Regulatory capture is dangerous. But you won't find it in the agency's new hires.

Today's New York Times came out with a bizarre hit piece on the Consumer Financial Protection Bureau and the first wave of hires. They attempted to argue that there are already huge conflicts between those staffing the creation of the Bureau and those that they will be tasked to regulate. This will be a problem for any agency, and it's one to be very conscious of and make sure that proper disclosures and vetting have occurred.

But what's so surprising about the article is how little they were able to find. After going through the record of the initial hires of advisors for the CFPB, the only thing they were able to flag was that Warren advisor Raj Date was, up until recently, a director of Prosper Marketplace Inc. The company is lobbying to be regulated as a bank, instead of regulated by the SEC, debating whether their practices constitute issuing securities. I read the piece waiting for a bang, but all I found was a whimper.

Having written a paper with Date on Glass-Steagall and the future of financial reform, as well as working with Date when he contributed to Roosevelt's Make Markets Be Markets financial reform conference on the subject of the GSEs, I was kind of curious to see if he was actually some sort of deranged financial hitman. But if this is all the 'dirt', I'm almost worried for the opposite reason: that the agency will be too academic and not take advantage of people involved in the shadier side of the financial world who want to repent.

The Times article relies entirely on the implied assumption that peer-to-peer lending is some sort of shady, fly-by-night operation. In reality, it is simply part of the over-hyped phenomena of trying to integrate the internet with new financial institutions. From Mark Gimein's very critical take on the company:

Person-to-person lending -- loans made by individual investors who had money to spare to borrowers hoping for better rates than they could get from banks or credit card companies -- was supposed to be to loans what eBay was to garage sales. Prosper.com, the pioneer, was one of most hyped internet startups of the last decade.

TIME Magazine chose Prosper.com as its top new website of 2007, and the Wall Street Journal featured it in a high profile story. Prosper television commercials picked out nifty stories like that of a New York cop who lent money to a Chicago fashion designer, and the press followed with quirky human interest stories (like a loan for breast implants). In short order, Prosper was followed by imitators such as Loanio and Lending Club -- the latter a Harvard Business Review featured in the Harvard Business Review's picks for “breakthrough ideas for 2009.”

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"Most hyped internet startups of the last decade." You don't get that impression from the Times article. It merely quotes a default rate to condemn the practice. And Prosper contested that measure of default rates when Gimein wrote about them for Slate, both as a solid measure of its business and particularly in the context of a gigantic credit bubble and the Great Recession (where everyone is having to take massive consumer credit writedowns).

In my personal opinion, in the same way middle-class people turned amateur stock analysts was the sign of a tech bubble, or middle-class people turned amateur realtors was the sign of a housing bubble, middle-class people turned amateur credit risk analysts and credit channel intermediaries was the surest sign of a credit bubble. But Prosper has been a useful experiment. It's challenged thinking about information, prices, the "wisdom of crowds" versus institutional information, fringe lending, and creative ways around low-quality high-churn payday-style lending, regardless of whether or not it is going to take off. Either way, wasn't the problem that the CFPB was going to kill small-scale financial entrepreneurialism? So isn't it good to include someone in the agency who has experience with it?

Even more striking is that the article fails to mention that Date and his former policy shop, Cambridge Winter, which they summarize as being "active in the Dodd-Frank debate", were really at the cutting edge of the consumer financial protection debate. I actually wasn't sure if the auto dealer exemption for consumer protection was something worth fighting until I read Date's Baseline Scenario post on the topic, Auto Race to the Bottom. Particularly pertinent was the excellent phrase: "Even by the low analytical standards applied to hastily arranged, crisis-driven corporate welfare initiatives, the exemption of auto dealers from the CFPA appears profoundly ill conceived. Exempting auto dealers would simultaneously be bad for consumers, bad for industry stability, and bad for what remaining sense of free-market integrity we still have." Heh.

He was also active in the Volcker Rule debate, bringing sanity to the discussion of the strengths and weaknesses of resolution authority (also here), and a whole ton of other research that created markers for serious financial reform.

