Comment Last Three
May 09, 2010
The average investor does not know of all of the regulations that Congress dictates to the commercial market. It is hard to track and we as investors have trusted both Congress and Wall Street with our money. Wall Streeters make millions of dollars while betting against the investors who they seek. With the failure of Freddie and Fannie and the wild rides on Wall Street, what must be done to help protect the average American investor?
The government needs to step in: to stop people from being cheated, to help capitalism regain some of the public trust it's lost, and to make markets transparent enough that people other than a handful of elite insiders can figure out what's going on. Who needs to step in to check the anti-market regulations promoted by Congress?
The financial fix now being offered by Congress is suspect at best. Congress follows the money and does what it best for its members, not the public. What are the solutions? The point of the current legislation shouldn't be to do what's easily sellable or to punish Goldman, everyone's favorite whipping boy. It should be to make the U.S. financial system work better for all of us.
There are six simple steps to help fix the financial system that I like. They would change Wall Street's incentives to make game-playing more expensive for the firms and the players; force both institutions and individuals to put serious amounts of their own money at risk, which would reduce future taxpayer losses; and give regulators, creditors and the general public access to information that Wall Street now hoards to enhance its profit margins. Also, Congress should not force banks or Wall Street to make risky loans or use risky financial instruments.
1 Increase capital requirements
Any reform plan worth its salt should greatly increase capital requirements -- the amount of money that stockholders have at risk, relative to an institution's assets. This is what people mean when they talk about reducing leverage. Lower leverage would make institutions less likely to fail and any bailout of them less expensive.
In addition, Congress should revisit the policy allowing the Federal Housing Administration and the Department of Veterans Affairs to guarantee mortgages made with down payments of as little as 3.5 percent and zero percent, respectively. These programs made sense in the long boom era after World War II, when house prices almost always rose and homeownership was a route to wealth. However, it may not make sense now. If those loans are continued, the government should sharply increase the insurance charged to borrowers, because residential mortgage lending is far riskier than it used to be.
2 Increase fear of too much risk
If any financial institution fails or needs extraordinary help from the government, the United States should be able to claw back five years' worth of stock grants, options profits, and cash salaries and bonuses in excess of $1 million a year. That would apply to the 10 top executives, current and former, with a five-year look-back period. It would also apply to board members, present and past. (People brought in by regulators for rescues that ultimately fail would be exempt.) Anyone subject to the clawback would be permanently barred from executive positions or board seats at any institution that has federal deposit insurance or protection for brokerage customers from the Securities Investor Protection Corp. This provision would give executives and directors a huge incentive to make sure the institutions they supervise don't take on excessive risk.
3 Expose the derivatives trade
Derivatives are contracts whose value derives from that of an underlying asset. They were once relatively simple, socially useful things -- instruments that allowed a farmer to lock in the price of wheat or an airline to know how much it would pay for jet fuel. Over the years, the derivatives market has morphed into a monstrous game consisting of speculation piled on speculation piled on speculation. At the end of last year, there were $30.4 trillion of credit-default swaps outstanding -- almost as much as the entire U.S. debt market -- according to the International Swaps and Derivatives Association (ISDA). There were also $426.8 trillion of interest-rate derivatives outstanding. A lot of this is double (or triple or quadruple) counting, but any way you look at it, the numbers are scary.
The market is essentially a vast black box in which no one ever knows who's got what obligations outstanding. So when problems began appearing in mid-2007, fear froze the financial system because many big institutions didn't know who was solvent and who wasn't. Regulators, lenders and stockholders couldn't tell, either.
4 Beef up the bankruptcy laws
We have to worry about what happens when institutions holding custom derivatives fail. That forces us to fix the flaws in the bankruptcy code that made Lehman Brothers' bankruptcy much worse than it had to be. Because of changes that have crept into the code since the 1980s, Lehman's counterparties could terminate their deals and dump vast numbers of hard-to-unload positions onto the market without being subject to the "automatic stay" of bankruptcy. Chaos ensued.
Together, steps 3 and 4 would prompt derivatives players to demand far more collateral, making the markets far smaller and less liquid. The folks at ISDA, the derivatives trade association, argue that forcing derivatives into clearinghouses and exchanges would introduce "excessive rigidity" into the system. They warn, also, that changing the bankruptcy law would have negative consequences. "Reform proposals encourage or require use of collateral, but collateral will only reduce risks if a party can use it when it matters most -- when its counterparty goes bankrupt," ISDA executive vice chairman Robert Pickel says.
5 Create a mortgage-securities database
One of the major problems that led to the meltdown was that it was impossible for many investors to figure out what collateral supported the mortgage-backed securities and derivatives they owned. We can solve that problem by setting up a publicly available database for all mortgage-backed securities that would include up-to-date payment statuses for each mortgage in each security, as well as the estimated market value of each house. Investors, regulators and creditors could use this powerful tool to do their own analysis rather than having to rely on credit-rating agencies. Such a database would help close the information gap between the big players (who have access to customized information through high-priced, high-powered services) and the rest of us.
6 Truth in credit ratings
A major reason for the worldwide mortgage disaster is that Moody's, Standard & Poor's and Fitch, the big three credit-rating agencies, gave "AAA" ratings to toxic waste securities that should have been rated "ZZZ." Investors at the mercy of the ratings stocked up on this trash, to their detriment.
A widely recognized part of the problem is that the agencies are paid by the issuers of the securities, which want the highest ratings possible. But the bigger problem is that the world has become too complicated and fast-paced for the agencies' formulas to work as well as they once did. They've missed corporate debt problems, been late to downgrade European sovereign debt and so on. When house prices began falling rather than continuing to rise, as rating formulas assumed they would, the ratings were toast.