by Daniel Stafford, President, Securities Finance LLC
(www.securitiesfinance.com) email: dws@securitiesfinance.com

"Patience and perseverance have a magical effect before which
difficulties disappear and obstacles vanish."

- John Quincy Adams

There is no doubt many a small financial firm owner in America these days wishes it were as simple as the famous Adams’ maxim implies.

Unfortunately the truth is not so benign.

I confess that I was tempted, as I watched the top brass of venerable Goldman Sachs squirm through yet another round of emotional attacks during the U.S. Senate hearings last week, to fall right in behind just about everybody else in the country. I confess to an almost visceral compulsion to jump on board and lay the blame for our economy’s miseries on something as neat and easy to label as Wall Street Fat Cats. After all, wasn’t I watching greed incarnate on my screen? Emails from arrogant money men with four-letter words for the products they were pumping? People who were pleased to see poorly disclosed mortgage-based securities they had hawked drop into an abyss causing massive losses to investors who had trusted them to fully disclose the weakness of the securities?

The plain truth is that it’s very difficult for most any human being to watch the hearings, where the beleaguered Goldman brain trust is captive to both journalists and an unfriendly Congress, without leaping right on top of the anti-Wall-Street bandwagon. Like a powerful undertow at the beach, you feel your options are somewhat limited unless you struggle with all your might.

And then there’s the culture-media backwash as well, and a populist president who had pointed the way. His view, shared by many in his party and elsewhere, is that our recent economic meltdown was principally caused by the reckless trading of mortgage-backed derivatives and these very same Wall Street greed merchants. End of story. Mostly unregulated, Goldman, Lehman and a host of others, according to this version of history, interacted in one way or another with these instruments to destabilize the entire financial system and bring it to its knees globally.  The antidote and only prophylactic that will prevent a reoccurrence is the financial reform bill along with a new agency to protect consumers.  In other words, if you accept A – the culpability of Wall Street - as factual, then we must have B – the Obama administration’s reform bill – as the antidote.

Except for a discussion of whether the taxpayer should bailout out large failing financial institutions, as I write this critics have been mostly silenced into election-year agreement, unwilling to be portrayed as friends of the pinstriped folks who are responsible for unemployment and a deep recession.  (A silly position, since both Democrats and Republicans and even Independents have happily accepted campaign donations from huge investment banks for years). Populist Democrats in particular have shown no hesitation to use the “Wall Street buddies” card to the max. Even normally more cautious Republicans who tend to believe in less rather than more government intervention have find it difficult to come to the defense of Wall Street and by inference the greater financial world.  Facts and calm analysis are of less importance now. What is important instead is to take the focus off Congress’s role in the meltdown and economic distress and to quickly place it on a caricature of rich, well-heeled investment banks and brokerages, in a current headlong rush to find somebody to humiliate or “punish”.  A second victory for the Obama administration would be frosting on the cake, so this thinking goes.

One recalls other times of economic difficulty in human history when the financial industry made a convenient target for politicians and helped them rise to power. The National Socialist Party of Germany as early as 1934, in the midst of the worst inflation any nation has ever experienced, used the anger and pain of its citizens to focus attention on what the future Fuhrer portrayed as the “a banking and securities industry run primarily by Jews” in a chilling forecast of the anti-semitism to come. Blaming those with money has been a classic game of politicians when the need is to appeal for the votes or backing of people working class people who are suffering economically – even though in the same breath they are typically happy to accept campaign contributions from the very same persons they villify.

So it is a bit hypocritical.  It is also flat-out wrong.

One can understand why Congress would be in such a hurry to fix blame. First, it is a pivotal election year, when one or both houses could easily change hands. The electorate in the U.S. is deeply, deeply polarized in 2010, perhaps more so than at any time since the Civil War. Private militias have even sprouted up to grab headlines, while positions on both sides have hardened considerably. States like Arizona – exasperated by partisan politics with fed up with no resolution to the pressing problem of illegal immigrants, have taken matters into their own hands. Partisan, polarized politics now infuses every issue in the United States these days, and thus no decision, no new agency, no new bill, can hope to escape it.

