Regulatory Whack-a-Mole

I hope you’re prepared for things to get tough.

In fact, much tougher than they ever got in ‘08 and ‘09.

Most will not openly admit it, but the economy, markets, banking, finance, and geopolitics are headed for dire straits. And there isn’t a dang thing anyone can do to prevent it.

Not the president. Not his gaggle of diversity hires parading as an administration. Not the next president. Not congress. Not the Federal Reserve. Definitely not the regulators.

And deep down, I believe everyone knows it.

What everyone doesn’t know is who to blame.

Now, I know it’s tempting to point to the usual suspects listed above. But they ultimately draw power from voters. Voters that never fail to fall for political schemes, solutions, pandering, and burden shifting.

But since regulators just backstopped every depositor in the country (you know, those depositors with over $250K in the bank that clearly deserve taxpayer-backed federal protection), I thought I’d take us on a trip down memory lane.

Back to a time when regulators had to bail out banks from decisions those same regulators forced them into in the first place.

Near Miss

In 2006, I was Chief Investment Officer for a regional bank north of Portland, Oregon.

We underwent a routine bank examination. After a couple of weeks of camping out in a big room and requesting documentation and records from everyone, the regulators gave us a clean bill of health.

With one exception.

It turns out the bank wasn’t generating as much income as it should. So, the regulators encouraged us to buy higher-yielding bonds. Specifically, mortgage-related bonds like CMOs (collateralized mortgage obligations).

Besides, their overseers in the Bush administration wanted to encourage home ownership. And bank examinations proved a perfect way to ensure all banks did their part by soaking their balance sheets with mortgages.

The bank didn’t bite, thankfully. And it didn’t defy regulators for long because, within a few short months, they had bigger fish to fry.

Homebuyers began to default. Mortgage bond prices dropped massively. Bear Stearns failed. So did Lehman Brothers. And, just like that… the Great Financial Crisis was upon us.

Any bank or financial institution holding CMOs now had steep losses on its balance sheet. And, back then, those losses had to be recognized and reported. Which only compounded the problem.

In stepped Senators Chris Dodd and Barney Frank. They reasoned that had banks not been forced to recognize those losses, then the whole problem could have been avoided. With the passing of the Dodd-Frank Bill in 2010, banks could ignore losses on bond holdings provided they intended to own those bonds to maturity.

And now we’re paying the price for that bit of regulatory magic too.

With the cover of unrealized (and unreported) losses, banks could buy bonds with longer maturities, thereby earning more yield.

But when depositors started moving their money to higher-yielding money market accounts, banks had no choice but to sell those bonds, realize losses, and create panic.

Essentially, the only difference between heading into the GFC and whatever you want to call where we’re headed today is that banks swapped out the credit risk of CMOs for the maturity risk of long duration bonds.

The net result is the same – contagion.

But my big fear today is not what happens as a result of financial contagion. It’s what problem the usual suspects create for tomorrow in their attempts to solve the problem they created today.

Think Free. Be Free.