the natural fear of loss is low. Losses sting. And catastrophic losses, or outright failure, kills.

Yet we observe conditions of excessive leverage routinely. To anyone practicing reason, this should suggest that something must be muting the natural regulatory mechanisms of the market. I'll leave that for you to ponder. The questions you, or anyone truly interested in solving the problem of 'excessive leverage' in our financial systems should be asking, are twofold:

1) Where does the large supply of credit come from? What might reduce concerns among suppliers about the risk of extending too much credit?

2) What drives firms to borrow so much? What might reduce concerns among borrowers about the adverse consequences of excessive debt?

Hint: The Dodds Frank bill does nothing to address these fundamental issues. Indeed, it is more likely that the bill escalates the problem.

position in SPX