Imagine a health care system where the FDA is limited to regulating the labeling of medication and cannot pass judgment as to their efficacy. Does anyone feel confident enough in the integrity of drug makers to trust them not to misrepresent their products or put them on the market without adequate testing of their safety and effectiveness? Despite criticisms of the FDA, few would prefer this alternative.
When it comes to our financial health, however, the above situation is an example of the role the SEC plays in regulating the financial instruments sold to the public. They regulate the labeling of financial products and monitor for ongoing disclosure and abuse. Now, I believe capitalism is the best road to prosperity as Larry Kudlow is fond of saying, and America�s long record of success is the proof. But capitalism has a dark side, and that dark side is greed, or �excesses� and �irrational exuberance� as more tactful media commentators like to describe it.
Balancing government regulation and over-regulation of capitalism is a constant battle, but there is little argument with the notion that such regulation should have as its principal objective the preservation of its free enterprise principles. The recent financial crisis had many causes, but greed played a key role. Its most obvious role was in how executives of major financial institutions used their positions to take inordinate risks with other peoples� money in order to earn multi-million dollar salaries for themselves.
Some have argued that the solution here is simply to ban such short-term performance based compensation, but this cannot work. Financial talent will always find an employer or compensation scheme willing to pay them their worth. To legislate rules tight enough to prevent this would mean either forcing such workers overseas or abandoning the core principles of capitalism.
A more workable solution is to more closely regulate the type of financial instruments available in the market place to those which can show real worth to the system. This is like the FDA only approving the sale of medications that have proven efficacy. We accept the logic of such regulation to safeguard the health of the public. Why would we not apply the same principles to safeguard its financial health as well? If anything, such regulation is even more important in finance because the risks are not only to individuals and groups, but rather, they are systemic.
The financial crisis of 2008 came about due to excessive leverage and financial instruments (derivatives) created by Wall Street to compound leverage even further. The purpose of all that leverage was to earn inordinate rates of return on capital, i.e. the greed factor. New types of financial instruments were designed to enhance leverage and thereby overcome existing government regulation, as well as to provide hedges against default and against the mismatch of maturities that all the leverage was creating. This allowed the building of super leveraged positions by overpaid financial engineers because it allowed them to demonstrate that the leverage was being hedged.
However, it was done on such a massive scale that it lead to systemic risk for everyone. When the crisis came, the authors of the excesses had to be bailed out to prevent an even greater calamity to the public at large and all at the expense of the taxpayer. Sad to say, it did not result in policy changes that will result in avoiding an even greater crisis in the years to come.
The market for financial derivatives covers a vast range of products, measured in hundreds of trillions of dollars and is pretty much unregulated. Most derivatives such as commodity futures contracts, option contracts and forward currency markets have been around for many years and serve an important role in risk management. In the 2008 financial crisis the troubled derivatives such as CDOs, CMOs, CDSs, MBSs, etc. were sold by firms like Goldman Sachs, Merrill Lynch and JPMorgan Chase, mainly to large institutions and hedge funds.
Since 2008, we are seeing an expansion of the market to retail investor through the ETF market. This is a dangerous development since it brings into a market with already huge systemic risk, participants who have limited understanding of what they are really buying, and a tendency to panic when the going gets rough. Hence, they add to the risk of a financial crisis in markets that are �too big to save.�
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By way of example of abusive instruments, take Credit Default Swaps (CDS). This is a contract that pays the buyer if a specified debtor defaults on his debt during a given time period. On the surface this sounds like a normal insurance type of arrangement, however, it ignores the fact that the buyer of the contract does not have to own any debt at risk nor does he have to deliver the defaulted debt instrument to the insurer to allow him some recovery. Its structure provides the perverse motivation to the CDS buyer to profit by trying to make a default come about�this has happened in the past. It also encourages outright gambling such as when GM filed bankruptcy with reported credit default swaps three times the amount of debt outstanding. These instruments should be regulated to provide only insurance, not be an instrument for speculation.
The potential for systemic risk I am describing here is nothing new. In my book Income Investing Today I predicted under the subject of the derivatives market, �It has gained prominence because it has grown into a trillion-dollar market, so massive that it will someday jeopardize our entire financial system.� This was written in 2006. The Dodd-Frank financial reform act, which was supposed to remedy the excesses of 2008 and avoid another �too big to fail� scenario, did not recognize that regulating and outright banning some types of investment instruments in use today, and likely to be created in the future, as a key to stopping a future crisis.
I fear it will take another even more devastating financial collapse before such meaningful measures are taken. The main reason for this is that Wall Street is still the major influence on legislative policies in Washington DC. Failure to act before the next financial crisis risks a total revulsion of capitalism and legislation that could lead to its demise. That would be a tragic loss for future society. Income investors wishing to avoid these continuing risks, and therefore focus on capital preservation, should be aware that all safe havens for such investing have been made into conduits for subsidizing governments� needs. There are no more free lunches.
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