THE BLOG
03/18/2010 05:12 am ET Updated May 25, 2011

Claims of Financial Reform Victory? You Can't Reform Vampires and Zombies

If nothing else, the Obama Administration has learned the virtues of Clintonian spin. The so-called "financial reform victory" claimed Friday over approved new rules for over-the-counter derivatives is, in reality, akin to using a band-aid to treat gangrene.

Any kind of bill which (in the words of the Reuters report), "strives to balance a desire to curb speculative market excess with preserving the market's useful role in helping corporations hedge against operational risks" ignores the fact that it is not the market playing a "useful role in helping corporations hedge against operational risks," but the product of a big financial subsidy to Wall Street. Lack of transparency is a hallmark of these instruments and this gives huge pricing power to the banks. More importantly, it makes them tougher to regulate. There is no public, continuous record of Credit Default Swap trades that is comparable to the data available to investors and regulators from the major cash and derivatives exchanges, and the "reforms" introduced by the House of Representatives Financial Services Committee do nothing to address this reality for Credit Default Swaps.

This is in sharp contrast to the available pricing for other OTC derivatives, which is generally good and tracks the highly visible cash basis that underlie many other derivatives markets, OTC and exchange-based. Whether you are talking about currency swaps or a commodities related product, the world of OTC derivatives excluding CDSs is largely standardized in line with the exchange-traded products. Hence, they do not generate the same volumes of profits for Wall Street, which explains why the latter have fought to retain the status quo in spite of almost blowing up the entire financial system last year.

Obama clearly believes the BS fed to him by Jamie Dimon. I guess we should not be surprised; the President taught at the University of Chicago, after all, and clearly seems to have imbibed some of the Chicago School's free market ideology, and the unspoken assumption that free, unfettered markets are the optimal state. Anything else is a distortion or a rigidity. That of course fails to address the problem of fraud, which my colleague, Bill Black, has tirelessly sought to highlight.

Dealing with fraud is not only an important moral issue, but also crucial on basic economic grounds.

If we don't know what's really going on, we can't gauge whether the government's economic policies are working or not. The advantages of living in a society governed by the rule of law require both the right laws that, with common agreement, public purpose, as well as enforcement sufficient to deter non-compliance in the first place. Laws that most agree are okay to break, and a lack of enforcement, break down the core morality of the system, and result in a dangerous degeneration into lawlessness.

Leaving aside political agendas, the truest test of any reform is: will it have any kind of positive effect? As far as the current financial regulatory reforms go, the answer is probably yes in a very limited fashion, but that is more a function of the impairment of the capital markets themselves, which is precluding additional proliferation of these horrible Frankenstein financial products. If you don't deal with a cancer fully, it comes back and spreads, even if you conduct surgery to remove some of the tumor the first time around. And, as any oncologist can tell you, it's the secondary recurrence that usually kills.

Reform of the current US financial sector is neither possible nor would it ever be sufficient. It's a bit like saying, "Well, this slavery thing has a few problems, but we can 'reform' it and make it better." As any student of horror films knows, you cannot reform vampires or zombies. They must be killed (stakes through the hearts of Wall Street's vampires, bullets to the heads of zombie banks). In other words, the financial system must be downsized.

Downsizing can begin with the following set of actions:

a) All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and, more importantly, to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.

b) All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.

c) Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.

d) The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest.

e) In its examination, the FDIC will determine which of these banks is insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. Resolution will be accomplished with a goal of i) minimizing cost to FDIC and ii) minimizing impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.

These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose. The financial system would emerge with healthier institutions and with much less market concentration.

Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can't do it, as they do not have the financial resources to meet the potential claims (see AIG). And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behavior. As "Credit Insurer of Last Resort" (Professor Perry Mehrling's term, not mine), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behavior of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule - i.e. "lend freely but at a high rate during a crisis"): Insure freely but at a high premium.

We can spend more time blogging about these issues, but now is the time to do something about it. As my friend Dean Baker has already noted, those disgusted by the rapacious and highly destructive behavior of our bankers can go to Chicago on the dates of Oct. 25-27th when the American Bankers Association is having their annual meeting and make yourselves heard. If we stay quiescent, we'll get the kinds of "reforms" we deserve. To paraphrase Rahm Emanuel, it's time to ensure that this crisis does not go to waste.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.