The panel has been set for the congressional probe into the financial crisis, and some of the names are head-turners:
House and Senate Democratic leaders picked former California state Treasurer Phil Angelides to head the Financial Crisis Inquiry Commission. Mr. Angelides was closely identified with efforts by state pension funds to become more active in litigating over corporate misbehavior. Other panelists include Byron Georgiou, a lawyer with a major securities litigation firm and a business owner, and Brooksley Born, a financial regulator under President Bill Clinton who was an early and vocal proponent for regulation of derivatives in the 1990s.
The key person on this commission, in my opinion, is Brooksley Born.
Appointed to the CFTC by Bill Clinton in 1994 she was a strong proponent of regulation of OTC derivatives, asserting that there was serious systemic risk in the OTC market and its lack of margin supervision and transparency.
Alan Greenspan and Arthur Levitt, then chairman of the SEC, went after her with a vengence for the report that was published in what was called at the time a "Concept Release"; their claim was that the "turmoil" that could result from regulation would reduce the value of such instruments due to potential legal uncertainty, would stifle innovation, and would cause firms to move their business offshore.
Where have we heard this one before?
Of course now we know that Ms. Born was right - and both Greenspan and Levitt were dead wrong. In point of fact the OTC derivative market has created the ability to commit financial arson any time someone finds an unlocked door where they can get a can of CDS gasoline inside, creating rather than mitigating systemic risk. Rather than spread risk to those most able to bear it, the OTC derivative markets have done the opposite, concentrating risk on the backs of firms that are least able to understand what they're buying, thereby placing them at a very real risk of failure not just due to their ignorance but also from intentional exploitation by their counterparties. The lack of disclosure and central clearing has enabled insane leverage, prevented capital adequacy tests from being brought to bear that are necessary to prevent systemic meltdowns and have resulted in artificially-wide spreads, thereby screwing the buyer while returning outsized and unearned profits to a small cadre of banks that make markets in these products.
The means of preventing this sort of meltdown in the future is really not all that complicated; we did it in the 1930s, and called it Glass-Steagall. If we're serious about solving these problems and preventing it from happening again there are some relatively-simple steps that could be taken, although they would rankle a lot of powerful people. In no particular order:
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Recognize that commercial banking - that is, the taking of deposits and the making of loans, is a public utility function. Commercial banks inherently draw upon the strength of the sovereign government (The United States) for their legitimacy and funding, with FDIC deposit insurance codifying an otherwise-implicit relationship. As such commercial banks must not be allowed to speculate in any market, or indeed, to perform financial functions other than the making of loans and the taking of deposits. This means that all such banks today, like Bank of America, JP Morgan, Goldman and others must be broken up into their commercial banking company with said federal support and a legally and financially-separate firm that has no such backstop or access.
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Re-impose hard leverage limits, police them nightly, and sanction violators heavily. Hedge funds, investment banks and others operating in the securities market (with commercial banks removed from it) must have leverage limits re-imposed to prevent the sort of systemic concentration of risk that occurred in 2007 and 2008. 14:1 worked for 50 years, and we should re-impose it. Henry Paulson's lobbying in 2000 and 2004 (the latter of which was successful) in having this limit removed was directly responsible for Lehman's and Bear's demise; proof of which is found in the fact that both were running with more than double the former limit when they failed. In addition AIG, Fannie and Freddie, although they were not legally covered by these limits previously, all had higher leverage ratios as well. Every major firm that has failed had excessive risk as measured by this metric, and none would have failed had they been limited to 14:1.
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Recognize that from secrecy comes mischief and even outright fraud. Bar the sale of any product in which a "proprietary interest" is claimed in the underlying data supporting it, or the models used to price and rate it. CALPERS has asserted that they were prohibited from seeing the internal data on securitized offerings under the rubric of "proprietary" data of the securitizers and raters. These products have now collapsed, yet CALPERS could not see inside the box either before or after they purchased it! While one can argue that nobody in their right mind would buy such a product, obviously, there are a lot of insane people, and we therefore need legal protection against them being defrauded.
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In light of the above, bar all "dark pools" and off-exchange trades of derivatives or other instruments related to public companies, municipalities and organizations in the United States. Every publicly-traded security and instrument referenced off it or a public firm must be traded on a public exchange with a central counterparty that guarantees the other side of the trade, whether long or short, much as the DTC and OCC do for listed stocks and options. All instruments must be traded on a public exchange where bid, offer, last trade, volume and open interest are reported contemporary with the execution of the trade. To prevent gaming of this rule through offshore operations bar any US-licensed institution (e.g. brokerage, investment bank or other company) from trading in markets that do not substantially conform to US regulations.
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Bar "high-frequency trading" intended to "shoot at" other people's order books. Providing liquidity is admirable but doing so at the expense rather than to the benefit of everyone else in the marketplace is unacceptable. Current "high-frequency trading" implementations lead to a whole host of abuses including computer programs that intentionally "probe" the order book of other market participants then scalp trades in front of them. The result is not the provision of liquidity but rather degradation of execution quality for the other market participants, while skimming off profits for the HFT firm. Essentially all of the major investment banks have engaged in an "arms race" in this regard; the problem with arms races is that they are always negative-sum games, resulting in losses on balance to the greater marketplace. Current market data shows that more than half of all NYSE volume is in fact comprised of these computer-armed bandits passing shares between one another, scalping off fractions of a cent. Any legitimate institutional or retail customer who is on the other side of these computer programs is guaranteed to get the worst execution quality they will tolerate rather than the much-touted "price improvement" that liquidity providers are claimed to bring to the market. The exchanges love these guys because every trade generates a fee (even if a good part of it is rebated back to the so-called "liquidity provider") but the end customer - that is, the legitimate retail or institutional investor - inevitably gets screwed by their presence. One simple change to exchange rules would inhibit much of the "sniping" - force any bid or offer to be valid for one full second, thereby making it impossible to issue "IOC" (immediate fill or cancel) orders in rapid-fire succession to probe other market participants.
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Bar "ratings shopping" and other similar actions. The simplest method is to separate the issuance of "opinions" (protected by the First Amendment) and "underwriting services." A rating from an NRSRO such as S&P, Moody's, Fitch or similar firm that is paid for by the issuer is inherently an "underwriting service"; such opinions, when paid for by the issuer and forming part of the issued security's marketing materials should come with strict liability for errors, whether acts of omission or commission. Simply put, an opinion paid for by an issuer in conjunction with making their issue marketable isn't protected speech, it is a material representation of fact by both the issuer and their agent, the hired agency, and must be so held under the law with strict liability applied. Had this standard been in place the "zero risk" game of ratings agencies being essentially bought-and-paid-for mouthpieces for the issuing institutions would not have developed.
There's much more I can offer but these suggestions would have prevented much of the abuse that led to this crisis, and will prevent it from happening again.
Certainly all of these suggestions will generate much heat from those who would have their ability to literally rob the public, both through hidden operations such as HFT as well as explicitly via bailouts when they take pursuit of their leverage too far and blow up, curtailed by these changes in the law.
If we are to truly address the underlying causes of this crisis, however, we must return the provision of credit to an underwritten act rather than something that is rubber-stamped to anyone who asks and can fog a mirror, and we must remove the dark corners where mischief and outright fraud has hidden over the last two decades.
We can do it, and indeed we must, if we are to return the financial system to the stability it knew from the 1930s after Glass-Steagall was imposed all the way up until the S&Ls started gaming the system in the 1980s.
50 years of financial system stability was squandered so a handful of Wall Street firms could literally steal hundreds of billions of dollars over the last two decades.
It is time to put a stop to it.
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