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Forbes: Now quickly on Dodd-Frank. In addition to this massive regulatory spewing out, there seem to be several things that are wrong here. One, if you could quickly explain – it sort of codifies too big to fail. It has a wild regulatory agency embedded in the Fed.
Malpass: You’re taking the easy ones. Let’s see. Yeah, it has made too big to fail the law of the land. That’s what we wanted to avoid. And yet, they’ve identified big institutions. Within the Fed – and this is particularly grating, because the Fed is so profitable – they’ve taken a portion of the Fed’s budget that won’t now go through Congress.
Forbes: But let’s stick for a moment on the other thing, in terms of – if you could explain it just a little more.
Malpass: Okay. The federal government, ever since we’ve had FDIC insurance – I was talking with Amity Shlaes the other day, and she was explaining that this came out of the early part of the 20th century. As FDIC insurance rose, there had to be some rules on, “Is the government guaranteeing bad behavior for banks?” We don’t want that. And so there arose this worry that a bank would take big risks, and then if it failed the government would bail it out. It creates a very bad incentive structure. So with Dodd-Frank, they were hoping to stop that. Because clearly in 2006 and 2007, the big financial institutions were taking bigger and bigger risks. Because in a way, it wasn’t their money.
They were gambling with the government’s money. So, I think there was the right intention out of Dodd-Frank, to say, “Let’s stop that.” The way they ended up drafting it, though, it enfranchised this whole concept that there are some banks that are so big that they would endanger the financial system if they failed.
And so they’re going to get a different regulatory structure than other banks. And the problem with that is going to be that they’ll be turned into utilities, basically. Where the electric utility doesn’t care too much about –
Forbes: Cost plus?
Malpass: It’s cost plus.
Forbes: And they get better borrowing costs.
Malpass: And they get a lower rate, because they’re stable. But they’re kind of told what to do and they don’t care about innovation, because they’re going to get to add 15% to their costs, and pass that through to their customers. That’s already happening for the big banks.
And it’s harmful – particularly harmful to the U.S. competitive structure against foreign countries – because they won’t have the same constraints. So I think their larger banks will be innovating circles around our banks. It’s bad. It’s a bad, bad, lose/lose outcome for the U.S. Also in Dodd-Frank is this consumer regulatory agency that has unbounded power, sitting inside the Fed with unlimited money to hire lawyers to attack financial institutions around the country on the grounds that they’re making too much profit.
We’re seeing it already with debit cards, where Congress wants to regulate how much a bank can charge. And, oh, by the way, if you make good campaign contributions to Congress, maybe they’ll go easy on your type of debit card. It creates a whole new layer of corruption in Washington, where the campaign contributions are tied to this plethora of legal angles that are coming out of Dodd-Frank.
Forbes: Dodd-Frank derivatives.
Derivatives Rules
Malpass: I wanted to – oh, well, derivatives. I want to mention first the resolution authority. They’ve given massive new rules to the FDIC and other regulators to intervene on banks before the bank declares bankruptcy. And that has a risk of them being able to pressure the bank, the shareholders, the executives, way beyond their normal regulatory authority.
It used to be that companies would decide when they went bankrupt, and that was part of the negotiation with their creditors. And it worked, I think, as a system. We have a federal bankruptcy code. They’ve cut through that and created a brand new process that is untested, can easily be politicized.
Meaning, if you’re on the wrong side of the FDIC and you have a couple of bad years, as far as profitability, they may take your ownership away from you. That’s going to mean less capital goes into these institutions, less innovation, and I don’t think it ends up making us safer in the long run. You mentioned derivatives, another huge area of problem in the bill. You know, that was almost intentional. Remember when they wrote the bill, there were campaign contributions being made to change the way the outcome of that bill was written.
And so what they did was wrote it in a very unclear way. And I don’t know how they’re going to sort it out. Under the way it’s written, the regulators can do anything they want with derivatives markets. It’s of vital importance to New York City, because it’s in competition with Chicago and with London all the time. The details of how this comes out are going to matter where they move the business. And it’s not decided yet. What do you think?
Forbes: It’s a huge source of power.
Malpass: Yeah.
Forbes: But emphasize your point – it also means a company like Deutsche Bank can go to an American company and say, “Hey, cut through this stuff and do what you need to be done.”
Malpass: Exactly right. If we have the most uncertain rules, then it means the other guy has an advantage in it. And you know the derivatives are – we ought to talk about what they mean. One of the big areas of derivatives is interest rate derivatives, swaps.
Forbes: Right, swaps.
