In last Saturday’s edition of the New York Times, Joe Nocera wrote an interesting piece outlining some of the major obstacles currently facing the House Financial Services Committee.  The agency, which considers measures ranging from the banking industry to economic issues to insurance, is responsible for drafting a new financial reform package on behalf of the Obama Administration.  At the heart of such a proposal lies the creation of a new Consumer Financial Protection Agency (CFPA), one which would regulate mortgages, credit cards, debit cards, installment loans and other financial products issued by financial institutions.

On the surface, such an agency would serve as a boon for US consumers.  For example, the agency could potentially reign in on some of the banking industry’s most questionable practices, such charging consumers egregiously high overdraft fees when they overspend on their debit cards.  In the past, banks were more apt to simply reject purchases by consumers who overspent with their debit cards.  Now, banks reap billions of dollars annually off such charges.  Other proposed regulations range from forcing brokers to spend more time explaining mortgage products to consumers to curtailing unannounced hikes in credit card fees.

Why is such legislation justified?  Well, after the near-collapse of our financial system in the past year, it has grown abundantly clear that the financial services industry must change its practices.  After all, we, the taxpayers opened our wallets for the Troubled Asset Relief Program to the tune of $700 billion.  A message must be sent, loud and clear, that the risky, irresponsible practices of the past are not to be repeated.  Part of the government’s role as chief rescuer is to hold these institutions accountable for their actions by 1). collecting on their TARP loans to the banks, while 2.) instituting new regulations preventing  the risk of moral hazard.  However, these two responsibilities are not one and the same…

As an example, take Citigroup and Bank of America.  Citigroup received $50 billion in TARP funds last year, in addition to receiving $306 billion in US Government guarantees on troubled assets.  Likewise, Bank of America received $45 billion in TARP funds, to go along with $118 billion in troubled asset guarantees.  The two, amongst the largest consumer banks in the world, are hugely indebted to the US Government.  Yet to the surprise of few, neither has repaid a cent of TARP money to date.

If the new House Financial Services Committee places more stringent controls on the banks, such as limiting overdraft fees, these banks could miss out on billions of dollars in revenues.  Placing caps or limits on credit card interest rate hikes could have the same effect.  This lost revenue, while protecting consumers (mainly, the minority with the weakest credit histories), would effectively hurt the US taxpayer, and further dampen the chances that the US Government fully collects on its loans to the banks.

Coupled with this, many of the more traditional revenue streams for these banks earlier in the decade have since dried up.  For example, with the housing industry’s continued struggles, banks cannot rely upon the heavy fees previously generated through the bundling and selling of mortgage-backed investment products.  Likewise, after being caught with over-levered balance sheets over the past few years, banks have considerably cut back lending to businesses and consumers.  Instead, many are shoring up their balance sheets to meet appropriate reserve levels.

So, what does this proposed legislation ultimately mean for the big banks, consumers, and taxpayers?  For the banks, such rules will force them to abandon formerly profitable practices and seek out new revenue streams.  This could be accomplished through several means.  First, they could sell company assets, as Citi did by selling Phibro, its profitable energy trading (albeit, controversial) business, just last weekend.  However, the selling of assets is not a sustainable activity over the long run.  Rather, the banks are much more likely to cut costs (lay off workers, close branches) or hike up consumer fees in other areas (think higher ATM fees and account charge hikes).

For consumers, the new CFPA will look out for their interests, serving as a watchdog for banking practices it finds unscrupulous, irresponsible, or even predatory.  That’s great, especially for the 10% of consumers with the poorest credit histories-those largely responsible for paying hightened fees for services like debit card overdrafts.  However, in forcing the banks to abandon practices it finds unacceptable, the agency indirectly forces these banks to seek revenues in other areas.  For example, by protecting the consumer who overdraws on her debit card account each month, the agency’s actions could simply force the banks to raise standard fees on all customer ATM withdrawals.  In other words, in return for protecting the interests of a minority of consumers, legislation could simply force banks to raise fees for ALL customers.

Lastly, we have the taxpayer.  Ultimately, you benefit when the banks repay their TARP funds.  As such, you need the banks to continue to increase revenues, grow, and flourish.  However, from the taxpayer’s point of view, the CFPA could inhibit this from occurring.  By placing more controls on the industry and limiting its ability to generate the necessary income, the agency could serve as an obstacle to these banks’ attempts at recovery.

When it was launched last October, the Troubled Asset Relief Program was widely lauded as a means of preventing additional bank failures.  Thus far, few can argue that the program has positively affected the financial landscape and reassured investors.  However, while it appears necessary for agencies such as the CFPA to prevent future abuses by ramping up regulations, those same regulations will undoubtedly inhibit some banks’ abilities to repay TARP funds.

For the Obama team, encouraging a more traditional, “bread and butter” model for the big banks is necessary to appease the needs of an industry, consumers, and his taxpaying constituents alike.   Yet, as you can see, introducing new regulations is a sensitive issue which can produce a variety of consequences to multiple parties.  Perhaps above all else, he must promote a sustainable industry model which ensures the banks’ ability to repay TARP funds without resorting to the same sort of wreckless behavior which brought about this crisis in the first place.  After all, as novelist George Santanaya once wrote, “Those who cannot learn from history are doomed to repeat it.”

