Mark Hamrick: From Bankrate.com, this is "Special Report: The Unfinished Business of Financial Reform." Hello, I'm Mark Hamrick, Washington bureau chief. It's now been about five years since the financial crisis hit its zenith, and all these years later, the record is mixed on the response. While much work has been completed, including the landmark Dodd-Frank reform law as well as creation of the Consumer Financial Protection Bureau, experts agree there's still much left to do. Our guests are professor John Coffee, with Colombia Law School, and Jim Angel, expert on financial crises from Georgetown University's School of Business. So, where do we stand in trying to prevent the next crisis? Where are the greatest risks? And, by taking unprecedented steps in trying to give the economy a push, have new risks been created? We'll hear one guest describe how despite Congress' attempts to get things done, delays are occurring at the administrative level. We'll be exploring those issues and more in this edition of "Special Report." From the crisis came the response, or should we say responses. First, we speak with an expert on crises. He's professor Jim Angel from Georgetown University's McDonough School of Business. And I asked him whether he believes much has been accomplished to prevent the next crisis.
Jim Angel: Well, I think we have fixed a lot of things. We're working on fixing a lot of things, but eventually something else will break. And I think one of the lessons of the financial crisis is we should never get too complacent. The raw materials that create financial crises accumulates just like dry brush in the western forests. And if we get too complacent, say, "Gosh, we haven't had a forest fire in a long time," well, the raw materials are building up. So you might ask, "Well, what are those raw materials?" Well first of all, complacency. The notion that, "Oh, things can't go wrong." The notion that, "Wow, we have all these great financial tools, and we are so brilliant. We're not going to make the same mistakes as people have made time and time and time again." One of those mistakes is too much leverage. The idea that we borrow money, we invest it to make more money, and we become rich. Well, if you're lucky and it works, that's great. But when you're investing with borrowed money and you don't make as much money as you planned, you amplify your losses just like you would have amplified your gains. And when you have too much leverage that builds up in the economy, it's like too much dry brush out west. A spark can set it off. So unfortunately, this natural human instinct to want to make money leads to a natural human instinct to want to borrow money to make money. And when too many people do that at the same time, it looks like it works for a period of time. "Gosh, I borrowed money, bought a house, the price went up. I am a real estate genius. So I'll do it again with five houses." Well, that kind of mentality leads to a herd instinct, and before you know it, you've got a bubble. And eventually, that bubble's going to burst. Now, this is human instinct. This is natural human behavior. If you look at the history of financial markets, you see this happening over and over and over again in different areas, different generations. Every generation has its own set of bubbles. And whether -- with us it was the Internet bubble and the housing bubble -- we've seen bubbles in just about everything over history. So it's going to happen again. It's just a question of when, where and how. So what we need to do is, just like we build our roads and our bridges to be resistant to earthquakes, we need to build our own institutions that are resistant to the inevitable financial earthquakes that are going to come. And that means that we need to have a regulatory system that is smart enough to understand how markets work. And we also need people to be aware of the fact that yeah, these bubbles occur. And you don't want to get caught in the next one.
Mark Hamrick: Fed Chairman Ben Bernanke sort of indicated that it's become clear to him that the Fed needs to refocus on what its initial mission was, in his view, and that was to prevent financial panics. Do you think that that somehow had been lost in the view of the Fed in the past?
Jim Angel: Well, there's been a lot of debate over this, but let me just start by saying I think Ben Bernanke will go down in history as either the greatest or the worst Fed chairman of the century. And I think it's too early to tell how he will be viewed. I mean, it's -- you know, 'cause it will take several years to see the impact of his polices. Now, he was slow in the uptake to understand and deal with the crisis, but once it hit, he took a lot of bold steps that he thought he couldn't do a few weeks earlier. And then he ran the printing presses with his so-called quantitative easing to massively increase the amount of monetary base that he injected into the economy. And time will tell whether that was just the right thing to do or whether he was setting the seeds for another great inflation. So time will tell what kind of job Ben Bernanke has done here. Now, the basic job of the Fed is to maintain the stability of the banking system. As economists like to put it, the Fed's job is to be the lender of last resort to the banking system. Now, why does the banking system need a lender of last resort? It's simple. The basic structure of a bank is they borrow money from depositors and they make loans to people who need to borrow money. Now, the depositors can get their money back on short notice. But the bank can't go back to the borrowers and say, "Hey Jim, you know that car loan I made you last week? Well, I know I told you you had five years to pay it off. But my depositors want their money back, so I need you to pay off your car loan today." Well, banks can't do that, so they're stuck with this maturity mismatch between depositors who can get their money back at any time and borrowers who borrowed because they need to borrow money. So even a sound bank, whose assets are worth far more than their liabilities, is stuck with this maturity mismatch. So, there needs to be a safety valve in this system so that if too many depositors ask for their money back at the same time, the bank can go to Uncle Fed and say, "Oh, Federal Reserve? My depositors are standing in line. They want their money. Can I borrow some money from you?" And since the Fed has a printing press in its basement -- just metaphorically, they do it all electronically now -- you know, the Fed says, "Sure. I'll create some money and lend it to you because I know you're going to pay me back." That's the basic job of the Fed. But because that power to create money is so important and so powerful, the Fed is tasked with other things. Their job is also to maintain a stable price level and to maintain a full-employment economy. You know, so the Fed has multiple marching orders from congress. And sometimes those marching orders conflict with each other. You know, for example, if you print too much money, you get inflation. But in the short run, that can help the economy and reduce unemployment. So the Fed always has this really hard balancing act between creating too much money or creating too little money. And no matter what they do, they get criticism.
