Finger Paint Anyone?

Today is a day I wish I was writing a blog about finger painting. Last night, I thought I would write a nice simple piece about the stock market and the valuation of stocks. This morning I got around to reading the Sunday Business section of The New York Times and read both articles on the front page of this section. The top article “What Created This Monster?” by Nelson D. Schwartz and Julie Creswell deals with what is at the core of the problems facing this country as it works its way through the present financial crisis. If what they wrote was about military hardware, I think the Pentagon would classify it as TOP SECRET. Let me try and explain.

In the "financial shadows", there are financial products that are unregulated and because of their mathematical complexity, out there on the fringe. Add to this that these financial products are not really even understood by the people that buy and sell them, and one more thing, they have a high degree of difficulty in accessing their worth, their market value. Why financial shadows? Because they are so unregulated and under the radar.

Hedge Funds. Do we all know what a hedge fund is? Simply put, a hedge is an unregulated fund, unlike a mutual fund, that can buy just about anything its portfolio managers want to buy and think they can make money from either buying or selling. Mutual funds buy investment securities for their portfolio. A hedge fund can either buy or “go short” an investment security for the portfolio. Some of you might know this as short selling.

Hedge funds can buy derivatives. Derivatives can limit the damage from financial mistakes. Derivatives can become very complex as they attempt to hedge a portfolio with a variety of investment securities from several angles at the same time. Let us say I sold you a life insurance policy, a home owners’ policy, a health insurance policy and an auto, boat, ski mobile policy. I could take the premiums from those policies and invest them, or I could create a derivative that would calculate the risk of each policy as one, and then put a value on that combined risk and sell it. I would then have created a derivative to off set that risk.

Another product that lurks in the financial shadows is what are called credit default swaps. Credit default swaps are unregulated and do not trade on an exchange. They are just out there. The size of this market is estimated at over $45 trillion dollars. What is a credit default swap? They are described as acting like an insurance policy designed to cover losses to banks and bondholders when companies fail to pay their debts. They are also largely untested.

What does all this mean? How did all this take place? Where were the people charged with oversight? Let me start with the last question and work my way backwards.

The regulators were in place, but there was a climate of “hands-off.” Regulators can for the most part only go after what they are authorized to deal with. If the Chairman of the Fed is governed by a personal philosophy of let the markets do what they need to do, then “hands-off” becomes the mantra of the Street.

As the underwriting spreads in the bond business narrowed and the investment banks looked for areas with the potential for greater profits, new and more complex financial instruments were developed. Unfortunately for many, these new financial instruments and the trading of them, fell outside the regulatory authority of the existing system.

What does all this mean? It means that Congress has a big job ahead of itself. As I mentioned yesterday, the lines against and for new regulation are already being drawn. There will be a big fight with lots of threats about how new regulation and oversight/auditing will drive business from our shores. Congress will have to ferret out the truth of these accusations and use their best judgment, and hopefully they will consider the advice of experts from both sides of the battle, in drawing up a system of regulation and oversight that will be a match for the brains on Wall Street working 24/7 to go around what they put together.

I have not even begun to give this subject justice. I do not know if it is even possible that one man can know the countless facets of what is taking place in the financial markets today and be able to address every concern and weak link effectively. But, one thing is certain. The Street and the regulators and the Congress better apply themselves to the task, for in the balance rests the freedom, liberty and economic welfare of this nation. Stay tuned.