June 30, 2010

PUT THEIR OWN MONEY AT RISK:

6 simple steps to really fix Wall Street (Allan Sloan, May 5, 2010, Fortune)

1. Demand more skin in the game. Any reform plan worth its salt should greatly increase capital requirements -- the amount of money that stockholders have at risk, relative to an institution's assets -- for financial institutions. This is what people mean when they talk about reducing leverage. Lower leverage would make institutions less likely to fail, and any bailout of them less expensive.

Our most recent financial crisis, in which a relative handful of U.S. mortgages metastasized into a worldwide financial cancer, started with loans in which borrowers had nothing or almost nothing at risk. Neither did the companies that made the loans and sold them to other companies that bundled them, turned them into securities, and sold the securities to investors. At the end, these players walked away at little or no cost to themselves from the mess they had created, and stuck investors -- and society as a whole -- with a huge cost.

The fix? First, require any institution that turns loans into securities to keep at least 5% of each issue in its portfolio. Second, require a cash down payment from the homebuyer's own resources of at least 10% for any mortgage that's sold as part of a security or package of loans. (Lenders could make and hold lower-down-payment loans, but not sell them as securities.) [...]

2. Increase the Fear Factor. If any financial institution fails or needs extraordinary help from the government, the government should be able to claw back five years' worth of stock grants, options profits, and cash salaries and bonuses in excess of $1 million a year. That would apply to the 10 top executives, current and former, with a five-year look-back period. It would also apply to board members, present and past. (People brought in by regulators for rescues that ultimately fail would be clawback-exempt.) Anyone subject to the clawback would be permanently barred from executive positions or board seats at any institution that has federal deposit insurance or SIPC protection for brokerage customers. This provision would give executives and directors a huge incentive to make sure institutions they supervise don't take on excessive risk.

3. Expose derivatives to the light of day. Warren Buffett famously called derivatives "financial weapons of mass destruction." My colleague Carol Loomis somewhat less famously calls them "the risk that won't go away." They're both right. Simply put, derivatives are contracts whose value is derived from the value of an underlying asset. They were once relatively simple, socially useful things -- instruments that allowed a farmer to lock in the price he'd get for his wheat or an airline to know how much it would pay for jet fuel. But over the years the derivatives market has morphed into a huge, monstrous game consisting of speculation piled on speculation piled on speculation. At the end of last year there were $30.4 trillion of credit default swaps outstanding -- almost as much as the entire U.S. debt market -- according to the International Swaps and Derivatives Association. There were also $426.8 trillion of interest rate derivatives outstanding. A lot of this is double (or triple or quadruple) counting, but any way you look at it, the numbers are scary.

The market is essentially a vast black box in which no one ever knows who's got what obligations outstanding. So when problems began appearing in mid-2007, fear froze the financial system because many big institutions didn't know who was solvent and who wasn't. Regulators, lenders, and stockholders couldn't tell either.

The widely agreed-upon fix is for derivatives to be handled by clearinghouses that guarantee payment and require collateral to be posted, and for them to be traded on exchanges. That way regulators, creditors, and regular investors can see the price at which the market values them. Derivatives players wouldn't have to worry as much about whether the "counterparties" on the other side of their contracts could make good on their obligations, thus solving much of the too-interconnected-to-be-allowed-to-fail problem.


Posted by Orrin Judd at June 30, 2010 11:56 AM
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