Mark Hamrick: Yes. And clearly it's having a very vigorous debate at the moment as to the future path of monetary policy. Let me ask you this, we know the Congress, because of any number of different dynamics at play, is largely dysfunctional in the sense that it's not able to produce much in the way of legislation these days. If there was one thing that you'd like to see Congress do that has to do with financial reform, whether it's amend Dodd-Frank a bit or come through with some other legislation, what would it be?
Jim Angel: Congress needs to fundamentally overhaul the structure of financial regulation. Dodd-Frank took a bunch of ideas that had been floating around, and they basically swept everything off the floor, stuck it in one monster bill and passed it. But the one thing they did not do was overhaul the structure of regulation. We have literally hundreds of different financial regulatory agencies at the state and federal level, and they don't always play together. As a matter of fact, often times they not only don't play together, they fight each other. And what we need is a thorough overhaul to the structure of regulation. The fact that we have separate regulatory agencies for futures versus commodities versus insurance versus banking leads to a real mess. Because financial services cover all of those different areas, and it doesn't make sense to have this fragmented system of regulation when we have these large financial supermarkets that basically do everything. Now, I think it's very efficient that we do have large institutions that can do everything because that provides better services to the consumer and it allows them to diversify across different product areas. And that can actually reduce their risk. So big is not necessarily bad. But I also want to say that there's no such thing as a too-big-to-fail entity because big entities do fail. The real question is what you do when they fail.
Mark Hamrick: Sure. Well, you know, obviously you're a college professor. I wanted to ask you all these years after the financial crisis, and perhaps to some degree, crises. What kind of grade would you give the government's response in the sense that it's also been a moving response over these several years.
Jim Angel: Well, I think we need to grade different actors in the government differently. Okay, clearly I would give the Bush administration treasury a D. They failed to see it coming and they panicked at the wrong time. They threw gasoline on the fire at exactly the wrong time. I would give the Obama Administration a B. As far as the SEC goes, it's hard for me to grade the SEC because I think congress created a very dysfunctional design. I think the people there tried their best, but they had neither the tools nor the expertise to deal with the problems that were basically in between the regulatory cracks in the agencies. So, I give Congress an F because of their lack of oversight of the industry. I also give congress an F because Dodd-Frank was very badly crafted. You know, there are some good things in there. There are some horrible things in there. But it was a quick political knee-jerk reaction that turned into a partisan brawl. And they left us with a very unworkable piece of legislation that, you know, it's going to take years to sort of sort out even what it means. So I definitely give congress an F. The Fed, I don't know whether I should give them an A-minus or a D, in that they were slow in the uptake. I think they, too, panicked during September of 2008, made things worse before they finally figured out what was going on and started making things better. Time will tell whether the Fed has the intestinal fortitude to pull back on printing money before they set off a major inflation. Now, that is going to be the real test of Ben Bernanke as Fed Chairman. The the time to be pulling back on the so-called quantitative easing will be long before the unemployment lines are gone because there's a lag between when the Fed does something and when it affects the economy. So whenever he does it, he's going to get a lot of flak. And will he have the guts to pull back at the right time? Or will he do the expedient thing, print too much money, and set off the next great inflation. Time will tell.
Mark Hamrick: So I guess perhaps we might give him an incomplete and give yourself …
Jim Angel: Oh, that's even better! Thank you. I give the Fed an incomplete because it's too early to tell exactly what they've done. It will take several years to figure out, you know, whether the Fed really made the right moves at the right time.
Mark Hamrick: Well, professor, we'd like to give you an A for the interview. It's always a pleasure to catch up with you, and we really do appreciate your time. Jim Angel. He's a professor at the McDonough School of Business at Georgetown University in Washington. Next up, we move from the subject of the crisis to a status report on financial reform. For our second segment, we spoke with Professor John Coffee of the Columbia Law School in New York. Among his areas of expertise is securities law and white-collar crime. I asked him all these years after the financial crisis, what worries him about the regulatory response or the lack of it now that we have the benefit of hindsight?