The case against him is so weak that even Mark Calabria, director of financial regulation studies at the Cato Institute, who loves hitting a regulatory conflict and capture slowball over the plate, seems kind of bored with it when he's quoted: “It would be very difficult to find anybody on either side of the aisle on this issue who doesn’t have a financial interest. What’s important is that those conflicts get aired.”

The issue of regulatory capture is a serious one, and I'll worry when President Palin is appointing credit card company executives to run the CFPB. But if this is the 'worst' that can be found out the door, the capture part of it is the least of my concerns.

Mike Konczal is a Fellow at the Roosevelt Institute.

This week on Bloggingheads, Roosevelt Institute Fellow Mike Konczal joined Noah Millman, blogger for The American Scene and The Economist, to debate foreclosure fraud, Fed policy, the unemployment crisis, and more.

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Mike uses the example of the Bailey Building and Loan to put the current mortgage scandal in perspective, noting that George Bailey had both the incentive and the authority to work out fair terms with the people of his community. Given today's securitization process, in which servicers are separate from lenders and ownership of mortgages is divvied up among any number of faceless corporate entities and even foreign governments, who's looking out for homeowners?

Noah notes that the current line from Wall Street is that we shouldn't get "hung up" on the details of the process because everyone knew what they were getting into and there will always be winners and losers. However, he points out that most homeowners don't view their mortgage as a bet. Mike also addresses the claim that delaying foreclosures will keep neighborhoods vacant and prevent the housing market from reaching its new normal. In banking, he says, "the first rule is you never foreclose on a home, and the second rule is you never foreclose on a home." He argues that the endless wave of repossessions and the lack of negotiation are symptoms of a "sick system" that has become like a car without airbags.

For more, including Mike and Noah's take on the labor market, the currency wars, and the flaws in the stimulus bill, check out the video above.

The Fed is between a rock and a hard economic outlook.

Fed Chairman Bernanke is signaling that a second round of quantitative easing will soon begin. In the first round, the Fed's balance sheet nearly tripled to nearly $2.3 trillion as it bought $1.7 trillion in Treasury securities and mortgage-related securities. Since the Fed appears to want to unwind its position in mortgages, QE2 will probably target federal government debt.

During Japan's long stagnation, Bernanke was famous for arguing that the Bank of Japan could have done far more to fight deflation. Since the BOJ's overnight interest rate target was effectively at zero, the conventional policy of lowering its interest rate target was not an option. Hence, Bernanke advocated quantitative, rather than price, activity -- the BOJ would purchase assets from banks, driving up their excess reserves, until they would finally make loans to stimulate spending that would reverse the trend of prices.

So when he had the opportunity, he put theory into practice in the US, driving short-term interest rates effectively to zero and filling bank balance sheets with excess reserves by purchasing their assets. So far, the impact has not been significantly different than Japan's experience. Indeed, Bernanke has been publicly warning of the dangers of a Japanese-style deflation, as US inflation has dropped nearly to zero, well below the Fed's informal target of two percent.

And so we are now set for round two of QE -- more of the same old, same old.

In truth, the Fed has done only two helpful things. First, during the liquidity crisis of 2007 and 2008, it lent reserves to financial institutions that faced a liquidity crisis. To be sure, it took the Fed far too long to figure out that in a liquidity crisis you must lend to any financial institution, and you should not look too closely at the quality of assets submitted as collateral. The Fed's bumbling made the liquidity crisis far worse than it should have been. But eventually we got through that phase.

We then moved on to the insolvency phase, as everyone discovered that banks were, and still are, holding assets whose value is far below the value of their liabilities. A flimsy "stress test" was concocted, designed to ensure that all institutions would pass. The government then injected a bit of capital into some of them and proclaimed the problem resolved. Next, banks cooked their books and showed healthy profits so that they could buy out Uncle Sam. More importantly, they wanted to party like it was 1999 so they could pay record bonuses to top management.

