Thursday, April 29, 2010

My humble comment to Yves Smiths's "Your Humble Blogger Discusses Financial Reform on PBS Newshour"

As you know, I read Yves Smith's excellent blog Naked Capitalism whenever I can. Here is my comment:

It was exciting to see you on PBS News Hour last night. Everyone with me saw your depth and breadth of knowledge. By the way, I had been reading the copy of ECONNED that I purchased earlier in the day at the Starbucks in my local Tucson Barnes & Noble. Thank you for writing it!!

I think it is likely that a bill will pass because the Republicans cannot be seen as being pro Wall Street thieves. It will happen quickly because the Democrats have been burned and educated by the Republican delay and vilify tactics on healthcare reform.

As a practical matter, the best that can be hoped for is that knowledgeable people such as Yves Smith, Brooksley Born, Elizabeth Warren, and perhaps certain States Attorneys General, draft and submit amendments to ensure implementation of effective oversight, regulation, and controls. Amendments to the bill should include administrative oversight guidelines for the relevant agencies.

The difficulty you raised of controlling international corporations is not insurmountable. Foreign governments will likely not comply with US requirements. However that is not a show stopper. An amendment can stipulate that what the bank does in its foreign operations must be in conformity with this bill, and must be transparent. Required reports on the activities of foreign branches or divisions to US agencies in the bill and the amendments should be no less frequent than quarterly. Potential penalties of losing their license for US operations is a big stick. Penalties involving the raising of reserve requirements in the US depending on foreign risk, as assessed by our oversight committees, is another big stick.

All off the books entities should be forbidden and called out as a prima facia proof of fraud and of the intent to defraud. Their mere existence should carry penalties that do not depend on proving any resulting fraud actually took place.

A sine qua non amendment repealing Senator Phil Gramm's infamous Repeal of the Glass-Seagall Act of 1933 should be inserted at the last minute.

As you said, exhaustive forensics would be very valuable and should continue long after a bill is passed. An amendment stating the intent of the bill that administrative agencies shall update their procedures and penalties as a result of ongoing Forensic investigation. It should provide a certain sum to fund this work for ten years, and should mandate which agencies must continue a level of forensic effort .

I agree with you that the use of CDOs should be limited. Their real value is in situations where the risk is stochastic, and not deterministic. In the case of adjustable rate, no documentation, subprime mortgages, involving the lack of documentation requirement, the use of ARMs, and the fact that these mortgagors were the last possible buyers at the extant prices, lead to an obvious, totally deterministic, easily modeled mechanism for any such mortgage failing to perform in 39 months of issue. Also, credit default swaps with entities holding similar mortgages in different regions were completely and predictably useless since all regions were using the same faulty application and review methods.

I should add that the tools developed and implemented to assess risk deal only with the stochastic parts of risk, and leave out totally the non-stochastic parts. An example of that can be seen in my assessment quite a while ago of the risk of the share value of Citigroup declining below the $40 price when I did my totally deterministic evaluations. Simply stated, given readily available data, it was easy to see that the model being used by banks and insurers was completely wrong.

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