John Coffee: Well see, I think congress acted boldly and broadly in enacting Dodd-Frank. But the implementation of Dodd-Frank has been a death by a thousand cuts as each step in the industry having much more lobbying skill, power and particularly staying power has been able to delay or prevent implementation of any meaningful reforms. Now, you can apply this to a variety of different contexts, but I would start with what I think are the crises most likely to happen. And the first crisis I would point to would be the world of money market funds. Money market funds really have a danger of all mass failure. They invest in exactly the same instruments. The prime money market funds basically invest in the commercial paper of financial institutions. And the commercial paper of financial institutions rises or falls together, and as a result, the money market funds are likely to go down together producing a panic. But for a bailout in 2008, many, many major money market funds would have been unable to pay redemptions. Now, the industry wants to respond to all this by having the government again bail them out if there was a crisis. The government knows that bailouts are not popular. What's going to happen? Well, the Federal Reserve through a body called the Financial Stability Oversight Council, or FSOC, instructed the SEC that they have to do something. And they wanted the SEC to require money market funds to have greater loss absorbency through acquiring more capital, requiring their sponsors to put capital into them to protect against a shortfall. The industry seems to have effectively negated that and has come up with a very minor reform of floating net asset value, which will give more information to consumers, but it actually could accelerate a run on the bank rather than delay it. So I would say that's one of the areas where we have not solved one of the major problems that could cause a run on the bank and panic. That's one. I could talk equally about the world -- if you look at what caused the crisis in 2008, it was partly Lehman but it was even more the failure of AIG, a much larger institution. And everybody was connected to AIG. It was too interconnected to fail because it dominated. It had 90 percent or more of the credit default swap market ultimately relying on it as the guarantor. Now, Dodd-Frank addressed all that by coming up with new rules for the trading of swaps because credit default swaps are one type of swap. Those rules have been delayed, are still being delayed. There's been a major difference between the Commodity Futures Trading Commission, which has a very aggressive chairman in Gary Gensler. And the SEC, which has been a little bit more captured by the industry and has a chairman who is really not particularly focused on the world of global trading of over-the-counter derivatives, Mary Jo White, who is basically the enforcer. To that extent, they have different rules now being proposed. The CFPC rules, which were just delayed today, according to breaking news, would have applied globally whereas the SEC's rules for securities-based swaps only apply to transactions within the United States. And that creates the danger that banking institutions will just trade swaps through their affiliates offshore, and that we'll be back where we were in 2008 with no real controls except to the extent that other countries create them for the trading of over-the-counter derivatives including credit default swaps, and this goes by name. This is a kind of regulatory arbitrage. Some country will want the business and will have minimal regulation, and banks will run like lemmings to the forum that has the less regulation. And we could see 2008 reoccur in the same way if there is a company like AIG that takes more risk or doesn't really understand just how toxic the product is that they were selling. Now, those are two examples, money market funds, credit default swaps and over-the-counter trading of derivatives. There are reforms, but they don't apply, and they can be evaded. We could go on and talk about the credit rating agencies, which I don't think have been meaningfully reformed. We could talk about bank capital, which Basel III does something, and the U.S. is trying to do more, but the real big questions will be whether or not there are strong liquidity ratios adopted, and that's still to come. That could happen, but that's still to come. So, those are a quick list of three. I don't know how many more you have time for.
Mark Hamrick: Well, I do appreciate you sort of highlighting them in a sense of priority there. And as you were talking, I thought about the fact that you're really highlighting the problem of regulators essentially not getting the job done. And as you said, the industry or industries have been largely …
John Coffee: Regulators are constrained both by their lack of resources and by the incredible lobbying power of the industry. There's no more powerful lobby in the United States than the financial services industry, and I think they have dominated the last two years because the issue is off the headline stage. It's not on the front page of the newspapers. And it's only the professional lobbies who understand the detail. And the devil is in the details.
Mark Hamrick: Sure. And then you know, I think the average person tends to think, tends to think that congress is most at risk of being substantially lobbied. But you're underscoring a problem that the people who might traditionally be described as bureaucrats are also substantially at risk just because of the reasons that you're citing.
John Coffee: I think there's two linked phenomenon there. They are being lobbied and pressured, and they know that lobbies can go over their head to the White House. But there's also the revolving-door phenomenon. The people in the financial regulatory agencies are intelligent, hard-working people who don't plan to be there forever. They want to go back to their partnership and law firms and investment banking firms, and they don't want to be seen as a typical iconoclast. They want to be seen as someone who helps the industry cope and deal with these regulatory problems.
Mark Hamrick: What do you think individuals can or should do if, in some sense, the government is failing them with these solutions? Obviously, they can try to lobby Washington, but is there any financial behavior they could engage in to try to minimize these risks?
John Coffee: Well always, I think individuals should diversify. If you get all into one thing, whether it's municipal bonds, equities, securities, you're exposed to risk. I think you do need professional advice. Frankly, investment is not a game for amateurs.
Mark Hamrick: Professor Coffee, thanks so much for your time.
John Coffee: Very good.
Mark Hamrick: That's professor John Coffee of Columbia Law School in New York. You've been listening to "Special Report" from Bankrate. For more on the unfinished business of financial reform and other personal finance issues, visit Bankrate.com. And you can follow us on Twitter @Bankrate. You can also catch our weekly podcast, "Your Money This Week." I'm Mark Hamrick. Thank you for listening.