One cannot envy those who genuinely seek compromise in Washington these days.

Second, Congress feels the need to quickly refocus blame off itself and onto some other culprit, and the supposedly rich pinstripe set on Wall Street are the best candidates during a time of economic hardship because they are the easiest. After all, who isn’t jealous of someone who is financially secure in times like these if they aren not? All but those who are doing well themselves..

However, it was Congress that first promulgated the politically very popular concept of loosening lending standards to give more citizens (read, lower income citizens) “a stake in the American dream” as Bill Clinton declared during his first presidential election campaign.  We so easily forget today, but back then the great lender sin was not to extend too many loans, but to extend too few of them. The papers were filled with trial lawyers finding patterns in certain types of lending data that they believed rose to the level of discrimination, resulting in costly law suits sprining up daily against banks and finance companies. We forget now, but back then the mere accusation, whether grounded in fact or not, of “redlining” – of not lending to certain neighborhoods on the basis of racial or ethnic criteria – was a virtual death sentence. The message was clear; loosen standards, and lend more. Do it. Or else.

Gradually, as the political wave of “more homeowners means more votes” pushed forward, it hit Fannie Mae, Freddie Mac, and Ginnie Mae right between the eyes. These quasi-governmental lending giants had always followed conservative, but open lending and made home ownership possible for millions of citizens with no unresolved problems over the years. But now the word had gone out from key Senators, including those who are now so strident in their attacks on the financial industry) that amiable relations with Congress would be tied to more loans to main street).  From the very finance committees that today point the finger at Wall Street for the financial meltdown came the directive from many different angles and sources: Lend more, give more people a stake in home ownership or else. Though no Congressman was ever foolish enough to specifically ask for lower credit standards it was clear that putting more primarily lower-income citizens into homes of their own was the rule of the day.

Was it such a bad thing after all? No. There is nothing inherently wrong and a great deal inherently right about wanting more people, more families, to have the opportunity to own their own homes. This very directive underpinned several housing programs of the 20^th center in the U.S., including provisions in the G.I. Bill after World War II,  and the creation of the FHA Mortgage Program itself. It was not the intention that was flawed, it was the failure to realize what needed to happen – the lowering of lending standards – to achieve that policy.

And thus they were lowered. Mortgage brokers relayed those loosened standards and did exactly what their jobs required to close loans for their clients. Some indeed were unscrupulous, without a doubt, pushing uneducated borrowers into financing they could not possibly handle. But the overwhelming majority simply went about doing their job. They got more people into homes of their own, even if at higher rates that those individuals should have undertaken.

Since those lower income people were often the least educated about home buying, a valid case can be made that much more disclosure and training should have been provided to them. But then the very same case could be made that people without the income to purchase a home should never have been encouraged to buy one in the first place, and that Congress should not have pressed for more loans to such borrowers to start the entire process moving. 

In fact, at the time everyone saw this as a win-win, across the board – something we all have apparently forgotten now. As a result of these loosened standards, more minorities and lower-income people were finally able to own homes, people who otherwise would not have had any chance to do so, or so the thinking went. More people were invested in their communities and neighborhoods too. The politicians, particularly those whose constituents were drawn from lower-income and minority ranks, were happy. Fannie and Freddie were happy, as Congress felt they were getting the job done, and they were profitable. Homeowners were happy, since more owners rather than renters tended to assist in supporting overall home resale values. And first-time buyers were happy as they could at last have a stake in their own property.

But how about Wall Street? Well, the directive would have been entirely toothless and short-lived had Goldman, Lehman, and others not stepped in to grease the financial wheels and keep the cash to the next round of prospective new home owners flowing.  After all, where did the cash for these Congress-pushed subprime loans come from?  Had there been no debt instruments for Wall Street to take off Freddie and Fannie’s hands, there would have been no way to continue the programs. The programs Congress had virtually mandated could not be sustained if Freddie and Fannie could not remain economically healthy, that is, if they could not move old debts out with new loan cash flowing in. So they allowed these subprime loans to be turned into debt obligations – CMOs or CDOs and similar instruments. These were then made available via Wall Street to investors. Cash flowed back in and back out, and the system was working, or so everyone believed.

