Facilitating dialogue to promote open and multi-faceted discussion and awareness

After all-night deliberating and concessions, members of Congress concluded legislation at around 6 AM on Friday, June 25th. This has been called the greatest sweeping piece of financial reform since the economic depression of the 1930′s. Many have called for greater regulation over major banks, insurance agencies, and “shadow markets” since the final and official repeal of Glass-Steagall in 1999.  Here are some of the important parts of the bill:

The Volcker Rule, named after former Fed Chairman Paul Volcker, made it through, but just barely. The original intent of the Volcker Rule was to separate commercial banks that are federally insured from investment banks that are involved in proprietary trading, and to keep these institutions between switching between the two types of banks. However, the piece that made it through this reform bill was a bit watered down, allowing banks to participate in private equity and hedge funds with up to 3% of their 1 capital. Another piece to this rule gained entry into the legislation, known as the “Hotel California” provision, preventing commercial banks from converting to investment banks and vice-versa.

The government’s oversight has significantly increased over financial markets as well. The bill grants the government resolution authority to break up big institutions that exhibit substantial systemic risk in an instance in which they may fail. The Treasury would initially provide funds to wind these Too Big To Fail (TBTF) institutions down, but a repayment plan is still pending. A new council is created to manage this task, known as the Financial Stability Oversight Council, given the responsibility to manage and analyze risk of the biggest institutions that may pose systemic risk.

The Fed made it out of legislation nearly unscathed. They are required to submit to a one-time audit on discount window lending that occurred between December 1, 2007 to the present. This was a scaled back piece of the legislation, bringing together the likes of Ron Paul (R-Texas) and Alan Grayson (D-Fla.) in the House.

Derivatives took a beating…. kind of. Derivatives, complex financial products and of which the famed MBS (Mortgage-Backed Securities) consist of, are coming under regulation for the first time. Under this legislation, routine derivatives are now to be traded in exchanges and siphoned through clearinghouses. “The Commodity Futures Trading Commission (CFTC) will emerge from the financial reform bill, which is close to completion, with a large new remit, authorised to look beyond futures exchanges to the $615,000bn privately traded over-the-counter derivatives markets.” This provision, proposed by Senator Blanche Lincoln (D.- Arkansas),sparked mean fight in legislation, and concessions were made to come to an agreement. The provision originally intended to pressure banks to spin off derivative-trading arms into separate, capitalized subsidiaries. A few kinds of derivatives are exempt from spinning off of commercial banks, including: interest rate swaps, foreign exchange swaps, credit default swaps, banks hedging their own risk, and gold and silver.

A new Consumer Protections Agency within the Federal Reserve made it through the legislation as well. More power (and eventually resources) were granted to the SEC to review credit ratings, an issue that arose during the crisis when ratings agencies gave AAA scores to badly underwritten and incredibly risky MBS’ and CDOs. Another issue with the ratings agencies was the moral hazard created between corporations that pay for ratings, and then agencies rating those same firms. The SEC is granted the authority to fine raters and to even de-register if one gives too many bad ratings. Hedge funds must now register with the SEC and provide information revealing risk in transactions. Also, holds broker-dealers to a greater standard, similar to investment advisers registered with the SEC. The SEC also now monitors and ensures that shareholders have more say in corporate governance, allowing shareholders to nominate directors for their respective boards and grants them a non-binding vote on executive compensation.

On top of all these provisions, last minute legislation included a $19 billion tax on large banks and hedge funds to pay for some of these programs and raised within 5 years.

Now, whether more regulation is the answer, that is up for discussion. There is a prime authority that may resolve TBTF in a more orderly manner than a collapse of a firm that may have significant effect on the market, presumably ending the issue of federal bail-outs. Many of the issues that caused the crisis are addressed in this legislation like derivatives, ratings agencies, systemic risk, TBTF, and executive compensation and moral hazard. To the chagrin of many, one 800 lb. gorilla sitting in the room was not addressed: GSE’s Fannie Mae and Freddie Mac, whom had underwritten nearly half of all subprime mortgages and has been leaking money since the dawn of the crisis. These firms have already been de-listed and recent CBO reports have the costs of maintaining these firms approaching $400 billion. The largest sweep of financial regulation is now prepped and ready to be passed, we will see what happens next….

I got a real-life example of a fundamental idea in the study of economics a few months ago I’d like to share with you today:

It was finals week and I was sick. Now, I’m a pretty healthy guy (although since getting married this past summer I’ve probably accrued a little more mass then normal…), but this was deathly ill. My esophagus was on fire, my lungs felt like there were hands squeezing them inside of my chest, and it’s about the point of near death or coma that I tend to decide, “Yep, maybe I should go to the doctor…..” There’s a Walk-In Clinic on the south-side of town that everyone from my school goes to, so I assume this guy must really like college students, or at least he’s been pretty successful in my demographic. So I walk in about 9:27 AM adorned with the typical sick garb (blazoning sweat pants and puppy-dog sad face). I wield my insurance card, implementing the dual “I need a doctor”/bellowing cough trick to express the gravity of the situation. “Fill this out with your information and we’ll be right with you.” Blast. So I sit and scan through a Healthy Living mag till I’m finally called in. The nurse takes my weight, blood pressure, height, barometric pressure, and gravitational pull on the earth… and then tells me to wait in the room two doors down the hall on the left.

