The Regulatory Dilemma with Derivatives

With all that's happened in the financial markets during the last year, we now know that a large part of the banking system has slipped away into the derivatives market. To a large degree, that's become the place where the real risks of borrowing and lending are taken. As the derivatives market has evolved over the last 30 years, federal regulators have assiduously avoided regulating it (with the minor exception of standardized stock options). Instead, they believed that the private sector, aided by ratings given by the credit rating agencies, would be able to take care of itself.

Unfortunately, they seem to have forgotten the hard lessons learned in the 19th century and early 20th century: unregulated financial markets inevitably suffer boom and bust cycles. If the unregulated markets become large enough, those booms and busts will have painful repercussions for the larger economy. As somebody somewhere once more or less said, those that ignore history are doomed to repeat it. And, today, we have a repetition that would be quite familiar to J.P. Morgan himself. The mess is in the unregulated portion of the financial markets. The stock markets, which are heavily regulated, are doing okay, all things considered. This wasn't a failure of regulation. It was a failure of nonregulation.

Everyone with a seat at the table of the derivatives markets realizes that things will have to change. The Fed can't keep lowering interest rates forever, so other action will be necessary. The traditional federal approach to securities regulation--registration and extensive disclosures in prospectuses--probably won't be taken, since the SEC has backed itself into a corner. Almost all of the derivatives contracts in question were sold in ways for which the SEC does not require registration. Essentially all of the investors that invested in derivatives are so-called "accredited investors" who can purchase in these non-registered offerings. Thus, these investors did not receive the protections given to ordinary investors buying in registered offerings. While there's a nice theory that "accredited investors" (i.e., institutions and wealthy individuals) can take care of themselves, the theory had a nasty collision with reality in the mortgage and derivatives markets last year. We shouldn't delude ourselves into believing that accredited investors such as municipal officials in the American heartland or northern Norway, or thrifty dentists, really understand the nuances of the Wall Street's financial engineering. Given all the losses recently recorded by banks, it's clear that Wall Street didn't understand all of those nuances. But the SEC probably won't want to change its regulatory structure enough to bring the derivatives markets under its registration and disclosure requirements.

So what to do? Here are a few ideas.

Substantially increase capital requirements. Capital requirements for commercial and investment banks that want to play with derivatives should be sharply increased to cover the real risks that these instruments present. This will impose costs that will make the banks pause and think before creating highly risky, opaque, illiquid, and downright stupid derivatives of the sort that have caused so much trouble recently. They'll be more prudent, and that will make the banking system safer and sounder.

Create a clearing firm that processes derivatives transactions and ensures settlement. This idea is already under discussion, and the clearing firm that results should be copiously capitalized to maintain investor confidence. It's imperative to eliminate counterparty risk in the derivatives markets. Counterparty risk was the essential rationale for the Bear Stearns bailout, but the Federal Reserve can't keep bailing out every too-big-to-fail firm out there because it simply hasn't got the moola. (Okay, it could print the money for further bailouts, but then it would have to raise interest rates to counteract the inflationary potential of printing money and we all know what kind of hissy fit the financial markets would have if the Fed raised interest rates.) A soundly run clearing firm would impose high margin requirements on risky derivatives, which would make banks think closely before creating and trading these puppies. And that would make for a stronger financial system.

Tighten up the accounting rules. A number of banks may have thought that they could siphon the really nasty derivatives contracts off their balance sheets and into alphabet soup entities with names like SIVs, SPVs, conduits, etc., and therefore not maintain capital to cover the risks of these investments. Reality eventually taught them that they couldn't get away with this. The accounting rules should reflect reality; otherwise, why bother with accounting?

Apply suitability requirements to accredited investors. A lot of accredited investors who supposedly were able to take care of themselves were flimflammed in the derivatives markets. The reality is that many financial instruments today are so complex that even the people who created them don't understand them. After all, how could the grand poobah of the mortgage-backed market--Bear Stearns--have gotten itself into such a mess that it went under? Because it really didn't grasp all of the risks it took.

