What Real Financial Reform Should Look Like

In what little time I have had over the last two weeks to ponder anything other than the difference between adverbs of modification and comparison as well as the present continuous versus the present simple, I've managed to read a bit about the background on the financial crisis (more like review material, or a brief for the prosecution) and have some thoughts to share. I want to talk about real reform. Not the Washington-type band-aid crap. Now, mind you, these are very preliminary ideas, but I think they will make good fodder for discussion between Numerian and I and Stirling as well.

I think an anecdote is appropriate here first. When the Bear Stearns hedge funds blew up last year I asked Bob Geiger, who has impeccable sources in the Senate, if this was on their radar. I pestered him for several weeks and he never got an answer from any of them that I am aware of. This just goes to show you how out of touch our Congress is with reality. Perception is everything and at that time, the wise men all agreed: it's contained.

That's what I call the rise of "post-modern finance" (you can substitute politics just as easily), as described by George Soros' ideas on reflexivity:

Reflexivity can be interpreted as a circularity, or two-way feedback loop, between the participants' views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation (the manipulative function), and changes in the situation are liable to change their perceptions (the cognitive function).

It's that whole post-modern "perception versus reality" thing and the idea (based in quantum physics) of the observer altering the outcome.

One serious thing to take away from this is mark-to-the-model finance. That has to stop. As Nicolas Taleb recently said, "we should jail all the quants." (Or something similar.) Mark-to-model should be excised from GAAP and disallowed. End of story. If you can't discover a real price, then there isn't a market for it. This is a part of that whole perception versus reality thing. If people perceive something is valued at such and such a price then it's a self reinforcing reality and leverage can be built atop it, with disastrous results. Indeed, if we take Soros' idea and turn it to the downside of markets, well, isn't that what we are seeing now? We all know that a great deal more of these mortgages are valued higher than they are being now, but because of a negative feedback loop, as they call it, it's all doom and gloom. (Now, as for unsecured credit card debt and sub-prime auto stuff? Well, there's going to be hell to pay there too, it's only a matter of time and it will probably be the next shoe to drop, although it will take a while for the markets to 'get it' because it will only become really problematic when there is no doubt the economy is in the tank.)

Second: Disclosure and absolute transparency when it comes to any kind of credit derivatives. As a codicil to this I would add, absolute regulation of CDSs (by the Chicago Merc for example) in a way that preserves the function of the market. (The commodities markets are not designed to be "investor friendly," they are designed for liquidity and to provide a well functioning market -- as opposed to the stock exchanges, which are more 'investor friendly.') There must be limits on the amount of contracts one can write on any specific security, just as there are limits for options trades and futures trades. You can't corner the market like Jesse Livermore did anymore. Absent these three reforms then I would ban CDSs. Period.

Third: I would make it mandatory for all bankers, hedge funds, all bank employees and executives and pretty much anyone who works in a "securitized" or derivative market to get licenses to work in the securities market, whichever aspect of the market they choose to work in. Why? Well, for starters, to prove they have a basic understanding of what it is they are dealing with. You want to write CDSs? Well, you have to take a test proving you understand the risk to your institution and the counter-party. You want to securitize home loans? Credit cards? You take a test proving you understand the process. Why? So you gain insight into when it might, just might, be getting a little out of whack. Knowledge is fundamental to the proper function and regulation of markets. A 25 year old just out of MIT or Harvard or Yale should never, under any circumstances be allowed to managed a $500 million dollar portfolio because his "daddy" is in the "biz." If Conservatives want teachers to take tests, then finance professionals should too!

Another key reason for this is that all of them need to relearn the idea of "fiduciary responsibility." When I was an asset manager I was on the hook if I accepted "little grannies" order for writing 1000 call options on her deceased husband's Exxon stock. If it was not in her interest I couldn't take the order. And believe me, this happened more than you think. And I lost a lot of clients because of it (of course, there were also guys who didn't care, but they usually washed out of the business quickly enough).

Fourth: Executive compensation and clawback provisions. It is simply obscene that Lehman Brother's filed for bankruptcy, but in those proceedings their executives were allotted $2.5 billion in bonuses. Are you fucking kidding me? (You didn't know this had happened did you? Well, it is true.) They should disgorge every last penny possible from Fuld, the former CEO. And they've already found a work-around for the executive compensation limits Congress enacted, in case you were curious. Who would enforce these provision? Well, one would hope the Justice Department would, although it's probably been FEMA-fied to the point of emasculation.