Tags: Add new tag, Bank of America, banks, brokers, citigroup, Consumer Financial Protection Agency, debit cards, financial products, George Santanaya, House Financial Services Committee, industry, New York Times, obama, overdraft fees, Phibro, regulations, TARP, taxpayer, Troubled Asset Relief Program, US Government

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Hedge fund regulation has long been a subject of debate, with the SEC pushing for tighter restrictions and managers doing all they can to avoid it. Both stances are understandable. Managers are known for their ambiguity. They provide just enough information to investors, but usually leave the tedious information about specific strategy details and asset allocation to themselves. The federal government and SEC claim to be looking out for the investor.

After the dozens of crimes involving hedge fund fraud over the last decade and the millions of dollars bilked from investors, the SEC rationalizes that somebody should step in to quell this epidemic of smooth talking swindlers. For that matter, even reputable names like the one time Bear Stearns don’t always adhere to the best practices.

Two hedge fund managers at Bear who are responsible for the implosion of two billion dollar funds swore to investors that the fund was doing fantastic. Performance reports showed no worries. Only internal emails to each other highlighted the scare and warned of the future demise of the fund. Could tighter regulation have prevented that problem? The SEC says yes.

In 2006, the SEC passed a rule that all hedge funds would have to register as investment advisors, only to have it overturned by the federal government. Dozens of high profile hedge funds wrote letters explaining why hedge fund regulation would result in more bad than good and that the SEC was overstepping the boundaries of its jurisdiction. Others argued that investors in hedge funds are highly sophisticated and they don’t need protecting. There are already rules set in place as to who may invest in a hedge fund, and as long as the investor knows there is risk involved, it is ultimately his decision.

Federalism then forced the arguments into the state’s hands, while some states pushed for tighter regulations and others like New York and Connecticut opted against it. After California called for stricter measures, it was ultimately overturned earlier this year after many prominent hedge funds expressed concerns that regulations would only push hedge funders into other states while taking their vast incomes and purchasing power with them.

One of the reasons that managers oppose greater transparency is the need for secrecy in their strategy. Since hedge funds may entertain a wide variety of strategies and combination of strategies, managers are very reluctant to let others view their moneymaker. Once a strategy is exposed, other managers may follow suit leading to the drying up of the waterhole so to speak. Particular strategies are the product of the brilliance behind the manager and other integral members of the staff and therefore do not want to be given up.

Also, since most hedge fund strategies are so complex, many investors might not understand the entirety of it anyways. Why disclose something that would only aid in confusion? Another reason is the obvious need for the non-disclosure of price. Buyers typically want to buy at the price you paid for it, not under the circumstances where you are going to make a killing off what they pay.

Size also correlates to the amount of transparency involved. Smaller, newer funds may have to disclose more information in order to attract capital and new investors. They may have to be entirely open on where investments are going and how they are allocating the cash. Larger, more established hedge funds are a different story. They may have an abundance of capital and are therefore not concerned with attracting new investors. If this is the case and the money is already locked up, they may become very secretive and start investing in riskier securities or use outlandish strategies to start reaping high returns in a short time frame.

But what is the investor’s role in all of this? Do they typically side with the openness pushed for by the SEC or the hush hush tendencies of hedge fund managers? One might think this is an obvious answer, with investors wanting to know exactly where their millions are going. But recent trends show just the opposite. Apparently, when it comes to hedge funds, trust is the key word.

Managers that have worked in the industry for years generally have a vast number of contacts and have gained the trust of many affluent individuals. I doubt that John Paulson, the man whose hedge fund has returned billions for investors, has to sit down and convince people of his accolades. If trust is directly related to experience, then established managers should have no problem recruiting investors.

Regulation or not, it is ultimately up to the investor to make the final decision. The SEC will never stop funds from collapsing, no matter how much light they shed on them. If hedge funds could promise massive returns and no losses, then everybody would invest. Reward only comes with risk. It always shocks me when investors are dismayed over an asset freeze. This is a real and distinct possibility that you knew could possibly happen going into the fund. Not that I think it’s fair or right. Keeping someone from their own money seems somewhat illogical. But still, it’s a pretty common practice. Some hedge funders just want to ride a bad wave out in the market and want to focus on strategy rather than dealing with withdraws and the liquidity crunch that would ensue. Unfortunately, a lot of the times, a redemption freeze is a precursor to the fund’s closing. These are things to think about. An investor in a hedge fund holds a certain responsibility.

Some choose to spend the money and perform a due diligence check. This is a smart idea and will raise any red flags in the manager’s past. Others choose to bypass this slightly expensive process and take faith in the manager. Whatever sleuthing they choose to participate in, the investor is always going to be exposed to risk. But the lure of the $3 trillion hedge fund industry and the very real possibility of massive returns will always ensure that there is no shortage in interest.

Tags: hedge fund managers, investor, Not Categorized, regulations, SEC, strategies

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