Suitability is a decades old concept in the securities laws that basically holds brokers responsible for selling investments that are suitable to the particular client buying them, in light of the client's wishes and circumstances. For example, it would surely violate the suitability rules to invest all of a widow's or orphan's money in an ostrich farm. It's not that much of a stretch to say that a municipality's operating funds shouldn't be invested in novel and esoteric instruments whose liquidity has never been thoroughly tested in the real world. After all, schoolchildren shouldn't be deprived of textbooks because a fast talking sales person on Wall Street earned a fat commission by selling a municipality an inappropriate investment.

In the past, many courts and arbitrators have been unenthusiastic about applying the suitability doctrine to wealthy individuals such as accredited investors, and have been even less inclined to apply it to institutional investors. That should change, at least in the context of derivatives transactions. Derivatives are products created by investment banks and the banks know much more about them than anyone else. They're in the best position to evaluate the suitability of these investments for a client, and are far more knowledgeable than any client. Many clients, even sophisticated ones, might not even know the right questions to ask. And if you don't know where to begin, you aren't likely to end up where you want to be.

Applying the suitability requirement to sales of derivatives to accredited investors would: (a) make banks pause and think before creating a piece of financial garbage that the bank wouldn't want to hold on its own balance sheet and selling it to clients; (b) result in greater disclosure to clients, which is an easier way for the regulator to foster disclosure than imposing registration requirements; and (c) make the client feel greater confidence about investing in derivatives (and investor confidence is something the derivatives markets desperately need right now). The suitability requirement wouldn't prevent sophisticated hedge funds from buying very high risk paper; but it would likely protect industrial cities in places like northern Alabama from having their budgets blown up by obscure financial risks.

Encourage increased transparency. A large part of the problem with derivatives is that you can't see them trading anywhere. Trading is done over-the-counter, which means by telephone, e-mail or other one-on-one communications not visible to anyone except the participants. This opacity is a very big reason why these puppies have become illiquid. By contrast, look at what happened to Bear Stearns' stock when the ship hit the sand--it sank dramatically in value, but trading continued and the stock never became illiquid. Let's be clear on this point: transparency enhances the true value of an investment because it reduces the scare and panic factor. Derivatives trading should be pushed as much as possible onto exchanges and other markets with public, real-time price quotations and trade reporting. Formalizing these markets will entail standardizing the various kinds of derivatives, and that will reduce broker-dealer profits. But it will enhance investor confidence, which is a higher priority than broker-dealer profits (we hope).

Stop using the credit rating agencies as pinch hitters. Up 'til now, the regulators have used the credit rating agencies, which evaluated the creditworthiness of derivatives and therefore gave investors something to rely on, as a proxy for federal regulation. That dog don't hunt no more. May we delicately observe that the credit rating agencies were perhaps a bit tardy in downgrading some derivatives? We don't want to heap too much blame on the credit rating agencies, since the primary responsibility falls on the firms that created the financial excretions we're trying to clean off the soles of our shoes. But the credit rating agencies aren't as all-knowing as many investors thought, and politically conservative federal regulators can no longer conveniently mumble ideologically-driven platitudes about the inherent superiority of the private sector over the government. The credit rating agencies evidently are trying to improve, and investors can rely on them or not, as they choose. But the United States government should stop trying to use the credit rating agencies as pinch hitters to do its job. It's time for the government to step up to the plate.

For more on the economy and economics, take a look at http://struckintraffic.blogspot.com/2008/05/american-economics-blog-carnival-june-1.html.

Borrow Less to Pay for College

As the credit crunch progresses, college loans are becoming harder to get and more expensive, even though the Federal Reserve keeps lowering interest rates. The reasons vary, ranging from indigestion in the asset-backed securities market to migraines in the auction rate securities markets. Whatever the reasons, the Great Credit Contraction of the 2000s is making it harder to borrow the money needed for college, and loans cost more if you're able to get one. Common sense tells you that when something becomes more expensive, you should think more carefully about whether or not to pay for it. This is true of loans as well as anything else. Let's look at the math.