However, purchasing toxic assets from banks did help them -- the second useful thing done by the Fed. The problem is that the Fed did not and cannot buy enough of the waste to make banks healthy. There is simply too much of it. When the crisis hit, the US debt to GDP ratio was 500%, and that has hardly come down. A lot of the debt was bad even before the recession, but far more of it is bad now that we have lost 10 million jobs and half of homeowners are either underwater in their mortgages or soon will be. And there are tens of trillions of dollars of derivatives deals. To resolve the insolvency crisis would require that the Fed buy tens of trillions of dollars worth of questionable assets -- QE2 would have to be orders of magnitude larger than QE1. Putting a number on it is nothing but a guess, but it could be at least $20 trillion.

The Fed can certainly "afford" to buy up all the bad assets and take on any counterparty risk from the derivatives that might be triggered. As Bernanke has testified, the Fed buys assets by crediting bank accounts, through a simple keystroke, and there is no way the Fed can run out of keystrokes. But it is politically constrained in a number of ways.

First, there is no chance that inflation hawks would stomach Fed actions on that scale. They still believe that bank reserves generate loans that inevitably create inflation. Bernanke carefully tries to navigate these waters by agreeing with the hawks that in the long run, Fed creation of too many reserves would be inflationary, but argues that in current circumstances the greater danger is deflation. Still, he reassures markets that reserves creation is temporary, and that the Fed will "exit its accommodative policies at the appropriate time". Yet, if the Fed buys junk assets that will never have any value, it will not be able to sell these back to markets later -- so there is no way to remove the reserves it created when it buys trash.

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Second, the Fed generally makes a profit on its operations and turns excess profit on equity over to the Treasury. Buying toxic assets will lead to losses, something Congress will not stomach. So the Fed is between the inflation rock and the hard place of losses. It cannot solve financial institutions' solvency problem without buying on a politically impossible scale.

This should come as no surprise. It has always been the central bank's role to deal with liquidity problems, and the Treasury's role to deal with insolvency problems. The difference is that US Treasury spending is directly controlled by Congress and accounted for in the federal budget. Bailouts by Treasury -- such as the rescue of the US auto industry -- inevitably generate a public debate. By contrast, bailouts by the Fed take place behind closed doors, and usually only come to light after the fact. Still, Congress and the public are fed up with the Fed and will tolerate such shenanigans no longer. That leaves the Treasury as the only chance for action, but President Obama claims it has already "run out of money". This is pure nonsense since Treasury also spends using "keystrokes", but it is a widely accepted myth.

So the Fed is left with the only option available to a central bank that has already pushed short-term interest rates to zero: buy longer maturity treasury bonds in order to push longer rates toward zero. It certainly can do this. It could, for example, buy all 10 year Treasuries, bidding up their prices until their yields fall to zero. Historically, 30 year fixed rate mortgages have tracked 10 year bonds fairly closely, so such an action could conceivably lower mortgage rates. But they are already below 4%, so it is not clear what could be gained. Dropping rates still further is not likely to bring forth any buyers except hedge funds that have been buying foreclosed homes. The "foreclosuregate" scandal has at least temporarily killed that demand.

Other potential buyers are waiting for house prices to fall further, or for a real economic recovery to begin -- one with job creation and rising wages. In short, the problem in real estate markets is not that mortgage rates are too high, but rather that prospects for real estate and job markets are too poor. The Fed is in a Catch 22: Interest rate policy will not spur borrowing until economic recovery is underway, but recovery will not begin until spending picks up. Only jobs and income will stimulate spending, but the Fed cannot do anything in those areas.

The Fed believes that it might spur bank lending by lowering returns on safe, liquid assets like Treasuries. If banks cannot generate sufficient returns by holding these assets, then they might have no choice but to take greater risks. But it takes two to tango -- banks need good and willing borrowers in order to make loans.

Recent data indicate that banks are instead trying to increase revenues through "churning" -- trading existing assets, which generates no new spending -- and by increasing fees and penalties. Conventional wisdom is that it costs banks up to 400 basis points (four percentage points) to operate the payments system that relies on checking deposits and credit cards. If Treasuries are paying less than half that, and mortgages are below that, the only way that banks can turn a profit is by charging customers for their deposits, debits, and charges. That is why they have been busy jacking up their charges. Yet if Elizabeth Warren is effective, she is going to make it harder for banks to gouge customers.