But this happy world could not succeed for long, because it was built on the assumption that lower-income people would figure out some way to pay their mortgages on time despite their limited income. When the economy began drifting dramatically downward in the summer of 2007, the writing was on the wall.

This is the point when smart people realized that the mortgage debt securities were probably a lot weaker than they seemed. Some began to sell. Today critics say Goldman and others should have disclosed the underlying subprime mortgages in the securities they were selling, and that failure to make these disclosures is at the heart of their wrongdoing.  I would tend to agree. It was not wrong to sell the debt obligations to those who wanted to purchase them. But in so doing, they had an ethical, if not legal, duty to disclose the underlying component of those securities so that prospective investors could have the opportunity to make their purchase decision fully informed.

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Economist and other experts might make legitimate arguments otherwise, but to my way of thinking the end began when oil prices reacted to the uncertainties in the Mideast and the increased consumption by China and India by climbing to unprecedented levels in the spring of that year – above $135 a barrel for Brent light crude. Stunned travelers watched as everything that used oil – virtually everything in the economy - went up with it, with $4 a gallon gas being the most dramatic and keenly felt result. I still remember the gasps of shock I overheard while filling up my car at a Shell station near my home as motorists stood transfixed at pumps staring at an $70-$80 price tags for a fill-up that just a week earlier was closer to $30..

The decline in prices in the subsequent months was not matched with equivalent drops at the pump – which resulted in many accusations of price gouging against Big Oil. Coming in an election year, this provided rich additional fodder against oilman George Bush and his party, as opponents had still another popular issue to wield against an already unpopular president. But it also sent shudders throughout the American economy, as costs went up drastically and suddenly, and layoffs followed. That often meant that the least educated, lowest income people were pruned from the workforce first – the very people who were made homeowners by the earlier, overly politicized push to expand lending.  When the recession took hold the circle was complete. Subprime mortgage holders now had debt they simply had no money to repay. The well-intentioned efforts by Congress to expand the American Dream had instead flipped over and become the Global Nightmare.

Should Congress have known what was coming? Should they have put the word out to hold up? Committee members had heard plenty of warnings, to be sure. But nobody wanted to tell lenders to lend less to the mostly minority, lower-income voters who were beneficiaries of the loosened policy.  Only a handful of mostly Republican and Independent politicians or writers, fiscal conservatives all, tried to raise an alert to a potential problem. They were ignored.

Once the layoffs started, the snowball began to roll. More people out of work or with fewer hours meant fewer consumers spending money; fewer consumers meant fewer orders; fewer orders meant more cutbacks and still fewer people able to pay their mortgages, pressing the entire financial system. Loans went bad, and the CMOs/CDOs that hadn’t already hit rock bottom soon followed. Wall Street anticipated this and dumped the weak CDOs they had, mostly too late, but sometimes at a profit if shorted (a large part of the focus of the current investigations). Investors fled stocks to gold as the Dow Jones caved in, meaning less liquidity, less cash for new investment. Big firms collapsed, and banks stopped lending. Soon many peripheral firms tottered on the brink of disaster. All of a sudden Americans, known around the world for being able to pull themselves up by their bootstraps, woke up to find themselves with no boots at all.

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When the smoke cleared we had a new, populist president at the helm, clearly no friend of large American businesses or Wall Street. No friend of the military-industrial complex that underpinned it either, and no friend of the banking system that was its lifeblood. A great friend to the lower-income, minority, and anti-big-business liberal wing of his party, however, Barack Obama certainly showed no hesitation to let those he opposed know where he believed the blame lay: Wall Street and the financial community as a whole. Where blame was not to be assessed was on lower-income Americans who should have realized they did not have the wherewithal to handle their mortgages, or on those members of his party in Congress who had deftly pushed for a more lenient standard of lending. Neither would be in the post-crisis spotlight.  Doing so would have had repercussions for his party’s electoral standing, which had finally regained the White House after a very long drought. A different villain was needed. 

