Regulatory update

By now it’s a dead horse – but hey, let’s beat it some more. I repeat myself here to help concepts take root in my beloved readership and also because I recognize that the blog is picking up new readers frequently who may not be up to speed with everything that we have discussed.

DEAD HORSE: For the economy to fully recover the institutions that led us here and that failed must change. So must the leadership that got us into this deep recession. And lastly, there need to be new ideas that supplant the old, failed ideas.

There is lots of “under the radar” movement on the regulatory front. Today, in particular, three additional measures have been introduced to help shape industry and regulation as it goes forward.

The first announcement was made by President Obama himself here in my home state of New Mexico. The President spoke about the need of Congress to have a credit card industry reform on his desk before Memorial Day. This effort by the U.S. chief executive and the U.S. Senate follows weaker House of Representative efforts last month, when they passed a “credit cardholders bill of rights.” Obama’s outline for change includes:

• Limiting the ability of credit card companies to raise interest rates.
• Limiting the ability of credit card companies to impose late fees.
• Simpler language in credit card disclosure statements (thank God).
• Limits on issuance of credit cards to college students.
• Stronger monitoring and penalties for abusers.

The second, and most important piece of potential regulatory change regards the derivatives markets in the U.S. Derivatives are investments whose value depends on the value of something else; that is, it derives its value from something else. So, for example, wheat futures derive their value from a change in the price of wheat. Options derive their value from a change in the value of the underlying common stock. Etc.

The derivatives market is estimated to be hundreds of trillions of dollars in size (!!) and currently is barely regulated. Most contracts are privately negotiated between parties. This means that the terms are not standardized and that regulators have no idea what kind of risk is inherent in the financial system as the transactions are executed privately. It’s almost like a black market. This also means that the instruments are illiquid should a holder of them want to sell quickly.

Derivatives are generally speaking risky investments. This is because they have no intrinsic value (remember their value is derived from something else); they are highly leveraged instruments (you either win big or win nothing at all); and they have an expiration date. These were the instruments that many financial institutions placed bets on that caused a rapid collapse in the value of financial firms in 2008. Ugh! As I have been saying for months, in order for regulators to prevent another catastrophe like the most recent one then they need to have transparency into what risks financial institutions are taking and with whom. Not only that, but no one entity has any idea how much total risk is within the system or what kinds of precarious inter-linkings of risk exist amongst the various incestuous transactions of the financial institutions. Right now there is no transparency. Double ugh!

Here is what is being proposed:

• Forcing standard derivatives contracts to be traded on regulated trading exchanges and electronic trading platforms. This would make trades and prices more transparent.
• Firms that have a lot of derivative investments would be forced to increase their disclosure.

Standardized derivatives would be forced to trade through a clearing house that guarantees completion of a trade. What was happening is that as financial institutions were failing they were not paying for the derivatives they had purchased, or not delivering the derivatives they had sold. Ugh! A trading guarantee would help cushion the blow if a major financial institution were to fail in the future.

The last announcement regarded the fact that the Department of the Treasury is going to be releasing details of a plan that would simplify which governmental agencies oversee the financial markets. This would make enforcement easier. And it also would mean that businesses could no longer shop prospective financial market changes to the most lax regulator. Amen!

I cannot EMPHASIZE enough how important these latter two changes are! Please pay attention to the movements of these regulatory changes.

Jason