No matter how mad at banks we might be, we have got to leave them with a way to return to profitability that does not rely on speculative bubbles, pump-and-dump schemes, and accounting fraud. Pushing returns on relatively safe assets toward zero is not the answer. Pumping banks full of reserves that pay very low interest will not help, either. What Bernanke might understand, but most in the mainstream media do not, is that banks do not and cannot lend reserves. Reserves are just an entry on the Fed's balance sheet -- a liability of the Fed and an asset of banks. Rather, banks make loans by accepting the IOU of the borrower and issuing a demand deposit. Only financial institutions have access to the Fed's balance sheet, so it is literally impossible for a bank to lend out reserves.

So anyone who thinks that pumping banks full of reserves while driving interest rates toward zero is a way to encourage lending simply does not understand banking. (This also means, of course, that whether banks have $100 billion or $100 trillion of reserves has no implications for prospective inflation.)

Note that if we really wanted to use our central bank to resolve this economic crisis, it would be far better to have it directly buy houses and create jobs for the unemployed. But it makes far more sense to use our fiscal authorities for that.

QE2 does not represent a solution to our current quagmire. No, this Titanic is still headed underwater. The sooner that the Obama administration recognizes that what we need is jobs, more jobs, and mortgage relief, the sooner we can get this ship afloat.

L. Randall Wray is Professor of Economics at the University of Missouri-Kansas City.

It's time to put the perps of this scandal in jail.

Yves Smith, Bill Black, and Mike Konczal have already done yeoman's work in seeking to explain the lender fraud scandal in the securitized mortgage market and its possible legal ramifications. Here, I'd like to restrict my discussion to the optimal government response.

President Obama recently used a pocket veto on a bill that would allow foreclosure and other documents to be accepted among multiple states (and therefore make it difficult for homeowners to challenge foreclosure documents prepared in other states). But I worried that this action was not sincere. My concern was that, following the midterm elections, the Administration would eventually come up with some grand "compromise" solution, which would in effect give the banks everything they wanted.

In retrospect, it appears that even that was too favorable an assessment. Per the Washington Post:

The Obama administration does not support a nationwide moratorium on foreclosures at this time, Federal Housing Administration Commissioner David Stevens said Sunday in an e-mail response to questions.

"We believe freezing foreclosures for all banks in all states, whether we have reason to believe them to be in error or not, is simply not the prudent step to take in this fragile housing market," he said. (Our emphasis)

Banks 1, rule of law 0. In effect, the President is making the argument, "If we penalize people for not following the laws as they existed at the time, it will have really bad repercussions. So everybody gets a mulligan."

Additionally, the Administration seems to be buying the prevailing spin that the foreclosure problems are merely the product of "sloppy paperwork", rather than recognizing this disaster as a case of rampant, systemic fraud. That deserves punishment: fines and jail time, not additional government support.

Most of the current administration proposals are misguided because they continue to be based on the twin presumptions that big banks only face a liquidity problem, and that if this problem can somehow be resolved, the economy will recover. This is a fundamentally flawed view. Using any honest measure of accounting, the big banks are insolvent. The latest debacle illustrates that big banks cannot and should not be saved. They do not hold the key to recovery; if anything, their rampant criminality demonstrates that they are a barrier to a sustainable recovery. Since they were given their handouts, they have been working assiduously to resurrect the bubble conditions that led to this crisis. (Not to mention paying out huge bonuses in the process -- this year $144 billion, a record high for a second consecutive year, according to a study conducted by The Wall Street Journal.) Your tax dollars at work!

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As Randy Wray and Eric Tymoigne presciently wrote over a year ago:

The best approach is something like a banking holiday for the largest 19 banks and shadow banks in which institutions are closed for a relatively brief period. Supervisors move in to assess problems. It is essential that all big banks be examined during the "holiday" to uncover claims on one another. It is highly likely that supervisors will find that several trillions of dollars of bad assets will turn out to be claims big financial institutions have on one another (that is exactly what was found when AIG was examined -- which is why the government bail-out of AIG led to side payments to the big banks and shadow banks). There probably are not ‘seven degrees of separation' -- by taking over and resolving the biggest 19 banks and netting claims, the collateral damage in the form of losses for other banks and shadow banks will be relatively small. Government lending, guarantees, and purchases of bad assets will be much smaller if we first consolidate the balance sheets of the biggest players, net the assets, and shut down the institutions. This will help to downsize the financial sector and reduce monopoly power. Moving forward, policy should favor small, independent, financial institutions.