If you go to a private college and graduate with $100,000 of debt bearing interest at a rate of 9% per annum, paying $800 a month will repay the loan in about 31 years, with about $196,851 in interest payments. If you boost the monthly payment to $1,000, you'll pay off the loan in about 15 and 1/2 years, with about $85,532 in interest paid. No matter how you look at it, though, $800 to $1,000 is a lot of moola out of a young college grad's monthly income.

If you go to a state university and graduate with $50,000 of debt bearing interest at a rate of 9% per annum, you need make only a $400 monthly payment in order to pay off the debt in 31 years, and you'll pay about $98,425 in interest. A $500 a month payment will repay the loan in 15 and 1/2 years, with about $42,766 in interest paid. These payments are nothing to laugh at, but are a lot easier than $800 to $1000 a month. And the much smaller amounts of total interest paid leave you with more money to invest for retirement.

There isn't much of a relationship between the college or university a person attends and that person's career success later in life. How hard and effectively you work is much more important to your career success than the sheepskin hanging on your office wall. A CEO of an S&P 500 company is much more likely to have a college degree from a public university than an elite private college. One public school, the University of Wisconsin at Madison, can count as many or more S&P 500 CEOs among its alumni as any Ivy League or other elite private college. And it's quite a bit less expensive, even if you're paying out of state tuition.

Go to college, by all means. People with four-year degrees or more generally have good careers with incomes that keep pace with inflation. People with less education usually struggle. But when college costs are as astronomically high as they have become, it makes sense (and cents) to borrow less. You'll have only a finite amount of lifetime income, and spending a big pile of it on interest charges will sharply reduce your chocolate budget. Here are a few ways to make less money for the bank.

Go where your total costs are lowest. Apply to several schools, all of which you consider acceptable. Then go to the school that will cost you the least. Factor in any scholarships offered, and any other assistance that you don't have to pay back, such as work-study programs. Even if you don't end up at your top choice, you may be better off in the long run. A diploma from a school with a fancy reputation may give you a sense of status. Less debt will let you live better.

Work while attending college. In the 1930s, another time of economic stress, many students worked part or full time while attending college. Those working full time took night classes, and needed a number of years to graduate. There's no law that says you have to earn a college degree in four years. Ten years after you graduate, you won't care very much whether it took you four or eight years to get the sheepskin. But you probably will care a lot about a heavy debt load.

Become a state resident. If there's a good public school you'd like to attend, enroll for the freshman year and then find out what it takes to become a state resident. You may have to work a year between your freshman and sophomore years. But that would be a year well-spent. Not only could you save some money from your job, you'd lower your college expenses a whole lot.

Supercharge your course load. Take an extra course each semester. You may be able to graduate a semester earlier this way, thus saving a semester's expenses. You may think you need to be an academic star to pull this off. But the GIs who returned from World War II often took extra heavy courseloads to make up for "time lost" during the war. Many of your grandfathers did just this, and you can do it, too.

For more thoughts about kids and money, and personal finance, please go to http://www.money-hacks.com/

For more ideas about finance and money, please check out the carnival of wealth, money and life at http://www.howisavemoney.net/daily-links/carnival-wealth-money-life-june-2nd-edition/.

For more personal finance ideas, check out the carnival of financial planning at www.theskilledinvestor.com/wp/carnival-of-financial-planning-may-10-2008-edition-258.htm.

The Child's Version of Rising Food Prices

(To be sung to the tune of “Three Blind Mice.”)

Look at the rice.

It has a new price.

Up, never down.

I feel I will drown.

It’s taking all the fun out of life.

Budgets, stress and bankruptcies are rife.

Did you ever see such a sight in your life

As the price of rice?


Rice is the staple of more of the world's population than any other food. Its rising price has led to riots in some nations. Sam's Club and Costco are now limiting bulk sales of rice. What's next? Micky D limiting the number of double cheeseburgers we can get?

A Nursery Rhyme for the Housing Crisis

(To be sung to the tune of “Row, row, row your boat”):

Pay, pay, pay your loan,

Steady as a stream.