But as a young, relatively inexperienced politician, the President also was given to occasional bouts of partisan hyperbole in front of the cameras. This was pleasing to his supporters, but in 2009 the nation watched as AIG executives were relentlessly demonized and attacked for receiving contractually required performance bonuses in a kristallnacht-like orgy of industry-bashing that led some of the firm’s employees to post private security forces around their property following a series of Obama speeches that lambasted not only AIG’s reckless practices, but the “tower of greed” in his words that he said was “at the root of the financial and economic crisis” and for which AIG was singled out as a major player.  Like a man who didn’t quite understand the controls of the airplane he was flying, the president seemed impervious to the huge aftershocks his words sent throughout the American financial system, as though he didn’t fully realize that the majority of Americans employed in finance were not the titans of Wall Street.

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As I write this, financial reform is “the” hot topic here in Washington D.C., and it will probably remain so, at least until it is supplanted by the next politically driven Doomsday issue. Having lived here for the majority of my 56 years and worked for years in government and with the Hill, I am quite familiar with how the game is played.  There are many moving components surrounding virtually every issue, but in the end, the dominant party holds the cards.  

The Securities and Exchange Commission’s timing in the Goldman case is a good example of the art of a well-timed government action set to coincide seamlessly with a major policy initiative. In some ways, it could be said that this was brilliant (some see the hand of Rahm Emmanuel in this, Mr. Obama’s right hand man). Others might not be so charitable. A day before the Goldman hearings were set to begin, and a week after Mr. Obama had introduced Financial Reform Act as his first post-healthcare initiative, the SEC dropped a bombshell that including embarrassing Goldman emails at precisely the moment the administration was beginning its financial reform push on the Hill. Several days into the hearings, it was further announced that they had also sent the file over to Justice for a criminal investigation to go with the civil case – a move that guaranteed maximum headlines and front page money-shots of flustered Goldman executives battling for air in every world media outlet. Though the sharp and savvy Mary Shapiro, head of the SEC, later said that they were simply doing their job in a normal investigation and that the timing was “coincidental”, not a living soul inside the Beltway (and quite a few outside) believed a word of it.  

That’s because things don’t happen randomly in Washington D.C. Policy statements, filings, cases, etc. are always timed for maximum positive impact for whatever administration is currently in power. This is not news to Washington insiders, but it bears repeating in light of the Obama administration’s repeated statements that the timing was simply by chance. It wasn’t.

The goal was simple, even brutal: To have embarrassed and humiliated Goldman executives in the nation’s living rooms just as the administration was pushing its financial reform package, making it very difficult for the bill’s opponents to gain any traction. Still smarting from election defeats and the role of the Tea Party movement in the narrowly passed health care debate, the administration sought to undercut the financial reform bill’s opponents at the starting gate. Newspapers, particularly those traditionally more sympathetic to progressive causes, were expected to harvest statements from Goldman’s private emails in a financial version of the notorious Tiger Woods text messaging revelations. The Senate Finance committee’s Democrats in particular needed little prodding from the White House to turn all the rhetorical juice they could muster onto the Goldman brain trust, because there was simply no downside. The anti-Wall-Street pull was irresistible by now. The message, as Rahm Emmanuel indicated, was that the administration was demanding  “accountability. ”  Anybody who opposed “accountability” and by inference, the administration’s financial reform bill, was therefore “in bed with Wall Street”, which by now everyone agreed was the only entity to blame for the submprime mortage-related meltdown. Mission accomplished.

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Someday, after all the bills have been signed, and all the issues adjudicated, and the worst days of the recession have faded into memory, the country will slowly come to realize how reckless we were in allowing emotion to rule policymaking over an entire industry. At that time we will recognize the massive, unforeseen collateral damage to the millions of smaller financial firms that this approach caused, I believe, damage that in hindsight will be seen as far outweighing any good that was gained through better and stronger limits on financial irresponsibility.  When those revelations finally occur we will, I believe, realize that we were wrong to try to distil a very complex subject down to the nightly-news-ready nuggets of  “accountability” and “greed” to push over an election year policy victory to help a party on the defensive after several stunning election defeats.

