THE BLOG
12/03/2008 08:58 am ET Updated May 25, 2011

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.