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Hell has three gates: lust, anger and greed.” Bhagavad-Gita

While the Senate wrestles with hopes of regulating the over-the-counter derivatives’ markets, they seem to be attacking a symptom rather than the root cause of our current unstable financial system.

It’s Greed, Stupid! A balanced risk/reward relationship is the foundation of a stable financial system: the higher the reward, the greater the risk. The risk/reward relation was decoupled in the earlier part of this decade through a confluence of events that allowed financial institutions and individuals to “bet the farm” without holding the mortgage.

This “all gain and no pain” investment model encouraged a culture of greed on Wall Street that was fostered by two important regulatory changes.

  1. The repeal of the ban by the NYSE in 1970 that prohibited investment banks from being public companies;
  2. The repeal of the Glass-Steagall Act in November of 1999, through the enactment of the Gramm-Leach-Bliley Act, which prohibited commercial banks from owning investment banks.

Private Investment Banks: Prior to 1970, investment banks were private partnerships. The partners were typically owners and managers employing their own capital and participating directly in both the revenue and losses—a balanced risk/reward model.

Why Culture Is Important: There were several factors that created cohesive, conservative partnership cultures at private investment banks.

  1. Partners’ dependency on one another for high performance standards: A bad decision by one partner could cause the other partners’ capital to be wiped-out.
  2. The illiquid, long-term nature of the partnership: This caused the partners to avoid excessive short-term operational or financial risks. It also bound the partners together on a personal and social level.

Conversion to Public Companies: When these private investment banking partnerships converted to publicly traded companies, owners were no longer managers, managers’ risks were no longer directly tied longer-term to the profits of the enterprise, and excessive leverage could be employed in the pursuit of higher profits risking faceless shareholders’ equity.

It’s Sandy’s Fault: The merger of Travelers Group and Citicorp in 1998 was a “game changer” that signaled the repeal of the Glass Steagall Act a year later.

Decoupling Risk and Reward: With the elimination of the Glass Steagall Act, a bank holding company was able to take on additional risks as now a part of its business portfolio was guaranteed by the US government through FDIC depositary insurance. The banks had a “put” to the government in a financial crisis. Investment banks leveraged up to 30 to 1 during the peak of speculative derivatives’ activity.

Traders Gone Wild: As for units of the bank that operated proprietary trading businesses or designed exotic financial instruments for sale and trade, the traders took excessive risk because there was no personal monetary downside risk. If the trades worked out—even on a short term basis—they’d make a huge bonus that year. If it didn’t, they get another job.

Simple Solutions: The financial services industry needs to be restructured to promote a balanced risk/reward operational model that in turn would provide a basis for economic rationalization of their businesses.

  1. This may necessitate bringing back some form of the Glass Steagall Act to formally separate and possibly sever the various risk pools currently held by bank holding companies.
  2. While going back to the private partnership investment banking model may be impractical, there should be a regulatory imposition on proprietary trading operations requiring a painfully large long-term equity stake by the managers in these enterprises.
  3. An imposition of financial services “environmental clean-up cost” for current and future financial pollution generated by these institutions. This is no different than the costs imposed on manufacturing plants that pollute our rivers and streams. (The reason why Wall Street’s bonuses are so outsized is that Wall Street is not paying its fair share of “environmental costs” of sustaining a healthy and robust industry.)

Financial Tinkering: Congress will likely present us with a band-aid solution to the financial crisis in the form of derivatives reform; they’ll declare victory and go home to campaign. What is thought of as financial reform will amount to financial tinkering.

Investment Perspective: I’d continue to be an interim seller on strength of financial stocks as bank’s earnings power will likely be diminished. Prominent financial ETFs: XLF, FAS (3x Bull); regional banks ETFs: KRE.

Disclosure: No positions

Source: Financial Reform: It's Greed, Stupid!