Opinion and Investing Column

Skarbeck: Next wave of regulators needs to keep reforming

January 11, 2014

Ken SkarbeckSince last year, there have been several personnel changes in key financial and regulatory positions in the federal government. In February, Jack Lew took over as Treasury secretary from Tim Geithner, while in April, Mary Jo White became chairwoman of the Securities and Exchange Commission, replacing Mary Shapiro.

As 2014 begins, perhaps the most-watched financial appointment in years will take place with Janet Yellen poised to become chairwoman of the Federal Reserve. Yellen is expected to begin her tenure on Feb. 1, replacing Ben Bernanke, who served two, four-year terms as chairman.

Another key change was Gary Gensler leaving as chairman of the Commodity Futures Trading Commission. His successor is Tim Massad, a Treasury official. Also leaving the CFTC is commissioner Bart Chilton, a hard-charging critic of Wall Street’s behavior during the credit crisis. Both Gensler and Chilton helped write dozens of rules to reshape derivatives trading and in lobbying Congress to effect legislation in the Dodd-Frank Act.

These outgoing luminaries were instrumental in navigating the most tumultuous financial crisis in a generation. Observers have suggested that, with these departures, Wall Street hopes for friendlier regulators and sees an opening to roll back reform. While we can debate over-regulation versus deregulation, those who believe that rigorous financial regulation is unnecessary weren’t paying attention the past five years.

Some of the more complex rules in Dodd-Frank deal with regulation of the $35 trillion futures market and the massive $400 trillion market for swaps. Swaps are derivatives that allow two parties to change the character of a security to fit their needs. For example, a firm might want to swap from a fixed-rate loan to a floating-interest rate to better manage its cash flow. The firm will enter into a contract with an investment bank as counterparty. As interest rates change, money is exchanged between the two parties under the terms of the contract.

Interest-rate swaps contributed to the eventual bankruptcies in Detroit and Birmingham, Ala. Since 2009, Detroit has paid more than $200 million to UBS and Bank of America on their swap contracts. At present, Detroit is negotiating to pay another $165 million to end the contracts. Other cities and towns were burned by “structured products” devised by Wall Street that blew up during the credit crisis.

One recent regulatory challenge comes from the American Bankers Association, which sued over Volcker rule. The ABA’s suit is on behalf of about 300 community banks that are being forced to divest trust preferred securities. These securities counted as bank capital and are backed by collateralized debt obligations, or CDOs.

Wall Street created CDOs by packaging a variety of loans into securities. Enough of these loans are now delinquent or in default and would cause capital losses to the banks if forced to divest. The ABA’s position is disheartening since the point of Dodd-Frank is to purge the financial system of this junk. We wonder what the ABA thinks of the 7,700 other banks in the country that wisely chose to avoid these toxic securities.

The need for effective financial regulators is paramount to prevent another crisis. Investors’ interests are best served by regulators who have the authority and tenacity to enforce financial laws.•

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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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