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If Americans believe in just one thing after this crisis, it is that they do not want to see it all happen again. We often fall victim to the same mistakes and the current financial reform being promoted by our legislative body addresses some important issues, but seems to miss the largest problems. The new bill is rather vague in its descriptions of how all of the new controls and procedures will address specific issues such as ending the “too big to fail” and creating “transparency & accountability for exotic instruments”, but in addition to the vagary in implementation, it seems to completely ignore the perverse incentives of those who lend money.

I believe there should be more controls, centralization of risk, and transparency for derivatives trading. I believe that the massive dislocation in the financial markets and subsequent bailout of the banks had a lot to do with the systemic failure that occurred due to massively unregulated counterparty risk and leverage in the system. That being said, derivatives did not cause the financial meltdown, they merely served as unregulated vehicles for leveraging the negative effects of poor lending practices.

The heart of the issue resides with compensation structures that rewarded volume of loan origination and not on the quality of the loans originated. Money should only be lent out with underwriting standards such that a large pool of loans generates enough credit risk premium to pay for any expected future defaults.

What actually happened was a game of “hot potato” in which the loan originators did whatever they could to originate the loans (fraudulent or no-doc loans AKA “liar’s loans”), had the loans rated or examined by those who asked the fewest questions, then packaged and sold the loans knowing that the underlying quality of the loans was garbage.

Where in the financial reform bill does it directly attack these lending practices and perverse compensation systems?

Disclosure: No positions

Source: Financial Reform Bill Misses the Target