I believe we’ll see how we created an economic climate in which a man or woman of success or comfort was treated as a pariah, forced in effect to accept a virtual pogrom of rectitude and mob-dictated guilt, regardless of how he or she earned their wealth. We’ll see that the media-fueled hysteria of Americans facing economic hardship did not result in a safer financial market, new jobs or a more prosperous future as promised, but rather in decisions that poked at the very heart of the great American ability to rise from adversity, innovate, and prosper under the most adverse of circumstances. We’ll realize wistfully how new government powers, new protection bureacracies, higher taxation, and a huge new debts on future generations snuffed out the very source of the country’s resilience and sense of hope, how the “I Can” attitude that has always been so much a part of America was replaced with a “What’s the Point” attitude when faced with massive, complex regulations and high taxation at every turn.

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Now, that might seem like a perfectly acceptable price from the perspective of today. Maybe not such a high price to pay to rein in people who own yachts and homes in the Hamptons when we have to buy bread at Walmart to stretch our miniscule food budget. But the attack-on-the-rich mentality actually serves as the economic equivalent of a knife in the country’s back when it comes to the core fabric of what it means to have a chance at success as an American living in the United States. The reason is that it hampers and even removes incentives to solve, innovate, and invent and replaces them with a closed, limited world of penalties, monitoring, watchdogs, and bureaucratic power centers. It takes the justifiable goal of tightening regulations to avoid excesses, and offers a drastic, most partisan solutions that defeat its very purpose when all is said and done.  

Notwithstanding the other factors that characterize our country’s people – a sense of humor, a strong work ethic, tolerance of diversity -- our capitalist nation is built on the idea that by building a better mousetrap, we can profit personally; that by running faster or painting better, or testing more accurately or just plain working harder, we too can be financially comfortable someday.  We accept the right of people to the succeed and become wealthy.

But when that incentive is removed or dramatically watered down by well-intentioned but flawed regulatory bodies or government-encouraged populist discrimination – then the very best of our society starts packing their bags and departing for places where their efforts and ingenuity will be rewarded.

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And so it is with financial reform and the atmosphere within which today’s private businesses will soon be made to operate. Which leads us to the core question:

“What will the collateral fallout be of financial reform on American’s ability to obtain funding in a robust and innovative marketplace?”

The administration says that their steps will actually ensure a better marketplace. They say that forcing derivatives to be registered, for example, and having a clear policy on the bailout of large institutions is absolutely necessary.  Few objective writers would disagree.

But the president’s current plan calls for huge new increases in government oversight and even the creation of a brand new agency – the Consumer Financial Protection Agency – with mind-bending powers to fine, litigate, investigate, cajole, threaten, and thereby drive small companies literally out of business. This new Agency will grab entire departments from other agencies, and put immense power in the hands of a political appointee, and broad powers to haul almost anybody in court for anything. Indeed, the DNA for unbridled unfairness, politically driven harassment, and a deep freeze affecting the entire country’s ability to obtain financing for everything from cars to homes seems clearly embedded in the proposal’s genetic code.

The president’s assumption, apparently warmly shared by Finance Committee chairman Dodd, is that a Consumer Finance Protection Agency employee is going to be objective, fair, and measured employee as he goes about his job protecting the American financial products consumer. But such employee is a human being, with all the frailties and penchant for error of any human being anywhere.  He could be a human being worried about keeping his job, or moving up to a new pay grade, and eager to find fault somewhere to bolster his accomplishments. By giving them a new agency carte blanche powers that the bill now entails, such an individual could decide to open a costly investigation of a financial firm simply because they didn’t like the owner of the firm’s party affiliation, or because their target had underwritten a loan to a cause the employee did not support. Mr. Obama and Sen. Dodd paint a picture of benign, fair, bureaucrats who put fair play and the welfare of the consumer first, but in truth this is an impossible standard to maintain even as it is a necessary one if a new agency like this is to be built and to protect consumers without damaging our financial system.  That’s because of one of the other Laws of Washington Government: An agency given far-reaching powers quickly descends into a turf-protecting stat-producing machine focused on wins at any cost, with divisions and executives working constantly to prove themselves more worthy of continued employment or funding than this or that other agency.