Miss a payment and you’ll find

Your house is but a dream.


[To add to the fun, enlist four people with passable voices and sing it as a round.]

Ten Reasons to Keep Your SUV

With the price of gasoline rising every day, and the snide comments you get about a size 22 carbon footprint, you wonder whether to trade in the Behemoth Deluxe that takes up most of your driveway. Here are ten reasons to hold onto it.

10. The SUV is more comfortable to sleep in than a subcompact, which will matter after you lose your house to foreclosure.

9. The SUV can hold more of your things than a subcompact, which will matter after you lose your house to foreclosure.

8. A big SUV still carries the aura of prosperity, which will matter after you lose your house to foreclosure.

7. It’s tough to do Lab rescue with a subcompact, and you’re not ready for a minivan.

6. You can’t take your baby, and your baby’s bouncy seat, playpen and fold-up crib to Grandma’s in a subcompact, and you’re not ready for a minivan.

5. You’re not ready for a minivan.

4. You don’t like self-righteous people to tell you what to do.

3. You don’t like bike riding, car sharing, self-righteous people to tell you what to do.

2. You don’t like bike riding, car sharing, self-righteous people who litter the world with their plastic water bottles and styrofoam food containers to tell you what to do.

1. If you have to give up your SUV, your $20,000 bass boat might be the next sacrifice, and we aren’t going there.

Investors Diversify. Why Not Government Economic Policy?

For at least the last seven years, the federal government's policies for fostering economic growth have revolved around boosting a single asset class: real estate. We all know how that's turning out. Yet administration officials and presidential candidates continue to fixate on real estate. Investors diversify in order to maintain financial health. Why not the federal government's fiscal and monetary policies? For ideas, see http://blogger.uncleleosden.com/2008/04/america-nation-of-bailouts.html.

The Federal Reserve's Gamble with Inflation Policy

The Federal Reserve's policy on inflation appears to be the hope that an economic slowdown will restrain price increases. Yet the Fed is doing everything it can, including the use of kitchen sink policies that it created on the back of an envelope, to prevent a recession. If the Fed is successful in accelerating the economy, it won't get the restraint on inflation that a slowdown presumably would have brought. In such a situation, it may have to raise interest rates rapidly to tamp down inflation. But rapid rate increases could undo the Fed's stimulus, sending the economy into a tailspin.

We have recently gotten some stern lessons about trying to be too clever by half. That's how the big banks in the derivatives markets managed to offload risk and send it on a circular path back to their own balance sheets. The derivatives markets are so complex and opaque that the banks didn't realize the horse they were buying was the same toothless nag they had sold last week.

Inflation is rising worldwide, with oil and food prices leading the way. In some nations, we're seeing a revival of old-fashioned food riots, the developing world's equivalent of a run on the bank. The nations that manufacture the goods sold in American stores are struggling with rising costs and are passing them onto the American consumer. Higher shipping and transportation costs add to the prices of manufactured goods. Foreign central banks are keeping interest rates comparatively high to combat inflation, thus protecting their own currencies at the expense of the dollar. The weakening of the dollar increases the cost of imported goods. This worldwide flurry of price pressures will pop a lot of holes in the dam that the Fed is trying to hold back.

Fundamental to the Fed's inflation policy is the premise that an economic slowdown will reduce purchasing power to the point where it discourages price increases. But let's remember where today's purchasing power comes from. Employment is only part of the picture. For many people, credit is the principal source of purchasing power. Employment can be the beginning point for an extension of credit. But the amount of purchasing power one gets from a credit card may be multiples of one's monthly income. (Compare your monthly aftertax income to the combined lines of credit on your credit cards, and you'll see what we mean.) Even if incomes are constrained by an economic slowdown, price increases can be absorbed by greater use of credit. Many banks are cutting back on the amount of home equity lines of credit. But borrowers can simply turn to their credit cards. Even if these are more costly, the low monthly payments required on credit cards mask and soften the real costs.

