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All Da King's Men

The Financial Regulation Reform Bill

By Da King Published: April 20, 2010

Reading through the Senate proposal for financial regulation reform, I was struck first by what the bill doesn't seem to do...

It doesn't end subprime mortgages or adjustable-rate mortgages.

It doesn't end derivatives.

It doesn't break up institutions that are "too big to fail."

It doesn't regulate Fannie Mae/Freddie Mac.

It doesn't stop the massive bundling and securitizing of mortgage loans.

Maybe it's just me, but I kinda thought all of the above were responsible for the financial crisis. Yet, they will all still be in existence from my reading of the financial regulation reform bill.

What the bill does do is add lots more oversight of "systemic risk" to our financial system, in the form of new government agencies and the reform of existing government agencies. It adds increasingly strict capital and leverage requiremtents for large banking institutions, which the bill claims will keep institutions from becoming "too big to fail." It gives more power to the Federal Reserve (who was also complicit in the financial crisis).

I don't want to sound overly negative here, because I'm leaning in the direction of favoring passage of this bill, based solely on the notion that it's better than nothing.

But it could be light years better than it is.

Following is one part of the bill's summary, about derivatives, which already pose a tremendous systemic risk to the economy.

[FYI - A derivative is a financial instrument that has a value determined by the future price of something else. Derivatives can be thought of as bets. Financial firms first used them as a form of insurance against future losses. They were created to lessen financial risk (ironic, isn't it ?).]

Here's the risk:

Why Change Is Needed: The over-the-counter derivatives market has exploded– from $91 trillion in 1998 to $592 trillion in 2008. During the financial crisis, concerns about the ability of companies to make good on these contracts and the lack of transparency about what risks existed caused credit markets to freeze. Investors were afraid to trade as Bear Stearns, AIG, and Lehman Brothers failed because any new transaction could expose them to more risk.
Over-the-counter derivatives are supposed to be contracts that protect businesses from risks, but they became a way for traders to make enormous bets with no regulatory oversight or rules and therefore exacerbated risks. Because the derivatives market was considered too big and too interconnected to fail, taxpayers had to foot the bill for Wall Street’s bad bets. Those bad bets linked thousands of traders, creating a web in which one default threatened to produce a chain of corporate and economic failures worldwide. These interconnected trades, coupled with the lack of transparency about who held what, made unwinding the “too big to fail” institutions more costly to taxpayers.

Here's the proposed solution:

Bringing Transparency and Accountability to the Derivatives Market
Closes Regulatory Gaps: Provides the SEC and CFTC with authority to regulate over-the-counter derivatives so that irresponsible practices and excessive risk-taking can no longer escape regulatory oversight. Uses the Administration’s outline for a joint rulemaking process with the Financial Stability Oversight Council stepping in if the two agencies can’t agree.
Central Clearing and Exchange Trading: Requires central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared. Requires the SEC and the CFTC to pre-approve contracts before clearing houses can clear them.
Safeguards for Un-Cleared Trades: Requires margin for un-cleared trades in order to offset the greater risk they pose to the financial system and encourage more trading to take place in transparent, regulated markets. Swap dealers and major swap participants will be subject to capital requirements.
Market Transparency: Requires data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding to risks

Here's my take on the proposed regulation of derivatives. There will still be an enormous derivatives market (that $592 trillion figure was no typo), so there will still be enormous systemic risk. It's just that now, it will be more transparent and "regulated." Some requirements will allegedly prevent "excessive risk" in the derivatives market, whose very existence is an "excessive risk." If a $592 trillion market starts to fall (due to, say, the NEXT collapse in housing prices), or even if the derivatives market is scaled back to the 1998 level of $91 trillion, there isn't a government agency in the world that will be able to save us from disaster. Keep in mind, the entire GDP of the United States is just over $14 trillion. If the derivatives market crashes, we don't have enough money to stop that domino effect.

There's other stuff in the reform bill, such as limiting executive compensation, which plays well in the media but is essentially meaningless, a drop in the bucket.

In the end, we will be depending on more government bureaucrats and more government oversight agencies to prevent the next financial crisis. These will be the same government bureaucrats and government oversight agencies who were asleep at the switch while the current financial crisis exploded into a near nuclear financial armaggedon.

In conclusion, go ahead and pass this bill.

Just don't expect it to make any real difference. The casino is still open, and the same players are all still playing the same game.

As for the idea that this reform will prevent any future taxpayer bailouts....if you believe that, I have a bridge to sell you. I'll also sell you a derivative to hedge your bets on the bridge.

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