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Obama's Wall Street Rx: This 'fix' won't fly

Prof. Peter Morici - 5/2/2010

President Obama yesterday spoke in New York in support of the bills before Congress that, he said, would "enact a set of updated, commonsense rules to ensure accountability on Wall Street." But would they really do the job -- or, as Mayor Bloomberg has warned, interfere with markets (and slam New York) without preventing a future crisis?

Consider the issue of derivatives regulation: Because "part of what led to this crisis was firms like AIG and others making huge and risky bets -- using derivatives and other complicated financial instruments -- in ways that defied accountability, or even common sense," the president wants to "ensure that financial products like standardized derivatives are traded in the open, in full view of businesses, investors, and those charged with oversight."

The bills he's backing would:

* Create a platform similar to commodities-futures exchanges to push some 95 percent of trading from the over-the-counter market into those exchanges.

* Ban banks (institutions taking government-guaranteed deposits) from running trading desks and holding positions

* And limit "synthetic securities." These are positions on securities that neither party owns. It's like buying insurance on a North Carolina beach house you don't own.

Realize first that derivatives are as old as civilization: Ancient Greek farmers insured crops with investors prepared to speculate on the weather, just as life insurers today hedge mortgage-backed securities by purchasing credit default swaps.

When written against real assets -- farmers' crops or homes -- derivatives spread risk, lower capital costs and foster growth. But, like any other financial contract, derivatives can be abused -- and the big-bonus culture on Wall Street has given us some high-profile shenanigans.

Thus, how derivatives are regulated or overregulated is central not just to curbing excess, but also to ensuring that farmers can plant, home buyers can borrow and businesses can invest.

First: Pushing virtually all these transactions through standardized contracts on a public exchange platform will serve these "Main Street" interests poorly, because such derivatives often have specialized purposes. For example, chemical manufacturers and life insurers have exposures to energy prices and interest-rate movements that vary a lot, and these companies need specialized hedges. Standardized contracts will reduce their ability to hedge risk -- and thus lower economic growth.

Second: Banning banks from derivatives makes little sense, unless we bring back the Glass Steagall Act and restrict banks to taking deposits, making loans and holding government debt -- and Congress has no stomach for that.

Banks provide trust services and make markets in municipal and state bonds -- both vital services. Banks need to hedge positions, and the recent financial crisis would not have been averted had JP Morgan, Citigroup and other big banks been banned from derivatives trading.

Virtually all of the 200 banks that failed over the last two years had no trading desk. Most failed making lousy loans and investing in poor commercial mortgage-backed securities. Now, investment banking activities -- yes, trading -- is helping to redeem Citigroup.

Third: On synthetics, arbitrary limits just won't work. Derivatives are simple contracts among consenting adults, and we know how laws to enforce private morality work -- they don't.

Of course the problem is real. Synthetic securities do little to mitigate risk and aid investment and growth in the real economy, but the scale of those markets (estimated to be to more than five times the size of the global economy) can instigate financial calamity when underlying asset prices abruptly move -- for example, housing prices after 2006.

Yet the way to protect the taxpayers and stabilize the financial industry isn't to ban any particular form of "gambling" -- it's to make sure the game can't burn the rest of us.

What we can do is can require banks, licensed securities dealers and the like to only sell contracts when the originating party posts adequate resources to pay if prices drop abruptly on underlying assets. That was the missing key at AIG when its house of cards collapsed -- this reform would limit the scale of the synthetics market.

The rest of what's being proposed is Washington excess -- fixing what isn't broken, and breaking what's running better than we now recognize.