A conversation with Senator Ted Kaufman, visiting professor of the practice
"There still is alive and well on Wall Street the idea that we can operate without regulations. That it is like running a city without any police."
— Senator Ted Kaufman
Ted Kaufman represented Delaware in the United States Senate from Jan. 16, 2009 to Nov. 15, 2010, after which he chaired the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) until its completion in April 2011. On the Senate floor, in committee, in his frequent public commentary, and in Duke Law’s Duke in D.C. program where he teaches Federal Policymaking and oversees externships as a visiting professor of the practice, Kaufman has called for financial regulation that would, among other things, separate commercial and investment banking activities, pare down the size of too-big-to-fail banks, and track the market impact of high-frequency trading. In spite of such positive developments as the formation of the Consumer Finance Protection Board and moves by the Financial Stability Oversight Counsel to begin addressing systemic risk, he expresses frustration with regulatory progress to date.
Kaufman talked with Duke Law Magazine about his ongoing concerns in mid-May, shortly after the announcement by JPMorgan Chase of a $2 billion (now estimated at more than $3 billion) loss attributed, by the bank, to “hedges.” »
Duke Law Magazine: What does this news from JPMorgan Chase tell you about what banks, policymakers, and regulators have learned since the 2008 financial meltdown?
Senator Kaufman: There hasn’t been very much done, in fact, to alter what caused the great financial meltdown. I think the multibillion dollar loss is the latest example of the fact that it’s still easy for financial institutions to make the same type of bad bets that caused the taxpayer bank bailout and could lead to one in the future.
DLM: What are your biggest concerns?
Kaufman: The same concerns I talked about on the Senate floor. The same things I talked about in the Senate committees. First, you have to decide what caused the meltdown — what you believe the problem was. For example, many oppose any real financial regulation because they don’t believe that Wall Street had anything to do with the problem.
I think the repeal of Glass-Steagall in 1999 [the 1930s-era legislation that separated commercial and investment banking activities] and our failure to regulate derivatives by enacting the Commodity Futures Modernization Act (CFMA) of 2000 were two of the very big problems.
I was in the debates and I urged my Senate colleagues to be sure that Dodd-Frank ended too-big-to-fail banks. If you read what independent economists say, what financial people say, if you read what people on Wall Street say in their newsletters to their customers, none of them believes that our major banks are not still too big to fail. The biggest problem is that there is no way to have resolution authority of these gigantic banks across national lines. After three years, we are still trying to work out Lehman Brothers’ bankruptcy, which was relatively simple compared to what would happen if one of our five or six major banks went down. We’re still three years working on it because it’s very difficult to deal with the creditors in England in a bankruptcy action in the United States. And when you start thinking about Bank of America, and JPMorgan Chase, and Citibank with their hundreds of offices and investments around the world, there is no way that if they had a financial problem that we could rapidly — and it would have to be rapidly — deal with them other than to bail them out. I just don’t think there’s any data or information to support anything else.
DLM: Do you anticipate future bank bailouts?
Kaufman: One of two things is going to happen if the president and Congress face a crisis like we had in 2008: Either we’re going to have a bailout, or we’re going to watch the financial system disintegrate. No one involved in the negotiations around TARP who I’ve talked to believes that we could afford to not bail the banks out. When faced with the prospect of Citigroup going under without any real way to resolve it in the short term, I don’t know what else the government’s going to do. And as far as I’m concerned, we really haven’t implemented anything to materially alter that no-win choice at some point down the road.
DLM: Should the biggest banks be broken up?
Kaufman: Breaking up is a strong term. I favor “skinnying” some of the major banks. … Sen. Sherrod Brown of Ohio just reintroduced what was, originally, the Brown-Kaufman bill. There’s nothing draconian in that; it just begins to slim down the banks. If we don’t slim down the banks, they are too big to fail.
I also understand members of the Senate will introduce a kind of revised Glass-Steagall bill, which basically says that if you’re in the commercial banking business you’re in the commercial banking business, if you’re in the investment banking business you’re in the investment banking business. It worked for us for over 60 years. We have to go back to something like that. My feeling is that we’re going to go back to something like that; it’s just a matter of how much hardship we have to go through first.
Look at the multibillion dollar loss by JPMorgan Chase. Jamie Dimon (the bank’s CEO) says that’s not proprietary trading. What is a bank that has major assets guaranteed by the United States government doing in a situation where some guy in London can lose billions on what the knowledgeable observers keep referring to as a bet? That’s not why we designed the Federal Deposit Insurance Corporation (FDIC) — to make banks feel more comfortable in investing in what they call hedges against potential activity down the road. Hedges by definition are designed to reduce risk not to create gambles.
The Volcker rule in Dodd-Frank wasn’t half a loaf, it was like a tenth of a loaf. I wanted to put Glass-Steagall back. But when faced with nothing — you couldn’t pass that financial reform bill without saying that large FDIC-insured banks should not be engaged in incredibly risky behavior. And the Volcker rule was the way to do it. But I said on the Senate floor, again and again, that trying to define proprietary trading is like the Middle Ages when they were trying to define how many angels could dance on the head of a pin. Trying to define proprietary trading is, I believe, almost impossible.
