Report From the White House: Will Regulation Stifle Innovation?

As advocates for shareholder rights, we strive to make sure our members are heard on important matters that affect all of our portfolios. That's why the White House asked for feedback from the Motley Fool community and agreed to answer your questions. Here is the fifth installment of our interview with Austan Goolsbee, chief economist for the President's Economic Recovery Advisory Board.

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.

 

This is our time to speak up
The Fool is a hotbed of engaged and informed citizen-investors. And this is merely the beginning of our involvement. We'll continue to cover and comment on this proposal and other bills, and we're committed to keeping our conversation with the administration going and representing you, our community of Fools. So enter your comments below about financial-regulation reform and what changes you, as an individual investor, want the administration to make.

Tomorrow on Fool.com: What was the SEC doing for eight years? Plus, why more oversight is good for your portfolio, according to the administration.

Previous reports:

The only CDs Dayana Yochim owns are the round, plastic shiny kind and the ones that pay a pittance in interest (guaranteed). She owns no interest in any company mentioned in this article. The Motley Fool is investors writing for investors.


Read/Post Comments (4) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 21, 2009, at 4:23 PM, wuff3t 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?"

    Maybe because the US would be a powerful economy, less prone to the abuse of new and over-complicated financial products? As an investor that would suit me right down to the ground.

  • Report this Comment On October 21, 2009, at 8:57 PM, xetn wrote:

    Perhaps you should read and understand the real causes of the financial crisis:

    http://mises.org/story/3165

  • Report this Comment On October 22, 2009, at 12:32 PM, jfrankh57 wrote:

    Why can't common sense prevail??? It should be apparent to all that something shady, underhanded and transacted in back rooms and out of the eyes of the public, should be banned. There should not be any business transaction passed off to investors as legitimate, if the transaction can't stand scrutiny under the eyes of you or me (and specifically NOT those of lawyers except to verify legal terms) in the light of understanding. In times past these kinds of shennigans were attributed to con-men and these kinds of people were sent to jail when caught.

  • Report this Comment On October 30, 2009, at 12:17 AM, chasman143 wrote:

    My thoughts mirror jfrankh. There are certain events that need to be secret....but making money from the public arena is not one of those.

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