Thursday, March 13, 2008

New Financial Products Presents New Challenges

People working outside of Wall Street and the investment banking world might ask, “isn’t there some kind of regulations that would prevent the latest financial crisis?” There are regulations. I am going to list a few of them with their dates, but because there are new products being created all the time, often regulation is two steps behind.

After the Stock Market Crash of 1929, the Federal government passed two important pieces of legislation. The first was the Securities Act of 1933. That was followed by the Securities Exchange Act of 1934. Then later there was the Investment Advisers Act of 1940 and the Investment Company Act of 1940. Then in more recent times the Federal government passed the Sarbanes-Oxley Act of 2002. So, it isn’t like the government hasn’t tried to protect the investor from fraud, not full disclosure, not full transparency and not x-ray vision. Efforts have been made to instill confidence in the system and level playing field.

But, just as in sports, some people want an edge and will do almost anything to get that edge, so too in business people want an edge as well. In the 1980’s there was the insider trading scandal that rocked Wall Street. In the late ‘90’s there was Long Term Capital and its blunders. Not everyone plays by the rules. We see that everyday, even in the filming of football practices to get an edge. There is nothing wrong with wanting to be successful in business or in investing. The problems occur when people cross the line and commit a serious violation. Unfortunately, when this behavior becomes the norm, crisis ensues.

The corporate system as it is practiced today, in my opinion, lends itself to abuse. The market will not tolerate poor performance, and it should not, but the system needs better controls and even more transparency. Without them, there will be repeats of past mistakes. Boards hold CEOs accountable for their performance and the CEOs hold their division heads accountable to them. Pressure to grow the earnings is always there and Wall Street and the investors watch earnings and earnings projections closely. Some times financial products are created that have a greater elements of risk than others, but with greater risk comes bigger profits. At least that is the way it is suppose to work. Unfortunately, if due diligence is not done properly, as in the case of the sub prime mortgage bonds, catastrophe is not very far away. People every where want to do well, and they especially want to do well in the investment banking business because the stakes are so high. Bonuses play a role in motivating players and the rest, as they say, is history.

More regulation is necessary. The question is always, how much is too much. Unless steps are taken for regulators to get a better handle on the new products being created on Wall Street to meet the needs for capital and risk management, then we are going to have more of the same. The people overseeing all of this can not believe that without making some changes with regards to better controls and auditing that the results in the future will be different. Wall Street will fight against additional regulations and that is to be expected. When your pitching new financial products you want to pitch from a higher pitching mound. It is so much easier to throw downhill at the batters. Government needs to step in and level the playing field otherwise we will be covering the same ground again.

Not all financial products are created equal. Some products have a real function, while others are questionable at best. Computers have enabled investment bankers to create products, that without computers, would not be possible or feasible. This process will not stop and it should not stop. As the economy changes, new products are created to meet the new needs for capital and risk management. But, government has a responsibility to the people that buy these new products, and I think this chairman of the Fed has earned the right to be heard about the need for better regulation. Stay tuned.

1 comment:

Unknown said...

Ah, but then the question becomes, will he ask for better controls? Or maybe the question should be, will the controls he asks for be the proper controls?