There isn’t much going on in this room. There’s the cotton balls, the ear-temperature thingy hanging on the wall, the bed with crinkly paper, it’s all there. A poster displaying the skeletal structure of the human left foot hangs on the wall to my right, and in front of me is a blue poster of XYZ Nasal Spray explaining it’s miracle effects on the sinus system. After my first impressions ease my sub-conscious fear of evil, scalpel-happy doctors, I notice the sound of the doctor walking down the hall towards my room. And it’s here where it gets interesting.

He walks in and with an Indian accent he hurriedly offers a greeting and proceeds with the poking, prodding, and analyzing. It literally took about 3 minutes and he came to his diagnosis. “Respiratory infection. Take 3 Ibuprofen every 4 hours, pick up these antibiotics, here’s a $20 off coupon for this XYZ Nasal Spray you’ll need, and hydrate yourself….”. And with that he walked out. I payed the $60 bill for a meeting that took less then 5 minutes (do the math, that’s $720 an hour, and that was with a health insurance discount!). Regardless, I just wanted to get out, get drugs, and get better. I rushed to the pharmacy to get my drugs.

More waiting in line….

Finally, I’m at the register in the pharmacy, and I pull out my prescription and my credit card, and my student i.d. accidentally falls out. The amicable pharmacist noticed the card, and went on to tell me a story about her experiences when she got sick and she was at college; all the while her fingers flying at 80 mph on the computer without hesitation. “Impressive,” I thought, “but lady, please, I’m losing this fight and I need your wonderful medicine!”

It was at this point she did a double take between the prescription, the computer, me, and back again. “I know your in school, and money’s probably tight, so I’m going to let you in on a little secret. This XYZ Nasal Spray you’ve been prescribed is pretty much useless. It doesn’t really kick in till almost two weeks after it’s administered, and you will surely be feeling better by then. Also, WITHOUT this XYZ Nasal Spray your bill comes out to about $23, WITH this XYZ Nasal Spray your bill comes out to about $150, even with this joke $20 coupon.”

WOW. I left with a $23 bill and a sick feeling like I’d almost been jipped. All the talks I’d heard about the sanctity of the doctor/patient relationship kind of gave way to a simple doctor/profit-from-sponsor-drugs kind of a relationship.

What did the doctor have that I didn’t in this situation? What did the pharmacist give me that really helped me out in this situation? Information. The economics of information is a fundamental facet in the study of economics. In Economics 101 we learn that in a nominal world, information is “perfect”. Information creates an optimal condition for decision-making, therefore increasing the utility (benefit) gained from a mutual transaction for both parties. When one party in a transaction holds more information then the opposite side of the transaction, it’s known as information asymmetry, which creates an uneven balance of power in the transaction process. In the situation above, both the doctor and the pharmacist had more information on the usefulness of XYZ Nasal Spray then I did. The doctor did not share this information, leading me to believe that in order to attain the utility I was seeking (feeling better) I needed this medicine. The pharmacist was willing to share the information with me, letting me know that this medicine was of no good for my situation.

Granted, information is exponentially more accessible now then even a few decades ago. A brilliant invention, the internet, has created a mind-blowing cyber-library with information on nearly every single topic one can imagine. But even then, in the midst of a transaction, one may be limited to the information at hand while the other may have all the information to maximize his/her utility (this would be a great business venture, maybe a mobile phone application that details the benefits of medicines prescribed or the ratings of a certain doctors office, both options granting access to information). We recognize that in the Real Economy, information is not always perfect nor absolutely revealed in a transaction, hence often creating micro-distortions in the hundreds of millions of organic transactions taking place everyday. And theoretically, these micro-distortions can cause incredible distortions on prices of medical care (pretty hot topic nowadays…).

Also, when one finds out that the other side of a transaction is working and benefiting from information asymmetry, it breaches the trust of a transaction. Trust is another fundamental moral principle foundational to the workings of a free market society. Honesty and the punishment of both coercion and fraud. This experience has birthed in me an unhealthy (or maybe healthy) suspicion of the industry of medical care and doctors visits. It’s those kinds of feelings and experiences that drive societies to place regulations on industries in order to maintain “open-air” in transaction environments, a reactionary effect that may further manipulate the market, price levels, and perpetuate the distrust of business and industry.

We see from above that information is vital and beneficial to economies. Information asymmetry only builds distrust and more power for one side of a transaction, where as free and open information precedes a mutually beneficial transaction. Hopefully that doctor will learn one day, and if not maybe the amicable pharmacist will continue to help poor college students like me that may find themselves sick in the middle of finals week. Regardless, information in transactions is vital for success in the Real Economy.