"Platitudes and Misinformation are Drowning Out Sensible Finance Reform"

Sydney M. Williams

Thought of the Day

“Platitudes and Misinformation are Drowning Out Sensible Finance Reform”

May 17, 2010

As the Senate debates (or postures on) finance reform, words, written and spoken, swirl through the media, speeches and blogs, generally focusing on the symptoms and obfuscating, or ignoring, the causes.

Two examples, coming from opposite direction, make the point. The President, in his Saturday weekly radio address, urged passage of the Dodd bill. The other example was an op-ed in Friday’s Wall Street Journal. It was entitled “In Defense of Over-the-Counter Derivatives” by Mark C. Brickell, former managing director of Morgan Stanley and former chairman of the International Swaps and Derivatives Association.

The President, in his well articulated but vacuous words: “Wall Street reform will bring greater security to folks on Main Street.” “…it’s to make sure an economic crisis like this one that helped trigger this recession never happens again. That’s what Wall Street reform will do.” Putting aside the obvious error in wording – it was the credit and near-financial collapse, not the economic crisis, that triggered the recession – he, as is so often the case, spoke of no specifics. One gets the sense that either he doesn’t understand the causes, or that he views them as being beyond the comprehension of the average citizen – the latter being the more likely.

Even worse, in my opinion, was the column by Mr. Brickell. After starting out by lauding the growth in derivatives – $2.5 trillion in 1989 to $464 trillion today – he writes of the inherent value of derivatives. Most people understand that derivatives play an important role in reducing risks and lowering costs, for farmers, miners, manufacturers, bankers and consumers. He lays the blame for the credit crisis on a “system-wide misunderstanding of mortgage risk.” Give me a break! It was a result of too much debt, a function of too low interest rates; Washington, especially with its ties to the GSEs; a profligate consumer; bankers with the morals of Billy goats; and a proliferation of trading strategies, which provided no true economic value. Nowhere in his piece does he explain why a $60 trillion dollar global economy needs a derivative market almost eight times as big. Nor does he discuss the fact that speculators took valuable tools, such as credit swaps and mortgage products (CDSs), and perverted them for their own use.

By insuring its bonds, a corporation or a municipality (depending on the price of a hedging strategy) may be able to lower its cost. But permitting speculators to place bets that an entity will default, in an amount that exceeds the size of that entity, serves no economic purpose. It is as though I had a house worth $1,000,000 and that my ten neighbors each took out a fire insurance policy in that amount on my home. Who, in their right mind, would write such policies? Would not the self-interest of my neighbors be to burn my house down? The answer to the first question appears to have been AIG; the answer to the second is yes.

Mr. Brickell crows about the growth of the derivatives market, but doesn’t explain why the product category grew at a compounded rate ten times that of the economy. We all can agree that farmers, steel workers, exporters, bankers all use derivatives to lessen their risk and lower prices to consumers. We applaud the technology that allowed their creation. But we also know they were used for purposes other than that for which they were originally designed. The determining measure for any financial product should be: does it have an economic purpose, beyond enriching a few speculators? Does society benefit? Given the apparent inability of members of Congress to either understand or be able to explain, in sound-bite phrases the proposed bill, risks, to use a tired metaphor, throwing the baby out with the bathwater.

Attempting, as the President desires, to have a bill so comprehensive that what happened in September-October 2008 never happens again will prove an exercise in futility. One will never be able to fully anticipate the creations of every smart, but unethical, soul. What is needed are a few commonsensical, obvious and pragmatic rules that retain what is best about our system, while ridding it of its worst.

We need to restore confidence in our financial markets, a process that will require far greater openness, in everything from where derivatives are traded to corporate balance sheets. We must ensure that every financial product satisfy an economic need. We need to encourage long term investments and discourage short term, disruptive, trading activity. We need to encourage savings and discourage unnecessary borrowing, especially that related to consumption or pure speculation. .

The American people have a remarkable ability to understand commonsensical economics, which is one of the reasons that Tea Parties have proliferated over the last year or so. They recognize the close ties Congress has to Wall Street, despite the denials from the White House and the Hill that it’s “them”, not “us”. (In the past two years, the Democratic Party has taken in more than twice what Republicans have from Wall Street.) Those that are losing confidence in our markets recognize that Fannie Mae and Freddie Mac are nowhere mentioned in the finance reform bill, despite their obvious role in the melt down, and their extremely close ties to representatives like Senator Chris Dodd and Representative Barney Frank. They also know that part of the responsibility lies with regulators who ignored allegations against fraudsters like Bernie Madoff, or who chose not to enforce laws, like naked short selling. These people are disgusted with Washington and see in this proposed legislation a 1400-page populist tome, understood by no one, designed for sound bites, which keeps the current Wall Street-Washington cronyism in place, and that fails to attack the root cause of the problem.

Our capital markets are the essence of our economic well being. They are built on confidence, trust and the extension of credit. Their original purposes were to raise money for businesses and to provide liquidity for those who invested in those businesses. These markets provide investment opportunities for the citizens of this Country, so that retiring seniors may enjoy the fruits of their labor. Our capital markets also assist businesses in offering financial advice, including taking advantage of new tools in financial engineering that technology has permitted. Speculators provide an important role in taking the opposite side in hedging and in keeping corporate managements honest, particularly in their willingness to sell short a company’s stock. But, as our capital markets increasingly act as casinos and overwhelm their primary economic purpose, the risk is that the game ends.

The roots of the problem, not the symptoms, must be addressed. Mostly, it is simple common sense that is needed. It is these simple, sensible points that should be kept in mind as Congress debates, and the President preaches, finance reform.