March 24, 2010



Although Sen. Chris Dodd’s financial reform package would create an alphabet soup of new regulatory bodies, much of the responsibility of identifying and defusing the next big threat to the financial system will fall to the Federal Reserve. I don’t doubt that there are plenty of sharp, talented people working at the Fed, but the way things stand right now, the cards are going to be stacked heavily against them.

With last week’s release of Tony Valukas’ report on the Lehman Brothers’ bankruptcy, some problems with the reform bill have become all too clear.

The cost of clarity
First and foremost, we have to wonder whether the folks at the Fed can even keep up with the complex, fast-paced financial firms that they’re supposed to oversee.

To pick apart the Lehman situation, it took Valukas and his army of lawyers and other skilled pros a year of diligent effort. Over that time period, the team waded through “a patchwork of over 2,600 software systems and applications” and collected 5 million documents comprising 40 million pages — 34 million of which were reviewed by the Valukas and his team. As the Chicago Tribune points out, that’s like reading Tolstoy’s War and Peace more than 27,000 times.

In the end, the effort led to $38 million in billings to Valukas’ firm, Jenner & Block, and another $30 million in fees to Valukas’ financial advisor, Duff & Phelps.

Granted, a bankruptcy investigation and ongoing regulatory review are hardly the same thing. But it took the relentless digging of the Valukas team to figure out that Lehman was duping creditors, investors, rating agencies, and regulators with its “repo 105” transactions. And in many ways it was actually easier for Valukas, since he was no longer facing a moving target — or at least it wasn’t moving as much as before.

And this was all for just Lehman Brothers, which had around $640 billion in assets at the time of its bankruptcy. What do you think the process might look like for Goldman Sachs (NYSE: GS) and its $850 billion in assets? Or how about Citigroup (NYSE: C) and its $1.9 trillion in assets?

A broken business model
We can probably point to plenty of regulatory failures in the lead-up to the financial crisis. But I hardly think that they’re regulatory failures stemming from lack of regulators. As Valukas noted in his report, regulators were swarming on Lehman well before its collapse: “In mid-March 2008, after the Bear Stearns near collapse, teams of Government monitors from the Securities and Exchange Commission (“SEC”) and the Federal Reserve Bank of New York (“FRBNY”) were dispatched to and took up residence at Lehman, to monitor Lehman’s financial condition with particular focus on liquidity.”

It seems to me that the issue never was whether there were people trying to address the problem, but rather that they were trying to regulate on a fuzzy mandate of not letting something bad happen within the bounds of a very permissive system. For the same reason that we have speed limit signs posted in our residential neighborhoods, we need to give regulators a clearer, tougher set of standards that they can impose on financial companies.

First and foremost, those standards need to address the lunatic business model that Lehman Brothers — and, really, most of the big financial companies — was operating on at the time of its demise.

Specifically, Lehman was increasingly building up large, illiquid, proprietary investments while primarily financing itself through very short-term agreements. What it became was a massive, teetering Jenga game right smack in the middle of our financial system that could be toppled in the blink of an eye if it lost the confidence of major counterparties such as JPMorgan Chase (NYSE: JPM), Citigroup, HSBC (NYSE: HBC), and Bank of America (NYSE: BAC).

Not such a good start
There’s been a lot of hype about the fact that Dodd’s bill includes the so-called “Volcker Rule,” which would prohibit banking institutions from taking part in activities such as proprietary trading.

However, I’d say that the bill includes the Volcker Rule the way Cocoa Puffs include well-balanced nutrition. Little actually gets implemented in the text of the bill. Rather, specific regulations are supposed to come from a study on the rule’s potential impact. Not only is this likely to maximize the squishiness of the eventual rules, but it also gives lobbyists plenty of time to work their magic.

In the end, I don’t see the Fed folks as a bunch of incompetent bumblers. But when it comes to smothering the next Lehman, Fannie Mae (NYSE: FNM), or AIG (NYSE: AIG), I do think they’ll fail miserably because they’re being given a butter knife to regulate with when what they need is a buzzsaw.

Do you think the Fed will be able to keep our financial system safe and secure? Scroll down to the comments section and share your thoughts.

The U.S. is hardly the only place where fiscal fitness is an issue. Check out why the situation in Greece matters to smart investors.

“The Death of the Euro!”…Greece may seem worlds away, but be warned. What happens there next could reshape global finance and rattle your portfolio. The Motley Fool’s Tim Hanson is in Greece covering the story. Follow in real time and hear how best to profit from this historic development (Hanson returned from China in July with a stock that’s up 117%!). Enter email below.


Fool contributor Matt Koppenheffer owns no shares of any of the companies mentioned.