The Secret Law for Wall Street

By Kevin D. Williamson

Sunday, September 18, 2016

It is impossible to pity Wall Street for its current predicament. After doing so much to ensure the election of Barack Obama in 2008 and lavishly patronizing his congressional allies, the pinstripes-and-Adephagia set is suffering mightily under burdens partly of its own creation.

Which would all be good sport it if weren’t bad for the rest of the country.

In the wake of the 2008–09 financial crisis, major financial firms were in effect made subject to a set of secret regulations. Under the authority of the Federal Reserve, banks are subjected to “stress tests,” a kind of financial game — think Dungeons & Dragons as imagined by accountants. Regulators draw up test cases involving economic models used to project the effect of severe downturns, market crashes, and other nasty events on the solvency of large financial firms, of the sort we’re not supposed to call “too big to fail” any more — even though a decade’s worth of reforms has left them even bigger than they were back when they were only too big, instead of too-too big. Never mind, for the moment, whether the economic models behind those test cases are any good – what’s relevant to the question at hand is that they are secret.

It is easy to understand why the regulators want to keep the particulars of their stress tests a secret from the people who run the big Wall Street companies. The people who run the big Wall Street companies are – forgive the bluntness – a heck of a lot smarter than the people who would regulate them. If they know exactly what standards they will be required to meet, they’ll reverse-engineer a way to meet those standards, and the Fed may as well never do another stress test. We do not really have to guess about that: The entire field of structured finance exists almost exclusively as a response to various kinds of financial regulations and prohibitions. The people at Goldman Sachs and J.P. Morgan are intelligent enough to make their accounts say whatever they need to say to satisfy regulators. They may not be happy about it — they almost certainly will not be happy about it, because it eats into profit — but if they know the rules of the game, they will play the game by the rules.

But Washington is asking them to play by the rules — and then stapling the rulebook shut.

Banks’ stress-test performances have real, substantial effects on their businesses. If they do not satisfy the examiners, they are forced to reallocate their capital in ways that are more in keeping with regulators’ preferences but less profitable. Which is to say, banks are in effect being regulated, tightly, in accordance with an economic model that is kept intentionally opaque, not only to financial executives but also to the public, in whom the sovereignty of the federal government resides and to whom regulators acting under color of federal law are responsible.

A group of financial firms is so vexed by the situation that it is considering legal action against the federal government to relieve the industry of this burden — or at least to make the particulars of that burden known to those carrying it.

There is a kind of double bind at work here: Because of the 2008–09 financial crisis, Washington wants banks to engage in fewer different kinds of financial activities and to become more risk-averse than they were. (You know how you can make a bunch of banks really, really risk-averse? Let them fail when they make bad investments. One assumes that many of those Lehman Bros. veterans are very cautious ladies and gentlemen, indeed.) But there’s a problem with Washington’s trying to make banks more risk-averse: It is working. And that, combined with the ultra-low interest rates of recent years, has made financial firms less profitable. Perversely, that leaves them more vulnerable to financial shocks, rather than less vulnerable.

Banks are not the only firms subject to what amounts to secret law. Until their dreams came to a quick and ugly halt in a U.S. federal court, a cabal of lawyers and environmental activists with ties to the New York Democratic machine, the Obama administration, and progressive media outlets such as the Huffington Post had been (and, to a lesser extent, it still is) engaged in what is probably the largest single extortion attempt in modern history, trying to shake down Chevron for billions of dollars for environmental crimes with which the oil giant had nothing to do. A great many well-connected Democrats thought they were going to be paid behind that, and when it turned out that they (probably) weren’t, the Democrats, led by New York attorney general Eric Schneiderman, turned their attention to another oil giant, Exxon.

The case against Exxon started off as pure political harassment by a group of Democratic attorneys general representing New York, California, and a few other states, along with the U.S. Virgin Islands. Exxon and advocacy groups to which it had contributed (notably, the Competitive Enterprise Institute) were subjected to invasive subpoenas as part of a fanciful “fraud” investigation seeking to punish Exxon and free-market groups for refusing to toe the Democratic line on global warming. (Exxon, incidentally, does more or less toe that line so far as the question of the scientific consensus goes, though it prefers different policies — another illustration of the fact that if you are sitting on a large sum of money, you can never be progressive enough for the progressives who covet that money.) Now the jihad against Exxon is taking a new turn.

With oil and gas prices low due in no small part to the fact that the United States has been producing more oil than Saudi Arabia in recent years — thanks, fracking! — a great many oil and gas wells have been temporarily sidelined, because it costs too much to operate them with prices as low as they are. The energy business is remorselessly cyclical. Many oil companies have taken writedowns on their non-producing assets — for bookkeeping purposes, the value of those assets has been reduced to reflect lost production — but Exxon has not. Exxon has a few reasons for this, but the short version is that given the diversity and range of its holdings — by market capitalization, it has ranged over the past several years from being the world’s largest company to its fifth-largest — and the fact that its previous valuations were (so it says) very conservative, it has no need to write down assets that it regards as temporarily sidelined. Some analysts say Exxon is wrong to do this, others say the firm is on solid ground. Schneiderman has opened up an investigation under the Martin Act, a securities statute.

Is Exxon in the wrong? It is, in fact, impossible to say. There are highly technical questions in play, and, as in many such cases, it probably will come down to a matter of competing interpretations of a dozen or more different financial and non-financial issues. On the one hand, Exxon has a legal duty to make accurate public statements about its finances; it also has a legal duty to act as a fiduciary to its shareholders, which means not imposing unnecessary losses on them. The company also believes — it may be wrong about this, but it may not — that it is uniquely situated to wring profits out of certain assets even at prices that would have its competitors capping those wells. To call the law here “murky” and “contradictory” would be too generous.

But does anybody seriously believe that Eric Schneiderman is dispassionately considering the legal issues here? Or is it more likely that he has simply identified a new front in his campaign against a company, and an industry, that he intends to use as a political whipping boy and/or cash cow?

Whether they are banks facing stress tests or oil companies trying to figure out how much value their engineers and managers can actually derive from a certain asset, companies need legal and regulatory clarity and certainty. ExxonMobil is a $340 billion company — it needs to know whether it is breaking the law without bankrupting itself through excessive caution. The banks, for their part, are worried about the presidential election and what its outcome will mean for the regulation of their industry — and when the commanding heights of the economy are being held hostage to political worries, you have a deep and wide problem.

Sure, nobody weeps for investment banks or oil companies.