Fifth: Enforce anti-trust laws. If it is too big to fail, it is too big to exist. I repeat: if it is too big to fail, it is too big to exist!

Enforce anti-trust. Break up Wal-Mart, the media conglomerates, the mega-banks, the mega-retailers, Microsoft and quite possibly Google. ATT? You bet. Other phone and cable companies? Oh yeah. We're not a national-socialist state, but we're getting there. Let's have real competition in key markets! No more duopolies (like Wal-Mart and Costco) or the cable companies, or the phone companies. Remember how prices for telecommunications fell through the floor in the eighties and early nineties because there were 7 or 8 good telecom companies? Enforce anti-trust laws so we have real competition. The laws are already on the books and this is not anti-capitalist. Just ask Teddy Roosevelt!

Sixth: Regulate hedge funds, although keeping said regulation at a minimum. Basically, I'd propose a law that allows for snap inspections of the books -- not disclosure, as hedge funds may have proprietary trades that if discovered by the market as a whole would clobber the fund in question -- by the SEC to make sure hedge funds aren't breaking any pre-existing securities laws, i.e. having an illegal amount of options contracts on the books, naked short-selling, CDSs, etc... and bar them from excessive leverage: nothing more than 20-1. Mind you, most of the hedge fund guys I know act in good faith. One of my best friends funds just blew up and he was -- still is -- a good guy. They are real people, and many of them take their fiduciary responsibility seriously. But there are bad apples, and snap-inspections would go a long ways to keeping everyone honest, without blowing up "hedges" and "arb" plays.

Seventh: Overhaul municipal bond issuance, marketing, selling, and trading regulations. At the present time muni-bond buying and selling (at least on the retail level) is based on principles, there are no real regulations, per se. This needs to change. When I took my Series 7 munis were a large part of it, but the 'laws' weren't really laws, they were guidelines.

Eighth: Insurance industry reform, not really, except for CDSs (see above). It's a good things the states have authority over this or AIG really could have been a cataclysm of an altogether horrific order. Ian Welsh might have some good ideas here.

Ninth: Enact a Tobin tax on all cross-border financial trades of say, .01% of the total value added transaction and use it to fund real foreign aid projects like building water wells, and other essentials, not subsidizing the sale of weapons to Israelis and Egyptians as we currently do with our 'foreign aid' budget. Oh, did you think our foreign aid budget actually went to helping poor people? Did you then know that on a per capita basis each Israeli citizen gets about $500USD a year from you, the taxpayer? I bet you didn't.

Finally, everyone in the investment business, instead of having to take obligatory exams on new bullshit Patriot Act money laundering laws--which actually made it harder for new business to start up, not to mention the fact that anyone with half-a-brain and a sound understanding of fiduciary responsibility knows who's laundering and who's not--should take mandatory classes on financial prudence, what systemic risk is, what causes it, etc. . . .

As for 'fractional reserve lending,' well, I'm kind of partial to money creation. And I'm not a fan of the gold standard. But I really wouldn't know where to begin that discussion. I do think the Fed micromanaging interest rates is counter-productive--as the markets should be able to discover their own rates, as they are now, despite the best efforts of global Central Banks. There are many, many other issues. Note them in the comments and I'll try and address them. After all, I can't think of them all.

As much as I dislike Milton Friedman, markets are efficient, but they are prone to excesses when improperly regulated. And when the excesses occur we get what is happening now. The market(s) will discover it's (their) bottom(s), no matter what the Fed or Treasury does. But this could have been prevented. And don't let a single damned politician say it couldn't have.

Comments

[rationalcon]

Excellent list, but I would add two more:

10. Ban PACs and businesses from making any political contributions and limit individual contributions to something reasonable like $2500. Make taking money from PACs and businesses a death penalty offense (yes, that's right, I'm thinking this is treason) for every elected official from local, county, state and federal office. PACs wield ridiculous power and cause complete vapor lock of our government. They have no purpose except to get laws passed that benefit small constituencies - NOT the general public. Who rules this country? It's the NRA, NEA, AIPAC, AMA, ABA, AARP, etc, etc, etc.