Thus, the oceans of credit available to the American consumer allow price increases to stick even as the economy slows. People will reduce big expenditures, such as the next car, a new and fancier refrigerator, or a home remodeling project. But they will, with some grumbling, be able to absorb the increased prices of bread, milk, gasoline, heating oil, natural gas, airline tickets and so on. Easy credit facilitates stagflation. When banks can borrow from the Fed at bargain basement rates and relend to credit card borrowers at rates sometimes approaching 20% or more, they enjoy a nice profit. They won't cut back on their profitable lines of business.

Things are nowhere nearly as bad as the stagflation hell of 1979. But that's not the relevant comparison. The appropriate analogy is to 1973-75, the beginning of the era of stagflation, when the first OPEC oil price hikes were followed by a faltering economy, a falling stock market and increased inflation. The Fed focused on stimulating the economy, keeping interest rates relatively low. The stock market revived, but only temporarily. By believing too much that inflation and recession are mutually exclusive, the Fed wound up having both to contend with. The painful resolution came five long years later, when Paul Volcker replaced Arthur Burns as Fed chairman and decided that the only way to true economic health was to suppress inflation by sharply raising interest rates, knowing that it would throw the economy into a nasty recession. That was the right decision, but it probably resulted in more pain than would have been suffered had his predecessor made the same choice five years earlier.

The Fed's current policy is to believe that we can have it all, even though its restraint on inflation is the slowing economy that it is trying to prevent. This may be plausible to those who believe up to six impossible things before breakfast. But some--call us the skeptics--tend to think that the Fed is rolling the dice for a hard eight (a Las Vegas term for the dice turning up four and four). This play might have a generous payoff. But the chances of winning are low and we, the people, will pay the price if the government is wrong.

A Limerick for the Financial Crisis

There was a chairman named Bernanke,

Who had a problem with bad bankies.

They wanted a bailout

Without any time out

For all their past hanky panky.

America: a Nation of Bailouts?

As Bear Stearns’ counterparties breath sighs of relief, and homeowners targeted for foreclosure holler for federal assistance, we must consider whether we are becoming a nation of bailouts. Every time we have a problem, people turn to the government, and especially the federal government, to solve their problems. For better or for worse, the government is assuming more and more of society’s risks. Many of the bailouts started off as good ideas. Social Security has done much to alleviate poverty in old age. Medicare and Medicaid have prevented numerous needy patients from having to ask for charity at a time when their need was greatest. Federal financial assistance for college educations has allowed many who would otherwise have been left without college and/or graduate level degrees to become well-paid executives, professionals, engineers, educators, scientists, and the like. As burdensome as college debt may be, it’s better than being qualified only to make lattes and grandes.

Some federal subsidies no longer have much logic. Farm price subsidies and federal flood insurance are examples. But it’s too late in the game to suggest that the government step back from its role as national nanny. Every federal subsidy or bailout anywhere becomes a de facto Constitutional right in two nanoseconds. Congress always chooses the pork barrel polka over political courage. And Congress isn’t alone in doing this dance. The Fed joined in with its unilateral, unlegislated, weekend special bailout of the wealthy people who work for Bear Stearns’ counterparties while providing a federal subsidy to the shareholders of J.P. Morgan Chase.

It’s rather expensive for the federal government to bear such risks. Social Security and Medicare are prime exhibits. And the American taxpayer can only look forward to increased burdens. (See the same exhibits.) But this camel’s back can be broken. We must look for ways to ease the burden on the taxpayers, or the entire house of whatever will turn out to be a house of cards.

Taxation is imposed, ultimately, on the wealth of a nation. The wealth of nations is, in turn, based on a nation’s ability to produce goods. You don’t build sustainable national wealth with expensive coffee, fast food, real estate that’s bought and sold like tulip bulbs, and financial intermediation of esoteric and opaque investments. You build national wealth and strength by producing goods. World War II wasn’t won by overly clever Wall Street financial engineering. It was won by, among other things, the enormous manufacturing capacity of the United States in the 1940s. Look at the nations that today are considered economic powerhouses: China, India and Asian Tigers. They got there through production. How, then, to increase America’s ability to produce?