As someone who has read the Consumer Financial Protection Agency bill cover-to-cover,  I can tell you that if enacted as written, it will operate much like the SEC, but have far more power to inject itself into every aspect of every financial firm in the country. It will have the power to investigate and litigate every aspect of every activity carried out by anyone re-entering the workforce as a real estate broker, for example. Every mortgage broker, every lender, every credit card company, will be subject to its pronouncements.  The opportunities for abuse will be tremendous, all done under the golden sign of “protection”.

In theory, that may seem to be a good thing. After all, it could help financial firms understand that they cannot cut corners when serving their clients. It can make the entire playing field more clear than it is today. More accountability for what is marketed and how, and full disclosure to prospective clients are very good goals and no legitimate business could possibly oppose them.

But let us remember: A new Agency also means a horde of unelected officials tampering with the choices our consumers have. If good changes, then fine. But if bad or politically motivated – well, tough. Deal with it is, apparently what Sen. Dodd is prescribing.

There are plenty of existing government offices and agencies that are fully empowered to handle consumer finance issues for their respective agencies.  Laws are on the books for all of them, powerful laws that can be brought to bear easily. Before the country rushes into a brand new, politically inspired agency, shouldn’t we be looking first to consumer education and training? Before we arm new hordes of trial lawyers with fresh new revenue streams as they scurry to support even the most frivolous of investigations, shouldn’t we first examine how existing agencies and departments can be deployed to do their jobs better? After all, wasn’t that at the heart of the SEC’s mistakes? Not doing their job well enough in the Madoff and other high-profile cases?

If we are saying that we will punish banks for managing poorly, that we will let them fail or take them over, then why oh why do we not say the same for foolish consumers? Is it only because consumers vote? Logic would seem to dictate that this should go both ways, and that all elements of our financial system should be required to exert more responsibility before we create a new government agency as a panacea.

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By late 2007 I, like many small finance firm owners, together with my colleagues realized that if we were to continue providing securities-based lending programs, they would need to be through fully regulated and licensed institutions. The days of private-placement lending were receding rapidly along with the sagging popularity of hedge funds. The goal was simple: How do you merge the freedom and flexibility of a private placement lending program with the security and safety of a fully regulated SIPC-member institution? How do we do that without a change in the title of the securities to the lender?  

Having worked in the past with flexible Transfer-of-Title (ToT) loans, which often were often nonrecourse and noncallable, we knew our clients wanted as many of the same options as they could get in a new institutional structure. To do so, we needed leverage that could only be provided through private capital. After examining the many different options, we settled on a plan that would deploy the leverage and capital resources of a well-respected, major depositor and account holder at several top-tier U.S. brokerages as the catalyst for a carefully constructed, institutional securities loan program. With time and effort, we carved out a secure, brokerage-administered and bank-underwritten securities-backed loan program with full online access and where the shares do not change title or account but remain in the client’s possession throughout the loan term.  There it was – private sector innovation and institutional management, a loan product for our times. The program has been a rousing success with a wide range of clients and advisors.

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Today as I watch still another round of Goldman hearings it brings me to wonder: Could it be that when the dust settles and the financial reforms have been voted into being in some manner, that small-to-midsized financial businesses like mine will turn increasingly towards private-institutional partnership? Where American innovation will move under the umbrella of conventional, regulated institutional management? Could this represent the kind of marriage of innovation that represents a compromise the Obama administration and its opponents both accept?

It is unknown today just what financial reform will mean for innovation and the long-term success of small businesses in the United States, should these bills ultimately become law. We cannot know for certain whether such regulations will be applied fairly and sensibly, or be driven by politics and populist fervor and government turf battles. We can hope, however, that a happy medium will prevail, and that America’s great wellspring of inventive genius will not be shackled by good intentions.