Aligning Washington and Wall Street

Last week the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009. If the bill makes it through the balance of the legislative process, it will be the most extensive rewriting of our financial governance since the Great Depression.

There are 10 major provisions of this almost 2,000-page bill, which tackles everything from the creation of a financial products consumer protection agency, the development of a financial stability board and reregulation of OTC derivatives to mortgage industry reform and creating a Federal Insurance Office.

While the right will talk about the cost and the left will talk about "taking it to Wall Street" as the bill is debated, one thing is certain: Wall Street and Washington are misaligned. If we want this country to continue to grow, this needs to be changed now.

Wall Street is opportunity-driven. We deploy people and capital to the areas where returns are the strongest -- be that in bonds, stocks, options, futures or overseas. Capital is fluid. It flows from opportunity to opportunity, across borders and time zones, asset classes and products. Where there is a way to profit from capital, Wall Street will follow (if not lead).

Washington, on the other hand, is vote-driven. Washington takes root in populism, blossoms via outrage, is shaped by dogma and methodology, and wins in the ballot box. As a result, we have a legislature that doesn't understand business or trust capital and that develops laws that (pardon my mixed metaphors) use sledge hammers to kill flies and are more likely to regulate the last battle than anticipate the next -- neither of which helps the economy.

At a high level, this credit crisis was about getting people into houses, providing the financing, mitigating the credit risk, and profiting during a time of cheap and easy money. But what did we get in return? Other than the advent of a whole new federal agency to approve credit card solicitations, we now will have the federal government looking over the shoulder of the Federal Reserve, analyzing compensation, vetting credit rating agencies, breaking up banks, registering hedge funds, regulating OTC derivatives and keeping an eye on the mortgage industry.

But while all of these initiatives may be warranted, the question is: Will they stop the next crisis? I argue, "Absolutely not."

While these rules on the surface seem comprehensive, they fall into the fly-and-sledge hammer category and effectively regulate only the last battle. First, these rules are aimed at solving the sins of the past and not protecting the future. Second, they will be too inflexible and carried out too myopically to be effective for the next crises, which, by definition, will occur in a place we didn't think about, outside of our purview or both.

While I don't know which sector it will hit or when it will come, I do know that the next crisis will have nothing to do with housing, subprime mortgages, securitization or credit default swaps.

Capital is fluid. It will go where there is the most to gain and the least to lose. If CDSs become illiquid, other products will be developed; if mortgages become too restrictive or securitization is curtailed, other vehicles will be invented. And if everything becomes too challenging, capital will just go elsewhere. The more difficult we make it to do business here in the U.S., the easier it will be to do business in other countries.

The key to regulation is flexibility and common sense. Should we be giving loans to people who can't pay them back? Should banks be leveraged at 40 to 1? Should off-balance-sheet risks be greater than those on the balance sheet? Should Triple A-rated companies be exempt from putting up margin when they underwrite risk? Should banks be using insured deposits to fund risky investments? I would categorically say "no" to all of these propositions -- and that didn't even take a paragraph.

We once had the most attractive capital markets in the world, and they funded one of the most advanced societies in history. The sooner Washington learns that these two ideals are absolutely related, the better off we all will be.