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Alan Schram

Alan Schram

Posted: June 22, 2009 10:43 AM

Financial Reform: Don't Abandon It to Regulators


Since the beginning of the financial crisis, the government has become the nation's biggest mortgage lender, guaranteed nearly $3 trillion in money-market assets, restructured two car companies, taken equity stakes in almost 600 banks and lent more than $300 billion to the life-insurance industry as well as a variety of other companies. The government is now also responsible for "compensation practices" in many of those companies.

Last week the president unveiled his plan for financial regulatory reform with a profusion of promises. But the Obama plan ignores the source of the problems and instead picks some wrong solutions, mostly in the form of enhanced regulatory oversight.

The plan makes bailouts a permanent modus operandi. Tax-payer funds will now be available to any financial holding company, including insurance and consumer finance companies.

Meanwhile, the plan does not deal with the rating agencies. They aided and abetted the financial collapse by providing AAA ratings to questionable securities that were used to drive us into this mess.

And the Obama plan does not offer a mechanism to track leverage, which is the most dangerous and crucial factor in this crisis. Instead, the same regulators who missed the signs of the current crisis will receive added powers to prevent the next one.

But regulators pored over CitiGroup's books for decades and failed to detect its excessive leverage and sloppy credit standards, or prevent its demise. Why would they now do a better job for AIG?

Nor does the plan seriously address the government-sponsored mortgage companies, Freddie Mac and Fannie Mae. They were the single largest source of funding for the subprime market, with a 40% market share at the peak. Those two companies alone amassed hundreds of billions in losses and were at the heart of the storm engulfing our economy. They also had hundreds of dedicated regulators specializing in their mortgage business, but to no avail.

More disclosure is not an adequate solution because a big part of the problem was the Federal government's determination to extend the benefits of home ownership to low income families. The Federal Housing Administration, in pushing unsustainable mortgages to people who put up almost no equity, led to loose lending and the dangerous abundance of capital that broke our financial system.

And while the President mentioned compensation as a key cause of the crisis, his plan makes no reference to how he plans to change it.

As for hedge funds, I believe regulation and oversight will be beneficial for the hedge fund industry. My firm, Wellcap Partners, first registered with the SEC in 2005. But despite all the talk these last few years about the risks of "secretive, unregulated" hedge funds, they did not create systemic risks. While thousands of hedge funds lost hundreds of billions of dollars last year, and many have shut down, it was the big regulated entities such as commercial and investment banks that brought the house down.

This is because prime brokers, without any impetus from any regulator, simply wouldn't let hedge funds lever up excessively. Also, in contrast to banks who are focused on short term deals and do not have their own capital at risk, in most funds the managers have a meaningful slice of their net worth in the fund. That guarantees a different mindset.

Increased regulation and oversight of financial institutions, in itself not a bad idea, cannot be done in a manner that reduces their discipline and self reliance. We cannot create more institutions that are "too big to fail". Those institutions will enjoy lower funding costs, which in turn will allow them to gain market share and become even more insulated, powerful and dangerous.

More importantly, our financial system cannot be trusted again to regulators or the Federal Reserve Bank, in the futile hope that they are able to save us. This is a task well above their pay grade.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.