Malpass: And the reason that that is the giant market and giant profit maker for banks, is because the Fed has set interest rates from 6% down to 1% in 2003 and 2004, up to 6%, and down to near zero. And so, you need these derivatives as a hedge against what the Fed is going to do. So it’s created this gigantic market that’s profitable for big banks. We’re talking about a very narrow group of big banks that play. And the loser on it is the economy as a whole. Everybody has to pay one cent at a time into paying the profits that get concentrated at the big banks.
Also, current foreign exchange transactions are a different big source of derivatives, and it’s doing the same way. Big companies can hedge against the dollar risk, the weakening dollar, and that costs the little guy across the country. So we end up with this burden on the small businesses.
Forbes: It’s the corporate state again.
Malpass: Corporate state.
Weak Dollar, Weak Recovery
Forbes: The thing on the dollar – weak dollar means weak recovery. Explain how destructive that is, and then we’ll discuss QE2.
Malpass: The world is constantly in a race to the top, in terms of there’s a limited amount of capital and you’ve got to figure where it’s going. And if your currency is weakening, that means you’re paying a load. That every year the dollar goes down 5% in value, so your investment in the U.S. is going to have to be 5% better than the one somewhere else in the world.
And remember, profit margins aren’t that big. 5% is enough to sway almost every investment to go abroad. So as we’re trying desperately to create jobs here, we’re getting hammered on the other side by the capital flowing away from the U.S. And it shows up in the data. Jobs, where is there giant job growth? Well, it’s going on in Asia, not in the U.S.
A Desperate Fed
Forbes: Now on QE2 – what was the point of the exercise? On the one hand they bloat the balance sheet. But on the other hand, they in effect sterilize it by offering the banks a nice rate to keep it at the Fed.
Malpass: That’s right. You know, I think the Fed – some part of it was desperation. The Fed wanted to do something. The pressure in Washington, there was an intense pressure by politicians, by the White House, on the Fed to say, “Look, the economy’s falling into a double dip.”
Remember in the summer of 2010, there were a lot of economists that were sure we were falling back into a double dip, because they couldn’t – they weren’t being allowed to do more fiscal stimulus. I’ve been surprised, though by the White House even up to today. I was watching the morning TV shows and they were still talking about the need for more federal spending. And if we don’t get it, the logic went, well, maybe the Fed will do it. We need to do something. And so, the Fed said, “Well, we’ll buy some assets.” The risk of that is, for the next 20 years or 40 years, any time the economy slows a president is going to turn to the chairman of the Federal Reserve and say, “Why aren’t you buying assets?”
And remember, the Federal Reserve is beholden to the political establishment because of the nomination of the chairman. That position is controlled by the White House, with the advice and consent of the Senate.
And the same for the governors within the Fed. And that process actually now extends to the Federal Reserve banks around the country. And so they’re beholden, and that means if you have the power you should use it. Help the country, buy some assets. So they start with Treasurys. But why not buy real estate? Right now real estate asset prices are low. So the argument can be made – and will be, I think, over the next ten years – the Fed should be out there buying shopping centers. That’d help puff up the price of shopping centers.
The Fed today, of course, will say, “No, no, we’d never do that.” But then a year ago, they would’ve said, “We’re never going to buy Treasury bonds either.” So they did it, I think, to respond to political pressure. I’m sure they had some idea that, in economic terms, it might be helpful if they borrowed from the banks and bought long term treasuries.
Though, I’ve never understood. It just doesn’t make sense that that would be very powerful. And look what happened. We got very little pop in the economy, as a whole. I think the equity market would’ve gone up anyway in 2010, in late 2010, because there wasn’t a double dip. Growth was coming back, the U.S. was doing pretty well. So, my view is, QE2 has actually been harmful to the outlook because it diverted everybody’s business acumen to staring at the Fed and saying, “What are they going to do next?” So, every CEO around the country has probably been spending more time on QE2 than on efficiency gains in their own corporation.
Forbes: So even though the Fed, in effect, sterilized much of that, commodity markets looked and said, “They created the money anyway, distorting the capital markets.” Is that why they went up even though it wasn’t thrown out in the marketplace?
Malpass: I think the value of the dollar is set by your long term confidence in your Central Bank. So we had a Central Bank that went way beyond the normal rules. Let’s say what a Central Bank normally does – it buys Treasury bills and then banks lend the money. They inject funds by buying short term instruments and the banks go lend it. And that’s stimulative. Milton Friedman pointed out we ought to be on auto pilot, because you don’t really want the Fed even responding to the business cycle. Well, we’ve gone way beyond that, I think, into meddling by the Fed.
But now, in this latest round, the Fed said, “We’re going to buy long term assets, and we’re going to lock up the banks’ money for ten years, for some of these longer duration assets.” So it’s a huge expansion of the Fed’s involvement in the economy.