11. Corollary to #4: Ban any sitting corporate board member from being on more than one board at a time. These people are supposed to be looking out for the shareholders - BUT since they are all CEOs, CFO, and CIOs of other companies, they all simply look out for each other. This is the real source of the outrageous compensation packages.

[leftLibertarian]

One real reform would be an end to the federal government's propping up of the inflated housing market and let housing fall to a level supported by those who want to buy a home and have the means to do so.

[jhNY]

There are no free markets and there is no invisible hand. Powerful people manipulate systems to thwart the effect of regulation, and grab all the money they can before the roof falls in. That's where the rest of us come in--to hold the big bag of debt they leave behind.. Much of our present grief has come about because of the creation of new financial instruments such as credit defalt swaps,. These came into being in large part as a way to make money in areas relatively free from oversight.

New rules and greater transparency will not correct the doings of the intractibly greedy and predatious.

This is sort of like trying to control pickpocketing by making mousetraps mandatory in all pockets, which would only lead to a run on steel-tipped gloves.

[KillTheMessenger]

People who sign the dotted line of an interest only, nothing down suicide loan are not powerful. They are simply intellectually not able to make proper decisions about money.

We don't have to work hard to disprove irrelevant concepts like "invisible hand" when we already know where the problem originates.

[Sean-Paul Kelley - Huffpost Blogger]

And that problem originated in lax regulation, lousy government oversight etc. . . it was a failure of government, not a failure of the market.

[HUFFNAME]

"Enforce anti-trust laws. If it is too big to fail, it is too big to exist. I repeat: if it is too big to fail, it is too big to exist!"

THANK YOU!

I can't see how any other reforms measures could be effective unless this principle is rigorously enforced.

The "solution" we're being sold for the banking crisis seems to involve taking a fairly small number of large investment banks and remaking them into a tiny number of gargantuan (i.e. WAY too big to be allowed to fail) investment banks. GM and Chrysler are apparently talking merger. This is insane.

"If it is too big to fail, it is too big to exist!"

Government is not the problem here. Lack of government is. These corporations enjoy all the benefits of citizenship with none of the responsibilities.

Take away the golden parachutes. Jail the managers.

The justification--the only justification__ for investor profits is that investors are RISKING what they put up. These unregulated banks knew there was no risk for them since the inattentive government would show up just in time to change their diaper and put a boob in their mouth just as soon as the crooks stole enough to make this a crisis. Let the people who chose to invest with those companies pay the entire financial price, just as they have been reaping the entire financial gain. And again, let the manager's pay their debt to society by sitting in jail cells.

[paixa3]

A wonderful informative blog. I would like to add that the FED should not be owned by indiviiduals or families, but by US, the citizens. Government managed by the brightest of the bright and honest professionals. NO POLITICAL appointments.

Cross border transaction taxes, a minimum of 1% up to 5%. Set up a special fund to assure that it is used for humanitarian purposes in and out of the USA.

Eliminate ANY instruments (derivatives and CDS come to mind) that have no equity base and are just plain and simple gambles. No direct equity, no instrument, PERIOD.

I like that you set the limit at 20 to 1 (maximum).

[KillTheMessenger]

You own the Fed. You were screaming for a second Bush presidency four years ago. Remember, YOU gave him a mandate. And he used it.

:-)

[jsarets]

Actually, the last sentence in my previous comment should be: money flows toward people, people flow toward jobs, jobs flow toward productivity, and therefore money facilitates productivity.

[KillTheMessenger]

You will see them regulate the market and then you will see the market find another way to express its greed. I doubt that you can prevent bubbles by regulation. People want to get rich, QUICK. The only way that can happen, for some, is by means of a Ponzi scheme. And that's why Ponzi schemes will not go away. And neither will market bubbles. They are really the same thing.

[JBS]

Make Ponzi schemes a capital crime. And enforce it.

[KillTheMessenger]

Then you have to send half of the baby boomers to jail for supporting criminal organizations like fund managers.

:-)

[jsarets]

Real financial reform should look like democracy. In fact, democracy should primarily manifest itself through finance. After all, society is a function of the flow of money more so than it is a function of the rule of law. Campaign finance reform alone would reduce the power of money over the people, but it wouldn't increase the power of people over money.

