Wednesday, February 9, 2011

The Unknown Unknowns

Last night I watched an interview with Donald Rumsfeld, who is appearing on a number of talk shows to promote his new book.  As part of the interview, the host showed a series of clips of Rumsfeld explaining the degrees of information that we have about situations at any given time.  As Rumsfeld explains, there are the "known knowns"--information that we "know that we know", and then are the "known unknowns"--information that we know that we do not know.  The final degree of knowledge is the "unknown unknowns"--information that we do not know that we do not know.   This is the scariest place to be because we are not aware of dangers which might be lurking out there waiting for us.

Watching the old video clips of Rumsfeld's press conferences, I had to laugh until I really thought about how the principle of "unknown unknowns" applies to our industry.  We now have the challenges of new truth in lending disclosures, new loan officer compensation rules, and federal licensure.  These are our "known knowns."  We also face the challenges that will come from the new Consumer Financial Protection Bureau, new disclosures replacing the good faith estimate and truth in lending, and new supervision.  Because so many of these new areas of concern have not really been defined for our industry yet, these are our "known  unknowns."  But Dodd Frank also allows for hundreds of studies and many areas of new rule making by existing and new agencies.  These are our "unknown unknowns"  We have no idea what will these new rules could look like or how they can impact on our businesses, and we won't know until we start to see the proposed rules unfold.

For instance, the Federal Reserve has proposed new rules for determining companies which are "significant" to the financial system versus those which are "systemically important."  The rules will be enforced by the newly created Financial Stability Oversight Council, which is a new panel of regulators who will assess the financial system for threats.

The Fed's proposal deems "significant" to the financial system bank and non-bank holding companies with more than $50 billion in total assets.  Smaller entities can be deemed "systemically important" if at least 85% of revenues or assets are derived from financial activities, including originating, brokering or servicing loans or "extensions of credit", organizing and managing mutual funds, or acting as a "principal or agent" in insurance or annuities sales.

The significance of the proposed rules is huge.  Designating a company "systemically important" means that the Financial Stability Oversight Council can close down a private company if they determine that the company is in financial jeopardy.  A designated company which is in financial jeopardy can be deemed a "systemic threat" to the overall financial system and so to protect the financial system at large, the Secretary of the Treasury can recommend that the company be dissolved.

The Dodd Frank bill has given the government unprecedented authority to regulate, take over and dissolve private corporations.  While a company may file a suit to protest an order of dissolution, no judge has the power to issue a stay to protect a company that has been ordered to dissolve or to prevent a take over. In other words, while the Financial Stability Oversight Council has life and death power over the businesses they regulate, they themselves do not have outside oversight through the judicial process.

This is pretty scary stuff for people working in financial services.  Remember that non-bank financial entities usually take more risks than banking entities, and because of this higher threshold of risk they have been able to offer more aggressive products to consumers and higher returns to investors.  To have an agency that has the power to determine that such a company is a potential threat to the financial system and that it needs to be closed down flies in the face of ingenuity and entrepreneurship.

It is impossible to know at this time how small the entities that come under increased supervision as part of the Fed's proposed rule will turn out to be.  The Fed is accepting public comments on the proposed rule until March 30.  After that date, the Fed will issue its final interim rule.  Then we can watch as this latest government power grab takes shape over the next few years.

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