My Recommendations For Ending The Current Financial 'Crisis'

In the face of the looming, complex, multi-hundred page bill which will likely become law to buy the bulk of distressed, mortgage-backed structured finance instruments in the US financial sector, I offer the following outline of the key, simple changes in US financial services regulations to prevent a repeat of the recent chaotic situation in this important sector.

In discussing the unfolding financial services crisis with my business partner last week, several key principles became clear as necessary to a post-crisis, functioning financial system. We agreed that in-depth, micro-managing regulations would be unlikely to solve the problems. Instead, an assumption, if not expectation, of self-serving, opportunistic behavior on the part of financial service firms must be a cornerstone of new regulatory principles. Thus, one wants to consider the fewest number of broad, simple rules which would curb the worst excesses which one can expect to recur.

The behaviors which seem to have caused the most damage in the recent crisis are:

-forced 'mark-to-market' of exotic, structured financial instruments which frequently have no current market price.

-uncertain exposure to counterparty risk due to murky, over-the-counter, non-exchange cleared instruments such as credit default swaps and structured financial instruments.

-underwriting of toxic, opaque structured financial instruments by firms which offload the entire issue, taking only temporary packaging risk, but booking underwriting and distribution fees.

To remedy these weaknesses in the current financial system, the following solutions are proposed:

1. Scrap existing mark-to-market-only rules for securities held by any financial services organization. Instead, allow any financial services entity to:

a. value long-term holdings, including structured finance instruments and/or securitized debt/loans, at acquisition cost or present value while it is performing. This would allow non-banks to treat certain securities in a similar fashion to the current commercial bank's 'investment account,' or a whole loan held in portfolio.

b. Allow one-time switching of long-term holdings to trading accounts, for sale, where they would be valued by mark-to-market methodology.

c. Value impaired, delinquent or non-performing assets according to expected economic value. If no consistent, liquid market exists, best estimated economic values would be used. A variety of accepted methods, under continuing review for modification and enhancement, would be approved by the SEC and the Fed, as regulators.


2. For any institution buying, selling, making markets in or trading any non-exchange-cleared instrument, that activity must be done in a fully-equity capitalized subsidiary. Leverage will be a maximum of 1:1.

3. For issuing of any contracts promising payment of a sum in the event of a third-party event, i.e., insurance, such as credit default swaps or other swap agreements, the transactions must be held in and performed by a fully-equity capitalized subsidiary. Maximum leverage will be determined by the SEC, in the manner of margin account and collateral required for securities positions. The unit may be evaluated like an insurance firm, for ability to pay claims generated by contracts it sells. Where possible, historical actuarial bases of capital ratios for each type of contract will be used to determine maximum leverage.

4. A minimum percentage, by deal value, of any 'structured financial instrument' underwriting must remain on the books of the lead underwriting firm. This is refers to any underwritten financial instrument that is not straight, convertible or preferred debt or equity. If the instrument is not exchange-traded, then it must, per #2, be held in a separate, fully-equity-capitalized subsidiary.

4. Where possible, exchanges will will be used to clear and settle financial instrument trading, so that counterparty risk will be managed by explicit and clear collateral rules. This should minimize the ability of instrument default risk to morph into counterparty risk, even for securitized debt and swap instruments.

If these principles had been in place in 2002, it's safe to say that the US financial services sector would not be undergoing the chaos and crisis of counterparty risk management which it is currently experiencing.