In addition, it will be necessary to increase supervision and regulation of the financial sector. This can start with 3 simple measures, which were suggested to me by Bill Black (who was a long-time S&L investigator):

A. Replace every top banking regulator other than Sheila Bair and the head of the SEC. The regulators have to serve as the "sherpas" for any successful effort to prosecute and prevent frauds -- they do the heavy lifting and serve as the essential guides for the FBI. Two of the major banking agencies did zero criminal referrals. None has made putting the crooks in prison even a weak priority. Put new leaders in place who believe in regulating and jailing. End the instructions to regulators to view bankers as their "customers." The only client is the American people.

B. End the FBI's "partnership" with the Mortgage Bankers Association (MBA), the perps' trade association. The MBA has convinced the FBI that the lender was always the victim, never the perpetrator. That's why, along with regulatory failure, we have no top executives convicted, as opposed to over 1000 in the S&L debacle.

C. The Department of Justice needs new leadership. Do what we did in the S&L crisis. Create a "Top 100" priority list to ensure that we go after the elite criminals who caused the greatest wave of white-collar crime in world history -- and the Great Recession.

And we must get back to a fiscal policy that genuinely helps to sustain job growth and rising incomes -- this, in turn, will stabilize the economy. The costs of increased fiscal stimulus are dwarfed by the costs associated with an irrational reliance on monetary policy gimmicks such as "QE2". Fiscal austerity drains aggregate demand and induces reliance on PRIVATE debt. Today, a large number of Americans still suffer from high private debt levels and correspondingly sluggish income growth. Their ongoing reliance on the banks is becoming the 21st century equivalent of indentured servitude. With higher levels of debt comes higher levels of financial fragility and instability and then economic busts. With recessions we don't just experience extended losses of income. The accompanying costs manifest in the criminal justice system (rising crime), the health system (rising mental and physical illness), the family court systems (rising marriage and family breakdown), etc. The sum of these costs dwarf all other economic costs. And we should not forget that human lives are destroyed by prolonged recessions -- dignity is lost, self-esteem disappears and the children who grow up in jobless households inherit their parents' disadvantage.

If borrowers can meet their payments, lenders will receive their funds and will return to profitability; there will be less need for future bailouts. A full employment policy is also a financial stability policy. With a fully-employed population, you have consumers able to purchase goods with rising income. If they decide to expand those purchases or increase investment in a business via debt, they are better able to service it because a fully-employed person or a businessman with booming sales is far more able to service his debts, which means less write-offs for the banks and therefore less need for bailouts.

Amazingly, this is not only sensible economics, but also good politics. Yes, there is no question that some borrowers were overextended and probably took on mortgages they couldn't afford. But to use this as a reason to avoid the issue of fraudulent foreclosures strikes me as a colossal red herring. To be sure, one should not generally support the principle of abrogating loan agreements via strategic defaults, for example. But when the other contracting party is exposed as a rampant predator/fraudster, it changes the moral calculus considerably. If one ignores fraud, or downplays its significance here, it undermines the rule of law, the very basis for modern democracies. What's the "cost" associated with that? The fiscal austerians and defenders of bailout packages such as TARP (yes, I'm talking to you, Tim Geithner) ought to factor this into their calculations the next time they drone on about what a great "success" these programs have been, based on a bogus measure on how "little" it ended up costing the US taxpayer.

Wall Street bankers turned homeownership into an "investment", so owners ought to treat it like one -- walk away from bad investments. Business people do it every day and no one admonishes them about morality. But if we are going to sanction borrowers for strategic defaults, then it seems wildly inconsistent to avoid the issue of fraud, as well as recognizing that eliminating it (or significantly mitigating it) is the only basis on which we can construct a sound financial system going forward.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.