Common Sense Reform

In contrast to the President's faith-based Financial Services Reform package, sensible Financial Services reform would be ground in steps that would have clearly been helpful if in place over the past few years. Such reform would likely contain the following five elements:

• Too Big to Fail is Too Big: No single company ought be allowed to control more than a few percentage points of GDP. No single company ought be allowed to control more than a fraction of a percentage of any government insurance program. (Including the PBGC, which may well be the next bubble a burstin'). I continue to believe that the FDIC no longer serves any earthly good, but that is a more radical sell. At the least, there should be strict transparency requirements around all government insured institutions and those they who do business with them, and clearly defined limitations around aggregating, and leveraging, taxpayer risk.
• Regulating the Regulators:If we must create a new Government agency, it ought to monitor, evaluate and report on the costs, benefits, risks and consequences of existing regulatory policies.
• Derivative Ducktyping: Labelling any particular activity as a "derivative" ought not change its tax or regulatory profile. Selling CDS is selling insurance, buying TRS is buying on margin, etc.
• Protecting Vulnerable Investors: In deference to Senator Snowe's concern, market participants ought be allowed to self-identify as vulnerable. Self-identified vulnerable investors would be required to hire Brokers to represent their interests in transactions with Dealers.
• Educated Consumers: A licensing process, analogous to a driver's license, should be required of anyone who would like to participate in financial markets, whether by buying stocks or taking mortgages, etc.

These five elements -- preserving fairness, transparency and competition -- embrace the traditional spirit of regulation in our economy. The five elements proposed by the President, reflect a very different spirit.

Leap Of Faith

The President, at Cooper Union, declared five elements crucial to financial services reform:

* Instituting a system to ensure that "American taxpayers are protected in the event that a large firm begins to fail."
* Imposing the so-called Volcker Rule... limits on the freewheeling trading and risks taken by banks.
* Setting new transparency rules for derivatives "and other complicated financial instruments."
* Assuring "strong consumer financial protections."
* Instituting "pay reforms" to give investors and pension holders "a stronger role in determining who manages the companies in which they’ve placed their savings."

The logic behind the proposed mechanisms are, to a certain way of thinking, very straightforward: To protect American taxpayers from the failure of these Leviathan firms, regulators need to be empowered, in the first instance, to reduce the likelihood of failure and, in the second, to manage an orderly unwinding. Reducing the likelyhood of failure argues for the Volcker rule, pay reform, as well as greater transparency rules, so that regulators have an easier time understanding market interdependency. Finally, and certainly, ordinary customers have to be protected from predatory practices.

Ultimately, this logic demands large leaps of faith: It is simply irrational to believe that large Leviathan firms, representing double digit percentages of GDP, can be orderly unwound without requiring heavy taxpayer subsidy. The belief that, left to broad politician-regulator discretion, they can be fairly unwound, defies recent experience.

The bill itself calls into question the belief that a new, more complicated, patchwork of super-empowered regulators will reduce risk. The Volcker rule, premised as it is on the nonsensical notion that holding a loan is entirely different and less risky then buying a bond, and the politically popular, but economically misguided, "Pay Reform", are embedded evidence that this reform, will serve not to limit, rather -- in the now tried and true form of creating distorting market inefficiencies / regulatory arbitrage opportunities -- create risk.

Finally, if Madoff passed SEC scrutiny, and repo 105 passed muster with Fed employees placed at Lehman, how can Mom and Pop investors rationally expect to be reasonably protected by yet-another-agency?

Of Fiduciaries

One recurring line of questioning in yesterday's Goldman testimony, involved the notion that that market makers ought have a fiduciary obligation towards their customers. Olympia Snowe has taken a rather stark position:

10. Fiduciary Duty: Swaps dealers should have a special duty of care to pension funds, endowments, retirement funds, and state and local governments to protect vulnerable market participants from being taken advantage of by dealers.

Putting aside logistical questions about how such a duty could be coherently structured -- can dealers really be required to only buy what they want to sell and only sell what they want to buy? -- Ms Snowe's characterization of pension funds, endowments, retirement funds, and state and local government investors as being "vulnerable market participants" is jarring.

If she is correct, then Pension Fund managers who advertise themselves to their own clients as being -- and are paid to be -- savvy and sophisticated, not vulnerable and out-of-their-depth, investors appear guilty of fraud / misrepresentation.

Of Wall Street, Casinos and Derivatives

One common way of explaining "what went wrong", involves differentiating the Wall Street Casino, personified by excessive derivative trading, from the "productive economy".

This explanation fundamentally misunderstands the nature of free markets. Properly understood, free markets are Casinos. Every economic choice one makes -- of school, profession, employer, etc... -- is a bet. Above all, entrepreneurial activity -- the engine of a free market economy -- is bet-driven.

Imagine, for example, believing that parents in a particular city will increasingly demand environmentally friendly toys and therefore thinking about opening an environmentally friendly toy store. To do so would bundle a number of bets, first of all on the evolving demand for environmentally friendly toys, but also on demand for toys in general, on the real-estate, demographics and economy of a particular geographic area, on your ability to recruit, retain and motivate a staff, and so forth.

Underneath all the obfuscating mumbo-jumbo, derivatives are tools that allow free market actors to hedge their bets, which, by itself, facilitates economic activity.

To the environmentally friendly toys store example: If you believed strongly that demand for environmentally friendly toys will increase relative to toys in general, but are afraid that the market for toys in general may be about to collapse, you would choose not to open the toy store. On the other hand, if you were able to purchase a derivative that allowed your store to make money even if the market for toys in general collapsed, so long as the market for environmentally friendly toys collapsed less, you might choose to open that store.

Derivatives, like any security, are rendered dangerous when employees of institutions both too big to fail and too big to manage bet the house with them.

While no one, in our political arena, would claim to be opposed to free markets, one can see in various proposals, a frightening ignorance on the part of many, from both parties, who would "regulate" them.