Finance Reform, the Good, the Bad and the Ugly.

01 August 2010

The cause of the recession is multi-faceted, but the financial crisis grew out of the support to supply unqualified homebuyers with mortgages for homes they couldn't afford, or who were not sophisticated enough to understand the loans they were granted.   In a nut shell, this caused the housing bubble.  

Adding to all this, risks were multiplied by the derivatives industry, banks, loose practices at some credit-rating agencies, and the sale of these risky mortgages to Wall Street investors.  A perfect storm ensued, and left a generation of soon to be retirees questioning their future retirement.

When the bubble burst - well, we know what happened.  There weren't enough tools available to stop the carnage.

So, what have we done to prevent another disaster?  Is it the recently passed financial reform, or did Congress pass the buck to regulators?  There are over 2,000 pages in this recently passed legislation, and as with most legislation is full of compromises.

Good
Derivatives will come out of the back room and into the light. Derivatives are a multi-billion industry that will now be put on an exchange and the transactions made transparent.   What is a derivative?  Plain and simple, a derivative is a wager on the future performance of an asset.  And, you don't have to own the asset.  It has been suggested that this transparency may identify future systemic risk in the economy e.g., if everyone is betting against the future performance of an asset (say mortgages sold to Wall Street), it won't take an economist to figure out that industry may be in trouble.  

Large Banks will be required to increase the amount of capital they hold in reserve against loans going bad.  Banks will not be able to "proprietary trade."   This means they can't bet on financial markets using their own money (whose money?).  They will also be limited to investing a maximum of 3% of capital in speculative businesses, i.e. hedge funds.

Bad
Fannie Mae and Freddie Mac - no reform.
Credit Agencies - not much reform.
Congress has left most of the real tough decisions to regulators.

Ugly
Enough potential loopholes through which to shoot multiple howitzers.

Whenever I had a large task to complete, my mother would tell me, you can't eat an elephant all at once, you need to divide the task into doable pieces.  In this case, we may have ignored an elephant or two in the corner of the room, unattended.

Over the next few months will all be learning more about this legislation and I'm sure there will be more than a few surprises.

Citations:
BBC News, Business, 7/15/2010
Robert Reich, Former Secretary of Labor, Professor at Berkeley, Posted 7/16/2010
MSN Money 7/15/2010
www.whitehouse.gov/issues/economy/financial-reform

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