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May 23rd, 2016

Brave New World

In Brave New World, Aldous Huxley’s 1932 satirical novel, a benevolent dictatorship headed by ten World Controllers micro-manages the World State. Under this dictatorship, the population is permanently limited by the substitution of the Controllers’ judgement for individual action and initiative. Reality has begun to imitate Huxley’s fiction as the “nanny” approach to governing and the absence of common sense enforcement is making daily headlines. Recent examples of this zeal are: 1) Florida police arrested four women, aged 87-95, as they were playing Mahjong for money; 2) A Michigan woman was jailed for failure to renew her dog license; and 3) Students are being disciplined for smuggling salt shakers into school to improve the taste of food, as dictated by Federal guidelines, the same guidelines which have led to a 56 percent increase in the volume of food being tossed into the trash.

Financial services has drawn more than its share of the new rules. Last year, Congress passed 114 laws. Federal Agencies issued an astonishing 3,410 new regulations, a rate of more than 13 rules per Federal work day. A large portion of the new regulations are edicts for the financial services industry that directly affect private equity and other institutional investment activity. Metropolitan Life’s recent court case, where they successfully had the court reject the “systemically significant” label which the federal regulators had applied to them, produced a remarkable record of how capricious the decision to label them was. The judge threw out the regulators’ conclusions as they were deemed to be largely based on hunches and on very few shreds of empirical data. The judge described the regulators process as “fatally flawed.”

Two of the more hubris-laden ideas are the new requirements of Living Wills that the banks must create to prevent chaos in the event a bank collapses and the creation of a federal credit agency that rates and influences banks’ credit decisions. The Living Will regulation requires the banks to submit for approval a several hundred page plan to sell off the bank in pieces if the bank is failing. Setting aside the fantasy that a seamless sale process could take place for all or parts of a failing institution, see Bear Stearns, Washington Mutual, Merrill Lynch, Lehman, etc., the most fascinating part of the Living Will process is the regulatory response to the submissions. If your bank’s Living Will is satisfactory, you are told you passed. If unsatisfactory, you are told you failed and are required to amend the plan. All of this begs the question “Why do the regulators not outline a system that allows banks to fail?” Isn’t that their job? Continuing this motif of opaque regulations is the triumph of policy over reality, called SNC, the joint venture of the Fed and the Office of the Controller of the Currency, which is now charged with rating bank loan credits for regulatory capital purposes.

In a recent credit review by SNC that was held after a public company filed its March 2016 financials with the SEC the following took place:

• Borrower was not to be told there was an SNC rating.

• All performance since September 2015 was ignored as competitors were behind in reporting their results.

• Cash on company balance sheet was ignored when determining leverage.

• Neither lender nor borrower was given any information on how to improve ratings.

• There was no process to dispute the rating as incorrect.

Here are the fascinating Brave New World conclusions we see: The constituents are not savvy enough to be given information about their own institution and the regulator is so omniscient that there is no appeal of a decision. This is certainly a rich irony in a series of laws promulgated to increase transparency.

I’m Rob Morris and I approved this blog.

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