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.