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One of the most disheartening aspects of the extended financial crisis we are in is how poorly the US government has responded. Of course, it’s fair to ask why anyone should be disappointed, given the record of consistently bad choices the government has compiled:

But wait. Maybe—now that the health insurance legislation has finally been passed—we are expending some attention on regulatory reform to address systemic risk issues.

In our view, to be effective reforms must address five main points:

  1. Create an exchange for trading derivatives such as credit default swaps and collateralized debt obligations
  2. Ban ratings agencies from accepting remuneration from equity issuers aside from for subscriptions to ratings info
  3. Establish more stringent capital requirements for financial services companies doing business in the USA
  4. Clean house at the enforcement agencies to ensure that existing regulations—e.g., against naked short selling—are actually enforced
  5. Encourage improved corporate governance—e.g., for government contracts, prefer financial services providers who compensate top management more with stock and less with cash bonuses and high salaries

The first and second reforms are intended to increase transparency and create a more robust pricing mechanism for derivative securities. Having a market where everyone can bid on whatever is offered for sale applies the collective wisdom of the market to the complex problem of determining a fair price for these instruments. You can’t fool all of the people all of the time. And it is a blatant conflict-of-interest that most of the income for most ratings agencies is provided by the issuers of the securities being rated. Ridding ourselves of the bogus AAA ratings that were the predictable result of this incestuousness will go a long way towards unmuddying the waters.

The third reform is intended to reduce the level of risk it is kosher to undertake from the obscene, bet-the-farm-and-all-my-neighbors’-farms-too heights scaled in the recent crisis down to something manageable. The fourth and fifth reforms are intended to reward socially responsible behavior among market participants and better align the interests of management with not only shareholders, but all the stakeholders in their enterprise.

We are not too keen on the consumer protection agency concept currently being promoted the President. We believe that with the notable exceptions of the need for more stringent capital requirements and the need to corral derivatives trading into an exchange, there are already generally sufficient regulations in existence—but the problem is that they have not been effectively enforced. Adding a new agency to a broken SEC and a broken CFTC and a Fed with a schizophrenic mission is a recipe for spending a lot of money achieving not much besides a big turf war. We’d be a lot better off putting Harry Markopolos in charge of the SEC, Patrick Byrne in charge of the CFTC, and instructing Ben Bernanke and company to focus on controlling inflation and protecting the dollar.

We don’t much care for the concept of establishing a permanent mechanism to coddle “too-big-to-fail” companies, either. Management of these enterprises should not be operating with the presumption that they will be bailed out if they screw things up. Can you say “moral hazard”? In a world of transparent markets, stringent capital requirements, and firmly enforced rules against chicanery, it ought to be rare for management to run large enterprises into the ground…but when and if they do, let them fail. That is the way capitalism is supposed to work: if you succeed, you are rewarded; if you fail, smarter, more adaptable competitors will take advantage of the opportunity to win your former customers by serving their needs better. Propping up the failures is bad for everyone: bad for the customers who continue to get suboptimal service, bad for the competitors who are not rewarded for working harder and smarter, and bad for the failing organization’s personnel, who instead of moving on to something they can better succeed at are in effect bribed by government largess to persist to fail at something they are bad at.

OK, maybe it’s not bad for literally everyone—to the extent this sort of irrational behavior renders us less efficient, perhaps it is good for China.

But leaving aside the details, the combination of President Obama’s new focus on financial regulatory reform and the SEC’s filing of a civil suit against Goldman Sachs (NYSE:GS) for fraud last week is very heartening. Clearly, it’s not a coincidence that on the same day the SEC charges were revealed, Obama sent an e-mail to folks who had signed up to support his efforts in office on the subject of financial regulatory reform which stated, in part:

With so much at stake, it is not surprising that allies of the big banks and Wall Street lenders have already launched a multi-million-dollar ad campaign to fight these changes. Arm-twisting lobbyists are already storming Capitol Hill, seeking to undermine the strong bipartisan foundation of reform with loopholes and exemptions for the most egregious abusers of consumers. I won’t accept anything short of the full protection that our citizens deserve and our economy needs. It’s a fight worth having, and it is a fight we can win—if we stand up and speak out together.

Cognizant of the U.S. government’s consistent record of getting this stuff wrong, we are not overly optimistic that this time will be different. But we do find it ironic that the stock market—which is up 70% in the last year on what seems to us scant evidence that we are out of the woods—reacted to Friday’s news of the SEC suit against Goldman with a sharp decline. This is the most bullish development of 2010 so far. The Obama administration’s first major action was—continuing along the course set by W—to prop up the rotten financial system, which was a counter-productive thing to do, but they did it well (unfortunately). Their second major initiative was health insurance reform which, while a shockingly low priority given the problems that beset us, had the potential of being a good thing to do, but they screwed it up (unfortunately). Now, at last, they are focusing on an important problem to which a good solution has the potential to make life appreciably better for most everyone.

This, potentially, is change we can believe in.

Disclosure: No positions.

Source: America Gets Serious About Financial Regulatory Reform