Real financial reform starts with monetary reform. The basis of money should be the same as the basis of democracy -- population -- with the ratio of dollars to people remaining constant. Money should be issued and circulated free of debt or interest in the service of the public interest in the facilitation of commerce and trade.

The other end of real financial reform is labor reform. Labor should be organized into private cooperatives wherein employees collectively own the business, democratically elect their management, and share in the success or failure of productive output.

A public financial system should connect money to labor on the basis of employment. Each cooperative should receive an equal amount of credit per person employed, which represents the income of the average employee at the average cooperative. More or less productive employees of more or less productive cooperatives receive more or less income.

Cooperatives are connected to labor through open competition for the most productive jobs and to consumers through open competition for the best values. Jobs flow toward productivity, people flow toward value, and money flows toward people.

[paixa3]

You wrote some excellent theories and ideas. Kudos, cheers.

[Liberal2]

No he didn't.

Labor owned cooperatives fail too.

Currency must fit the size of the economy too. When there are too few units of currency moving through the economy to allow a transaction, an economy grinds to a halt.

You're both economic-illiterates.

[LeonBNJ]

We should look at those banks and investment companies that are in the best shape and why, then apply that to create the new laws.

[Rule Of Law]

Agree with almost all you say. BUT--the FED is the problem, followed by deregulation and Goldman-Sachs.

[Shaddup]

These are great ideas all around. Half of it is stuff we were supposed to be doing all along. I suppose our representatives could use some Cognitive Therapy.

[MatoSka]

The Fed really should be nationalized as a start. The low interest rates that it perpetuated for so long fed the rapid movement of crazy paper. Mortgages need equity requirements and need to be designed as conventional mortgages have been all along. The wall between commercial banking and investment banking needs to be restructured with a gatekeeper there.

Globalization presents its own problems because it establishes the economic domino cascade. Preventing overseas investments or tagging them with surcharges will make international competition much more politically and militarily aggressive, circa pre-WW1.

Politically, we have a disjointed system of representation. Nader gets blamed for electing Bush while his watchdog policies are simply disregarded. Minimum wages stagnate and the gap between the rich and the poor widens and there is no real representation for average Americans. Urban areas decay without any real say in the matter. Homeowners find themselves upside down in a world that first feeds the drive for consumption then attacks those sucked into its vortex. As 401(k)s go up in smoke, Social Security plays a much more important role in the lives of the elderly. It is no longer just a supplement.

The budget deficit from the bailout and the defense expenditures creates no win scenarios. Like peak oil and water supply depletion, the financial crisis was predictable.

[DuganS1]

The fed didn't necessarily "perpetuate low rates for so long" because the fed has frequently been unable to affect long term rates by manipulating the overnight rate. Plus inflation was very low through the 90s thru 2003 so it didn't make much sense to have rates much or at all higher than what they were. The comment about "urban decay" is simply untrue. A large number of our nation's urban areas, if not the vast majority of them, have been completely rejuvenated in the last 20 years.

[MatoSka]

The fact is that even Wall Street saw the train coming. See my post 10/08/2008 in comments on the article "The Bungled Bailout (Or the Perils of Paulson)" : "Just don't say BUSINESS WEEK didn't warn us. This one has the Fed's fingerprints all over it and now they think lowering interest rates will cure the addiction." JULY 19, 2004 Is A Housing Bubble About To Burst? (Excerpt) As rising rates send mortgage payments higher, demand may cool Today's housing prices are predicated on an impossible combination: the strong growth in income and asset values of a strong economy, plus the ultra-low rates of a weak economy. Either the economy's long-term prospects will get worse or rates will rise. In either scenario, housing will weaken. Caveat emptor." http://www.businessweek.com/magazine/content/04_29/b3892064_mz011.htm http://www.huffingtonpost.com/kevin-phillips/the-bungled-bailout-or-th_b_133036.html?page=2&show_comment_id=16594224#comment_16594224

[MatoSka]

A lot of good ideas here that I by no means want to discourage. There are systemic structural problems though that are inherent in globalization, capitalism and the economic and political system of the United States. It would require a dissertation to analyze all these. One thing is for sure, cures for the current crisis are unlikely to address future crises. I am NOT saying don't change things, just that the flow of capital is like the flow of water, it flows where it can flow.

