Report From the White House: Will Regulation Stifle Innovation?

The arc of progress has been described like this: First, you have
the innovators. Then come the imitators. And, finally, enter the
abusers.

The flow chart was followed nearly to the letter, with
the introduction of obscure financial products such as credit default
swaps (CDS). At first, companies used CDS and other derivatives as
protection against market fluctuations. The behind-closed-doors trading
tactic caught on and then morphed into speculative gambling on a
massive scale. Eventually, these unregulated securities rained ruin on
the likes of Lehman Brothers and AIG before they took their toll on the entire U.S. economy.

There's
no debate that derivatives such as CDS and collateral debt obligations
(CDOs) are mind-bogglingly complex. If you want to understand them,
here's an assignment from Professor Warren Buffett:

I
read a few prospectuses for residential-mortgage-backed securities --
mortgages, thousands of mortgages backing them, and then those all
tranched into maybe 30 slices. You create a CDO by taking one of the
lower tranches of that one and 50 others like it. Now if you're going
to understand that CDO, you've got 50-times-300 pages to read, it's
15,000. If you take one of the lower tranches of the CDO and take 50 of
those and create a CDO squared, you're now up to 750,000 pages to read
to understand one security."

Before you ask, no, there's not a Cliff's Notes version.

The White House's approach to derivatives
Buffett
calls derivatives "financial weapons of mass destruction," and his
right-hand man, Charlie Munger, has suggested banning derivatives
contracts entirely. 

That's unlikely to happen, but a major part of President Obama's regulatory reform proposal
(links to a PDF document) is to make Wall Street do its bidding (and
trading) of over-the-counter derivatives and asset-backed securities in
public, so that the transactions will have to take place on regulated
exchanges and reported and traded under the supervision of regulators.

Other key parts of the plan to regulate financial markets include:

• Requiring originators to retain some economic interest in securitized products.
• Setting more conservative capital requirements and establishing tougher rules on counterparty credit exposure.
• Giving the SEC authority to gather reporting from issuers of asset-backed securities.
• Getting the SEC and the CFTC to standardize rules related to the securitization markets.
• Setting stronger regulation of credit-rating firms and stricter disclosure rules.
• Establishing less reliance among regulators on credit-rating firms.

The problem with policing the next credit default swap
Fool.com members had a lot to say
about the use and abuse of complex insider-ish financial products. Here
are a few comments David Gardner and I brought to the White House on
your behalf:

• IIcx wrote: "Slowing the pace of new financial
  products to include oversight and compliance with Federal regulations
  is a good idea. But will this put companies at a competitive
  disadvantage -- and if so why would they stay in the USA?"
• DavidInTX
  wrote: "My biggest concern is that we'll 'throw out the baby with the
  bathwater.' Let's not discourage innovation. Credit Default Swaps
  aren't, in and of themselves, bad. On the contrary, they are a decent
  financial innovation that was badly misused. Let's focus on limiting
  the potential for misuse, and not on restricting innovation."

And
here's the response to your questions from Austan Goolsbee, chief
economist for the President's Economic Recovery Advisory Board.

© 2009 UCLICK L.L.C.