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SKARBECK: Financial reform should start with derivatives

March 6, 2010

Ken Skarbeck InvestingSome call them over the hill or out of touch, but a slate of tenured investment industry veterans are sounding the siren for a return to significant financial regulation.

Now in their 70s and 80s, investment titans like George Soros, John Bogle, Paul Volcker, John Reed, William Donaldson, NicholasBrady, Warren Buffett and Charlie Munger are pounding the table for meaningful reform.

Sure, one can hear the younger guns who now run Wall Street—Lloyd Blankfein, Jamie Dimon, etc.—complaining that those veterans have already made their money and are now just preaching to the choir of public sentiment. But the inescapable facts are that, ever since Bill Clinton penned the bill revoking Glass-Steagall in 1999, we have had two investment bubbles burst, an exponential increase in complex financial instruments, a casino-like atmosphere that permeates the markets and, of course, the near implosion of our financial system.

Certainly you would think some intelligent changes could be enacted after what we have been through. Yet there is concern that Congress is going to get it wrong. It is no secret the financial lobby is one powerful group, and it is fighting hard against giving up any of its lucrative turf. For example, a major area of focus is developing a regulatory structure to oversee the massive derivatives market. It is estimated that last year the five largest derivatives dealers, which include JP Morgan and Goldman Sachs, recorded $35 billion in revenue from unregulated derivatives contracts. They won’t cede control quietly.

The House bill approved in December was 1,279 pages long. Why on earth it takes that much ink and paper to develop a set of guiding principles is beyond comprehension. It strikes me that some of our most revered historical documents are marveled for their brevity—the Constitution and the Gettysburg Address come to mind.

While congressional legislation will never be confused with those masterpieces, a rational idea for financial reform was the so-called Volcker Rule. Former Federal Reserve Chairman Paul Volcker, 82, who was widely credited with whipping inflation in the 1980s, was commissioned by the president to come up with ideas for financial reform. Volcker’s answer was to put hard-line restrictions on commercial banking activities. Namely, banks should be banned from owning hedge funds and private equity funds, and in engaging in speculative trading of their own capital.

In urging support of the Volcker Rule, five former Treasury secretaries wrote in a letter to The Wall Street Journal: “The principle can be simply stated. Banks benefiting from public support by means of access to the Federal Reserve and FDIC insurance should not engage in essentially speculative activity unrelated to essential bank services.”

Unfortunately, the Volcker Rule is being dropped from the Senate version of the bill.

At the very least, regulators need to get control of derivative trading—transactions need to be more transparent and carried out on an exchange.

A few thinkers want to outright ban the use of credit-default swaps, which are financial instruments used to insure or speculate on debt issued by corporations or countries. Considering the following description of credit-default swaps by one credit analyst, that may make sense: “It’s like buying fire insurance on your neighbor’s house—you create an incentive to burn down the house”•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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