Promote technology--high tech and bio tech. America is a high cost nation and should manufacture high valued added goods. These would be high tech goods. Northern Europe’s economy relies heavily on this idea. America’s overall technological lead would allow it to use such a strategy potentially to even greater advantage. The following steps would help to promote technology.

Increase educational support for math, science and technical students at the grad school, college and community college levels. The advantage in high tech comes from having the best brains. Give these students more outright grants and scholarships; not more debt or cheaper debt. Make it easier for kids to enter these fields. We won’t enhance our manufacturing abilities with more English Lit majors who become lawyers or MBAs in order to get a job. We need engineers, researchers, and skilled machine tool operators.

Increase immigration opportunities for well-educated foreigners who have math, science and technical education and skills. This is an easy way of getting more of the best brains in the world. America offers greater individual liberty and opportunity than just about any other nation. People want to live here. Make it easy for the people would contribute greatly to our economy.

Increase federal funding to maintain and improve transportation systems. America is a big nation and its manufacturing facilities are scattered about from sea to shining sea. Manufacturing prowess in a big nation requires efficient transportation.

Provide tax incentives to businesses that invest in production of goods—not production of services (we don’t want to use federal dollars to encourage more dogwalking services or coffee shops selling $5 lattes). We need more plants and factories that produce goods.

Review Defense Department activities and files for technologies that can safely be released to the private sector. The Internet originated from a Defense Department project. So did the GPS system. Look where they are today. Sure, foreigners as well as Americans benefit from the Internet and GPS. But America has benefited the most. The Defense Department’s technologies were funded by the taxpayers and ultimately belong to the taxpayers. Anything that need not be kept secret for national security purposes should be made available to the public.

Sure, all this costs money. But it's better to spend some money to expand the economic pie than to squabble over a pie that will probably shrink as we rely on foreigners to fund our consumption with a depreciating dollar while we pretend that the next Fed-induced asset bubble is making us wealthy.

For more on economics and the state of the economy, please check out the American Economics Blog Carnival at http://struckintraffic.blogspot.com/2008/05/american-economics-blog-carnival-may-15.html.

The American Love Affair with the Car, 2008

Prayer of the Financial Speculator

As I approach the seventh chapter of the Book of Bankruptcy,
I repent of my greed, envy and pride.
Help me to the path of righteousness.
Give me the strength to continue through the financial wilderness.
Grant me just one more asset bubble.
Guideth the Fed to lower interest rates anew.
Resurrect real estate prices and my access to leverage.
Deliver unto me gullible investors to re-capitalize my hedge fund,
And greater fools than me to trade with.
Make my cup runneth over one more time,
And I will dwell in my house in the Hamptons,
Forever. Amen.

The Joy of Saving

The Federal Reserve has bailed out Bear Stearns. The Treasury Department has proposed the re-organization of the financial regulatory structure. The capital markets are receiving a lot of government attention. But what about American households? Many of them have tattered balance sheets. That's why so many people took out no/low downpayment, adjustable rate, interest only, option ARM, maybe we can repay them (but maybe not) mortgages. If their household balance sheets had been stronger, they could have gotten plain vanilla 30-year fixed rate mortgages. There'd be many fewer defaults and foreclosures, and Wall Street might not have needed a bailout. But is anyone in the federal government trying to strengthen household balance sheets? Is it sensible to tax interest on savings at ordinary income levels? Is it sensible to give borrowers a deduction for mortgage interest costs no matter how stupid the mortgage? Savings create a comparatively stable deposit base for banks, and banks desperately need stability now. Stupid mortgages created mammoth risks for banks that seem to persistently emerge in whack-a-mole fashion every fiscal quarter. The Fed can't keep sticking its thumb in the holes in the dikes because new holes are always bursting out like horror movie corpses popping up from graves. Some attention to the underlying problems is usually a better way to deal with a crisis than mad scrambles that create moral hazard. For more on this point, go to http://blogger.uncleleosden.com/2007/11/passbook-savings-cure-for-banking-and.html.