What Regulatory Reform Needs To Address
Regulatory reform is in the air. The debate is on.
Today, President Obama will give an address at Cooper Union in Manhattan. He will propose his ideas on regulatory reform for Wall Street and the banking system. I wanted to weigh in on this before hearing what he has to say.
After every market debacle, like the one we had in 2008, talk about regulatory reform always pops up. Let's hope something positive comes out of this latest round.
If regulations just increase the power of government, what good is that? On the other hand, if regulations help manage risk - to both individuals and the financial system - then maybe they make sense. Everyone involved in regulatory reform needs to keep risk management on their minds. And they should be taking a long hard look at leverage and derivatives. Here's why.
As an investor, risk management should be first on your list of good investment management practices. Before you start investing your money here and there, figure out what you might lose and how you can limit those losses. If you don't do that, you stand to lose a ton, as people recently did in 2008. Anyone who lost 40%, 50% or more then had no risk management going on in their portfolios.
In theory, derivatives are supposed to help manage risk. Sometimes they do. But sometimes derivatives increase risk. When a derivative transaction minimizes risk, it's because the parties to the transaction were acting in a prudent fashion. When derivatives transactions increase risk, it's because the parties to the transaction are gambling. Unfortunately, it seems the gamblers outweigh the prudent these days.
When the hedge fund, Long Term Capital, almost caused a systemic financial collapse in 1998, the Fed got involved. They called the Wall Street investment banks - players like Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, JP Morgan, etc. - to a secret meeting in New York to avoid a collapse. The effort succeeded.
Long Term Capital made big bets with borrowed money. The problem there was one of leverage,which is to say borrowed money. But while everyone was breathing a sigh of relief, part of the discussion of how to avoid another crisis turned to derivatives. People started to worry then that the use of derivatives had gotten out of control and could cause a crisis like the one the Long Term Capital caused. Some people thought that derivatives posed an even greater threat of financial collapse than the Long Term Capital incident.
Alan Greenspan, then Fed Chairman, assured everyone that derivatives did not pose such a threat. He said that derivatives were a way to control and limit risk, not create a financial collapse. At the time, I thought he was smoking something.
The fact is, no one then or now really knows what the heck is going on with derivatives. The reason is that a lot of derivative transactions take place between parties with no oversight of any kind. No only is there no oversight or regulation of the transactions, there isn't any transparency. There's no source you can go to to find out who's a party to what transaction. There's no where to look up how many transactions exist. In short, there's no way to know whether these sorts of hidden derivative transactions are minimizing risk or whether they might be increasing the risk of collapse of the whole financial system.
You would think that after something like the Long Term Capital incident, the use of leverage and the use of derivatives would have come under closer scrutiny. But in 1998, we were in the last years of the greatest bull market in stocks on record. In bull markets, stuff like this gets swept under the rug. Everyone's too manic about making money. No one wants to hear bad news. No one wants the party to stop.
And so nothing was done. In fact, even now, after the terrors of 2008, nothing has been done. Sure, there's talk of new regulations, or greater oversight. But right now, nothing's happened. It will be interesting to see just what President Obama has to say today and what happens in the coming months.
Keep your eyes and ears open for "leverage" and "derivatives." If these two subjects aren't addressed, then I don't really see any point to any kind of regulatory reform. Risk management using derivatives will continue to be a bogus idea. And we can bet on not only another crisis coming, but an even bigger one.
Depending on what the President says today, I may come back with additional comments soon. But I wanted to get on record now, whatever he has to say.
Today, President Obama will give an address at Cooper Union in Manhattan. He will propose his ideas on regulatory reform for Wall Street and the banking system. I wanted to weigh in on this before hearing what he has to say.
After every market debacle, like the one we had in 2008, talk about regulatory reform always pops up. Let's hope something positive comes out of this latest round.
If regulations just increase the power of government, what good is that? On the other hand, if regulations help manage risk - to both individuals and the financial system - then maybe they make sense. Everyone involved in regulatory reform needs to keep risk management on their minds. And they should be taking a long hard look at leverage and derivatives. Here's why.
As an investor, risk management should be first on your list of good investment management practices. Before you start investing your money here and there, figure out what you might lose and how you can limit those losses. If you don't do that, you stand to lose a ton, as people recently did in 2008. Anyone who lost 40%, 50% or more then had no risk management going on in their portfolios.
In theory, derivatives are supposed to help manage risk. Sometimes they do. But sometimes derivatives increase risk. When a derivative transaction minimizes risk, it's because the parties to the transaction were acting in a prudent fashion. When derivatives transactions increase risk, it's because the parties to the transaction are gambling. Unfortunately, it seems the gamblers outweigh the prudent these days.
When the hedge fund, Long Term Capital, almost caused a systemic financial collapse in 1998, the Fed got involved. They called the Wall Street investment banks - players like Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, JP Morgan, etc. - to a secret meeting in New York to avoid a collapse. The effort succeeded.
Long Term Capital made big bets with borrowed money. The problem there was one of leverage,which is to say borrowed money. But while everyone was breathing a sigh of relief, part of the discussion of how to avoid another crisis turned to derivatives. People started to worry then that the use of derivatives had gotten out of control and could cause a crisis like the one the Long Term Capital caused. Some people thought that derivatives posed an even greater threat of financial collapse than the Long Term Capital incident.
Alan Greenspan, then Fed Chairman, assured everyone that derivatives did not pose such a threat. He said that derivatives were a way to control and limit risk, not create a financial collapse. At the time, I thought he was smoking something.
The fact is, no one then or now really knows what the heck is going on with derivatives. The reason is that a lot of derivative transactions take place between parties with no oversight of any kind. No only is there no oversight or regulation of the transactions, there isn't any transparency. There's no source you can go to to find out who's a party to what transaction. There's no where to look up how many transactions exist. In short, there's no way to know whether these sorts of hidden derivative transactions are minimizing risk or whether they might be increasing the risk of collapse of the whole financial system.
You would think that after something like the Long Term Capital incident, the use of leverage and the use of derivatives would have come under closer scrutiny. But in 1998, we were in the last years of the greatest bull market in stocks on record. In bull markets, stuff like this gets swept under the rug. Everyone's too manic about making money. No one wants to hear bad news. No one wants the party to stop.
And so nothing was done. In fact, even now, after the terrors of 2008, nothing has been done. Sure, there's talk of new regulations, or greater oversight. But right now, nothing's happened. It will be interesting to see just what President Obama has to say today and what happens in the coming months.
Keep your eyes and ears open for "leverage" and "derivatives." If these two subjects aren't addressed, then I don't really see any point to any kind of regulatory reform. Risk management using derivatives will continue to be a bogus idea. And we can bet on not only another crisis coming, but an even bigger one.
Depending on what the President says today, I may come back with additional comments soon. But I wanted to get on record now, whatever he has to say.
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