DLM: To what extent have you seen a change in the resolve of rule makers — the regulators?
Kaufman: One of the biggest problems you have when you legislate is unintended consequences — where the law creates a situation that was unintended. I think that what’s gone on with the rule makers now was “intended consequences” by those who opposed any new real bank regulation. I said at the time that in Dodd-Frank we didn’t make some tough decisions. After the Great Depression, the Pecora Commission came in and said, “We’re going to make some real laws here,” and created the FDIC and implemented the Glass-Steagall Act. … What happened in Dodd-Frank — with me complaining the whole time, without much success — was to avoid tough laws and a constant march to kick these things back to the regulators. I had a number of concerns with that. One was that regulators change with every new president, so we should put something in that’s more permanent. But the bigger problem is that when you put all of this back to the regulators then you have a situation where the vast majority of people contacting the regulators are those with money and influence. Professor Kimberly Krawiecs’s excellent analysis of Volcker rule contacts shows that over 90 percent of those contacting the FDIC, SEC, Commodity Futures Trading Commission (CFTC), and the Federal Reserve were from Wall Street banks, financial trade associations, lawyers, and accountants. (Read more, Page 22.) Wall Street has completely stopped Volcker rule implementation.
DLM: What are other major threats to the financial system that we haven’t even begun to address as yet?
Kaufman: My major concern is that we do not know what’s happening with the changes in our financial markets and their structure. The major change is the development of high-frequency trading. The regulators do not collect enough data right now to determine the effect of high-frequency trading on our markets. A number of years ago, I called for a consolidated audit trail, which would give us a contemporaneous record of what is happening in our markets. Over 50 percent of our trades are now high-frequency trading. We cannot answer simple questions like why over 90 percent of the trades are cancelled by high-frequency traders. What’s going on there? Chairman Mary Schapiro has said the SEC is going to develop a consolidated audit trail. The head of the CFTC, Gary Gensler, said he wants to have a consolidated audit trail. But years have gone by without one, and once we decide we’re going to do it, it’s going to take years to implement.
Just as happened in the derivatives market, there has been an explosion of money in high-frequency trading, without any real transparency. Congress outlawed the regulation of derivatives in the CFMA, so we had no idea what was going on in the derivatives market throughout this incredible explosion. Without transparency you can’t have regulation. And when you have lots of money, no transparency, and no regulation … we saw what happened in the derivatives markets and I think it’s just a matter of time before, unfortunately, we will see the same thing happen in the high-frequency trading on our markets.
Our free markets are one of the things that made this country great. Free markets are incredibly important to this country. Credible markets are incredibly important to this country. … What do we do if we lose the credibility of our financial markets? … We now have 15 different exchanges, and a lot of them have no regulatory responsibility, and 50 other trading venues including “dark pools.” There still is alive and well on Wall Street the idea that we can operate without regulations. That it is like running a city without any police. Essentially there are going to be problems. There are bad things going on and the police are there. That doesn’t mean you’re going to stop all the bad things, but at least you have a handle on it and you’re trying to deal with it.
DLM: What are your final thoughts on TARP, given that you chaired the congressional oversight committee?
Kaufman: When I first showed up in the Senate in 2009, in the first couple of weeks the freshman members met in small groups with [Federal Reserve Chairman] Ben Bernanke and [Treasury Secretary] Timothy Geithner. And there was no doubt in my mind that at that point, they were very, very, very concerned about the potential for a financial meltdown even after TARP was put in place. So I think that in terms of “Did we need to put something like TARP in place?” Absolutely. It had to be done.
I would have leaned towards doing it differently. I would have leaned towards doing what the British did with the Royal Bank of Scotland, where they essentially went in and took it over. I wish they had done a lot more with regard to housing. Neither the Fed nor the Treasury really concentrated on the housing problem like they did on helping the big banks.
But in the end, it started out with estimates that it would cost over $700 billion and the last time I looked, the projections were that it would cost $25 billion. It’s like the saving of General Motors and Chrysler. It’s turning out to have been an incredibly courageous move by a bunch of people in the Bush administration and then in the Obama administration to take. And we’re still having the political fallout; one of the big issues being used against a number of members of Congress in the 2010 election, and it looks to continue in the 2012 election, is that they voted for TARP.
It was such a horrendous thing that I just keep focused on how do we make sure that this never, ever, ever happens again. And I just don’t see nearly enough in changes in the way we operate our financial system — our market structure, the size of our financial institutions, the risks that our financial institutions that have major pieces of FDIC insurance, or just the financial institutions, period — I just don’t see steps being taken to avoid this situation happening again.
And the final thing is that I just don’t think there is enough awareness or concern out there in places of power. “Financial amnesia” has set in. Average people have lost their homes and their jobs — there should be major changes implemented to reduce the possibility that this could ever happen again. But I just don’t see a sense of urgency on Wall Street to take into account what happened and who was hurt, and how bad it was for so many. Even worse, I do not see the efforts being made at all levels of government to enforce the changes required to protect us from the pain inflicted on so many Americans by the financial meltdown.