[Pdubya]

Indeed. Which begs the question: What is capital?

Credit?

Savings?

Fiat currency?

Sound money?

Capital is flowing where it needs to right now. In our pocket. We are cutting back, selling junk, saving, etc. The shameful thing is that the Fed is fighting us. They are diluting our efforts to do the right thing by debasing our currency by pumping more fiat currency into the system.

[Liberal2]

There's not enough gold and silver in the world to support gold standard currencies around the world. Plus, a modern technological society needs cheap gold and silver for use in manufacturing, You have no idea what you're talking about as far as the real world is concerned,.

[Pdubya]

Thank you for a refreshing article. I found it pointing to trees, and then towards the end you started to look at the forest. Perhaps your clinging to fiat currency is what is causing your intellectual struggle with what is happening? The Federal Reserve is the forest. Creating money out of thin air with no accountability is the grand manipulation of the market. (they pumped in $630 billion w/o Congress' "approval") before they were debating over the approval of the $700 billion. I am disappointed that you are not a fan of the gold standard. Hell, it could be an okra standard...we just need a standard. But perhaps you can see my point that our Constituion's call for only Congress to issue money (aka, the people, aka, the market) is something that needs to be re-illuminated. Credit comes from savings.

[Sean-Paul Kelley - Huffpost Blogger]

Pdubya,

I hear everything you are saying. But like I said, I am a fan of money creation. I think it can be, at times, when used wisely, a useful non-zero sum way of enhancing wealth. But at this point, the Fed's gone off the rails and needs to be revamped. And like I also said, the big Macro Fed stuff is beyond my paygrade and I'm not interested in talking about stuff I know too little about. Know what I mean?

[Pdubya]

It can not come from more credit! Friedman's views are not perfect. Nor is Keynesian. But, if you have a private cartel (The Fed) in control of the issue of currency, the ground is more fertile for corruption in Keynesian centralized banking. In essence, dog eat dog capitalism for you and me, socialism for the rich. Managed markets are fascism, not free markets. I would like a closer examination of Von Mises and Austrian economics. The free market will always prevail in any situation. The free market is not a separate body of principles or practices...it is simply how you and me conduct our lives and what we trust. The trust is gone, and we can not fool ourselves that we can manage or regulate trust. I fully applaud your views on anti-trust and fraud laws. Those are free-market safeguards - allowing failure. We had our chance to allow the free market to correct itself with a recession. We (they) blew it and opted to inflate our currency, furthering our chances for a depression. I will argue strongly that if we had sound money, only Congress to issue, and enforced these laws, rid ourselves of Sarbanes-Oxley and the Lobby driven regulations, true competition would ensue.

"Allow me to issue and control a nation's money and I care not who writes its laws!" Amshell Rothschild

[paixa3]

SOX was supposedly written to keep businesses, and financial reporting HONEST. Why would you want to rid the system of HONESTY. Granted, there may be less expensive ways to keep people honest.

Lack of principles, manners and morals HAVE casued the damn problem, and you want to perpetuate it..................NO THANK YOU.

[Sean-Paul Kelley - Huffpost Blogger]

When it comes to reporting corporate earnings outside of mark-to-market and mark-to-model industries, i.e. finance, Sarb-Ox has worked. I've seen it working up close and personal in my last job at a software company. And don't let anyone tell you it is "too onerous" and needs to be fixed. It's doing the job it is supposed to. The problem is not with Sarb-Ox, the problem is with Level 3 assets, mark-to-market and mark-to-model securities that everyone is terrified to have a price discovered because then the market might see them as close to insolvent at best, and bankrupt at worst.

[3dtrix]

And where exactly is this "free market"? Is it near Oz, Heaven, Valhalla? I hear various cultists speak about it, but even its most enthusiastic believers can't point it out...

[Pdubya]

start with U.S. History. Pretty close. Some of Europe too (historically).

www.mises.org

www.silverbearcafe.org

www.campaignforliberty.com

[Sean-Paul Kelley - Huffpost Blogger]

I too would like to see more Austrian economics looked at and discussed. While I don't buy the 'school' kit and kaboodle, I think there is a lot of good stuff to be taken away from it.