And so, if you’re thinking about the future value of the dollar, you’ve got this risk that any time the U.S. gets into trouble, the Fed’s going to buy up stuff and put itself at risk. It makes you less confident in the Fed and, in contrast, more confident in the ECB. Why is it that Europe, with all its debt problems, has the euro strengthening quite a bit against the dollar? Well, it’s because their Central Bank would not do this type of activity.
Can We Turn It Around?
Forbes: Pretty grim scenario. In conclusion, is it possible to turn this around the way we did in the early ’80s, from a decade of malaise?
Malpass: You know, I’m an optimist, Steve, I think that we could, and we can zero in on a couple of things that could be corrected pretty easily by the president. The president should be spending less money. He should ask for power from Congress. If he’s frustrated by his powerlessness over it, ask for the power and spend less.
And then on the dollar. The president, any day of the week, could literally say to the Treasury Secretary and the Fed, “You know, I’d rather have a stronger dollar. It’ll bring capital back to the U.S. We’ll get some jobs.”
He could say that and the markets would not stand in the way of that. The market, remember, loves momentum. Everyone short the dollar right now, they’d scramble to get long the dollar, to start creating jobs here. And so it can be turned around, I think, in a very short period of time.
I don’t mean to minimize the longer term problems. We’ve got a bad tax code. It’s very hard for Congress and the White House to work together on fixing it. People know kind of how to do it, but that’s going to be a long negotiation. They all agree that we, on the corporate rate, should have a lower rate on a broader base. But you’ve got to work out the details.
So, I’m not saying that problem can be fixed overnight. And on the spending side, you’ve made promises on entitlements. And so you’ve got to walk – you’ve got to gain confidence in the voters that you know what you’re doing and then propose very reasonable reforms to walk some of the excesses back. For example, on Medicare right now, there’s nothing in the incentive structure that causes the doctor to want to give you good care at a reasonable price. His incentive is to use as many procedures that are scored well by Washington.
Anyway, so we can’t fix everything. But we could fix these two problems. The government’s spending too much money and has a weak dollar policy. Start there, I think we’d start creating jobs.
Forbes: And roll back the corporate state?
Malpass: Well, that’s going to take us – I think we’re literally going to be at this 20 or 30 years to undo the damage that’s been going on. You’ve got to get at the core of this. Sarbanes-Oxley, the mark-to-market problems, the Dodd-Frank problems, unroll that. But in every area of government – the EPA is expanding its power. The contracts coming out of the stimulus bill – there was a good article in The Wall Street Journal in May talking about a contract in New York State, where the federal government is specifying, basically, that it be a union contract, and not cheap, on the expensive side.
They’re providing the money, so they say, “We can spend as much as we want into that contract.” Rolling all of this back is going to take fights, I think, in each area, all based on the Constitution. The tenth amendment said the federal government is supposed to only have powers that were explicitly given in the Constitution.
I think the federal government’s gone way beyond that. The Constitution never said that you could have a Federal Reserve that would have $2.8 trillion in assets. We’ve gotten out of control. I think that needs to be walked back. It’s going to take years and years. But the starting point is the president’s got to spend less and have a stronger dollar.
How Did This Happen?
Forbes: A final question. Even though this administration’s been on steroids in the corporate state, how could a free enterprise government under the previous president have gotten this ball rolling the way it did? What, didn’t they know what they were doing?
Malpass: Huge disappointments. One was, I’m of the view that the regulatory power was not properly used, even in the 1990s. They’d been told that they should leave the banks alone and the investment banks alone. And so they got to be over leveraged. Fannie Mae and Freddie Machad been building up for 20 years, really, as these deeply harmful institutions in Washington that were controlling the mortgage structure of the country. So you had that. You had the Federal Reserve, remember, putting in an absurdly wrong interest rate for years, in ’03 and ’04, and then even extending into ’06. The U.S. was arguably 2% or 3% below where it should’ve been on the interest rates.
Forbes: I.e., cheapening the dollar.
Malpass: That was weakening the dollar, putting money into Asia, into commodity prices – all eroding the U.S. net worth.
Forbes: And why, even today, even bank CEOs don’t see the harm from mark-to-market? What it did to their capital?
Malpass: You know, they’re part of the system. I think they’ve become the corporatist state. And so, mark-to-market problems hurt the newcomer – the new bank, the small bank. That’s not the problem of the big bank. They’re working out their deal with the regulators constantly. They live with the regulators and with the Basel 3 standards that are being set up. So, they’re looking to maximize the three year timeframe, their bonus window. And that’s not really good, I don’t think, for the long term health of the country.
Again, I don’t think we can criticize them. They’re looking at the incentive structure that’s being provided by the law of the land, the federal government regulatory authorities. They’re going with it. What we’ve got to do is get into the Washington system, and roll back some of that.
Forbes: David, thank you.
Malpass: Thank you, Steve.
source: forbes.com
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