Time To Straighten Out The Financial System

President Obama has set in motion sweeping changes to our financial regulatory system with the goal of minimizing risks to the global financial system and protecting the consumer. During euphoric economic times money is plentiful and the desire to take risks seems to always increase. Investors search for ever enlarged returns and Wall Street is always there to fill those pursuits. The result seems to be that leverage rises, bubbles appear, investment returns improve but inevitably risk has skyrocketed. These cheerful times may continue for long periods but inevitably the party end when some unforeseen event occurs and the bubble is burst.

Risk managers focus on protecting financial firms from significant losses when markets move in the wrong direction. Unfortunately, the models used for downside protection typically assume unexpected events which may be two deviations from the norm and disaster occurs when a five standard deviation event appears. There are plenty of example in history that have resulted in disaster when those financial models never considered the black swan event and leverage became the nemesis of failure. This was true for Long-Term Capital, Amaranth, Bear Stearns, AIG, Fannie Mae, Countywide, etc.

Consumers typically get hurt in a financial wipe out but in the current crisis the damage has been ubiquitous. The housing crisis has crippled many families who have or will go through foreclosure. Those who survived the housing crisis still have seen the value of their home decline dramatically as has their net worth. Declining stocks also put a dent in the consumer's net worth as did Madoff and other financial advisers who stole from their clients.

We are generally not in favor of more regulation but President Obama is probably moving in the right direction. We need new controls and guidelines for financial institutions and we need to protect the consumer. Unfortunately the devil will be in the details and Congress may not be able to adequately create legislation that focuses on the consumer without being political.

Simple mortgages and easy to understand consumer loans should be in the best interests of everybody except the financial institutions who want to garner excessive profits. Therefore, we are in favor of instituting policies that protect the consumer. Nobody benefits from a failed financial institution. Rogue money managers, banks, and other financial institutions can create financial chaos to many innocent consumers, companies, financial institutions, and governments. We need to minimize catastrophic events so if the oversight of all financial institutions is increased and effective guidelines protect the global economy from future shocks, we support it.

We have written about banks that are too big to fail. We suggested controlling their size by increasing their capital requirements. It seems like the Obama administration is also moving in that direction. If a financial institution is too big to fail, it is too big to exist. Therefore, such entity must have an adequate equity capital cushion to prevent failure or sell off pieces to become smaller. Well structured guidelines can achieve such results.

The Obama financial restructuring is aimed at protecting the global financial system and the affected consumers. This legislation will likely define President Obama's legacy. There are many aspects to this legislation and the plan needs to be debated not only by Congress but by Wall Street, Corporate Executives, and consumers. If the goal is to create a plan that makes the financial system stronger while protecting the consumer, then we look forward to new financial reform. However, if the final legislation results in feeding many political agendas, then the future consequences of poor reform will likely result in a replay of our current financial crisis.