5 Reasons Not to Expect the U.S. to Rein in Shadow Banking (or Pass Much Financial Reform)

When I was living in Hong Kong, I once saw a photo of the Chinese leadership that left a strong impression. China's political elite were having their annual conclave. The International Herald Tribune ran a photo of nine of the most powerful men in the country: all with hair dyed black, dark blue suits, red neckties -- except for one man wearing a blue one.

So, Sesame Street redux, one of these things was not like the others -- but the subtext was clear: not by a heck of a lot. Maybe he didn't get the "Red Necktie Memo." Or maybe he felt a little ornery that morning.

In the aftermath of the financial crisis, the U.S. government is the equivalent of the guy in the red necktie. He's different from those he regulates -- but not by much. That's a big reason the needle isn't likely to move much on financial regulation.

Just look at what was at the heart of the crisis: overly complex and leveraged products that sought to evade sensible (but inconvenient) accounting standards; that were blessed by ratings agencies with overt conflicts of interest; that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs); and that supported a shadow banking system through such activities as repos and reverse repos.

Why would the government crack down on any of this since it's been captured, cognitively, by the financiers? In effect, the government is now doing all this stuff that caused our problems. Let's look:

1. overly complex and leveraged products: When Treasury Secretary Geithner was given the job of coming up with a proposal to rid the big banks of toxic debt, he created a complicated monstrosity that could've emerged from the Goldman Sachs war room (and for all we know, it did). Known as PPIP, the plan proposed pairing private money with public to buy distressed debt through auctions; private investors would use taxpayer funds to leverage up as high as six to one. Geithner suggested this after it was clear that too much leverage had helped spark the original disaster. All this led one to wonder: Did he sleep through the crisis? PPIP's most redeeming feature: it flopped.

2. sought to evade sensible (but inconvenient) accounting standards: Financial Accounting Standards Board shenanigans anyone? Under government pressure apparently, the standards board ditched mark-to-market accounting for certain bank assets in April last year, making it easier to pretend the shlock on your books was actually gold -- well, tarnished gold at the moment, but it would look better in a year or two, you could argue. So transparency wasn't a priority for Team Obama, it seems.

3. that were blessed by ratings agencies with overt conflicts of interest: The ratings agencies midwifed a lot of ugly babies that they pronounced beauty queens: crap securities that received AAA ratings. And what has Washington done to shake up the agencies, or reform the ratings system? As far as I can tell, approximately nothing. Why? Is it because the government may have an interest of its own in manipulated ratings, for the panoply of Fed lending facilities that require assets graded AAA? Geithner and Co. want to recapitalize the banking system on the sly -- without another ugly headline number like "$700 billion for TARP" -- and maybe the brain trust has decided to lay off the credit raters to ensure there's no avalanche of downgrades that, should it occur, would prevent shovelling that low-cost Fed money out the back door for suspect "AAA" collateral.

4. that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs): This one's easy unfortunately. Fannie Mae and Freddie Mac are really the original off-balance sheet vehicles. It's no secret that Fannie Mae was moved off the government's balance sheet in the late 1960s because it was turning into a budget buster. Now it enjoys a funny quasi-public status: a "private" company that will get bailed out again and again (just like the SIVs of the big banks). Oh, and if you need another example, here's the government trying to spin a special-purpose vehicle off from TARP. Yup, they learned well from their Wall Street masters.

5. that supported a shadow banking system through such activities as repos and reverse repos: The Fed isn't so eager after all to shut down the repo market (in a repo, you sell a security to someone at a "haircut" price (that could be 10, 20, 30 percent off, depending on the security) with the promise to repurchase it shortly thereafter, say a day later). Turns out that the Fed plans to sop up extra liquidity through reverse repos of Treasuries. So since the reverse repo is a big part of its strategy, is it such a leap of the imagination to think that in the end the White House economic team will just advocate hands off most/all repos and reverse repos?

There you have it. The government has borrowed Wall Street's playbook. So why is anyone out there surprised we're not seeing reform?