On one hand Henry Kaufman should be pleased. Back in the 1980s he saw many of the flaws that existed and were developing in the US financial system. On the other hand he’ll be disappointed as he clearly wasn’t being listened too and the disaster he foresaw has come to pass. But what he’ll find incredible is that he still isn’t being listened to.
As a book, The Road to Financial Reform isn’t actually terribly good. Dr Kaufman starts off by stating the problems and outlining his solutions. He then presents three speeches he gave in the 1980s which repeat the same issues, though do emphasise his credentials in terms of understanding the problems. He tells us about the need for everyone to have an understanding of financial history, but his presentation of it is incredibly brief. He then repeats the problems, with small changes of emphasis, focusing on too-big-to-fail or the Federal Reserve, and continues to outline his solutions. I’m not sure he is entirely successful in linking the two. And the repetition makes you think that he could have covered everything in much less pages.
Despite this the book remains compelling. Even though they are repetitive, the 1980s speeches give you confidence that here is an author who know’s what he is talking about. And unlike the Roubini’s of the world there was no promise of imminent catastrophe, just the confidence that things will come to pass. Similarly, while the remedies (mostly regulatory) are not properly justified, an informed view would suggest that they would be far from ineffective.
Like many commentators, Kaufman’s understands that the problems are complex and the remedies are unlikely to be simple. It is interesting that despite that he views securitisation as being the single largest part of the problem. There are four reasons for this. Firstly, by divorcing the underwriting of credit from its ultimate ownership there is reduced incentive for the former to due a good job. Secondly there is a loss of transparency – which seems to be the largest sin in Kaufman’s eyes – which makes it difficult for regulators to understand where risk lies in the system. Thirdly, it has been promulgated on, and continues to encourage the incorrect view that the risk can be aggregated, measured and dissected precisely. Finally, it is essentially financial engineering that produces profits for financial conglomerates without producing a significant benefit to the real economy – on the contrary the other flaws have led to a dangerous credit boom.
The irony in the current situation is that the bulk of the US personal financial system is so dependent securitisation that it cannot function without it. The banking system is not sufficiently well capitalised to write mortgages and retain them on their books so its ongoing function depends on government agencies such as Fannie Mae & Freddie Mac to keep it going. It is disturbing that the accounts of these companies are no longer really being made public – in the short term it may cause concern, but it is clear that without that there is unlikely to be impetus towards finding a solution, despite President Obama’s investigating committee.
Which touches on another of Kaufman’s big concerns – lack of transparency. This extends well beyond the securitisation market and how much of a problem it is can be seen by the degree to which financial institutions continue to fight the limited provisions contained within the Dodd-Frank Bill. Our previously stated view remains – there needs to be a presumption in favour of disclosure unless it can be shown that would be damaging to proper market functioning. Alas the financial world seems to take the opposite presumption. Given its importance to a successful economy that isn’t good enough.
The final paragraph of the book is clearly meant to set the right tone:
“We can patch holes in our financial system, or we can undertake fundamental reform. The first approach is politically comfortable, but will do little to prevent turmoil – perhaps even another major collapse – in the near future.”
Written two years ago, it is clear that the US has indeed gone for the first option. While the heart wants Kaufman to be wrong, the head cannot help worrying that he will be as right on this as he has been on this topic over the last 25 years.