Sometimes regulations cause the disasters we're told they're supposed to prevent. 

The ongoing debate over whether we need more regulations or fewer regulations misses the point. We really need smarter regulations. Well-designed regulations generally have less text than badly designed ones, but the critical feature is not size, it's appropriateness.

The financial crash of 2008 is a fine example. The federal government imposed regulations on banks and other financial institutions that required them to make mortgage loans to people who otherwise would not qualify for loans. Using financial or other regulations to do social engineering usually causes social disaster. Making loans to people on criteria other than financial soundness led to a financial collapse that devastated many families.

Getting more people into homes that they own themselves is a good thing, but it makes a huge difference how it's accomplished. Instead of forcing banks to make loans to people who do not qualify, it actually would have worked to grow the economy - create new industries and new jobs - so more people would qualify for loans.

Making the disaster worse was the presence of derivatives - especially the credit default swap variety. The banks knew that the government was forcing them into an unsound posture. They sought to insure themselves against the risk to which they were being exposed. Established insurance companies wanted no part of it. So investment companies filled the gap by writing derivatives that acted like insurance policies. If a certain security (such as a bundle of mortgages) defaults, the writer of the derivative pays the buyer of the derivative a sum of money.

This strategy was just as risky to the investment companies as it would have been to an insurance company. Making it worse was the fact that the investment companies made no attempt to follow the reserve requirements that keep insurance companies sound. They made promises to pay (in case of default) which they had no capability of paying.

Instead, they made generous contributions to politicians! They bought off the politicians to guarantee their bailouts before they wrote their risky derivatives! They went ahead with their decision to put the entire financial system at risk of complete collapse because they had bought off the politicians to bail them out!

We all saw the catastrophe this caused. What's more, the politicians used this as an excuse to demand, "More regulation!" when it was their own corruption that enabled the collapse to begin with! It was the politicians who required unsound mortgage loans! It was the politicians who promised bailouts at taxpayer expense to the cronies who financed their campaigns!

The banks would never have made those unsound mortgage loans and written those unsound derivatives if they had known that their money was at risk! "Too big to fail" means too big to exist! The Sherman Antitrust Act was enacted for good reason. If any company gets so big that its failure endangers the whole economy, then it should be broken into smaller companies, who will act responsibly (because they can't buy bailouts from politicians) and not let their company fail.

Derivatives should be regulated by a fairly simple principle: treat them the same way that short sales of stock have been regulated since the 1930s. When someone sells a derivative, require the seller to deposit a margin equal to half the value received for the derivative. If the derivative moves in a direction unfavorable to the seller, require the seller to post more money, or close out the position.

If the derivative moves in a direction unfavorable to the buyer, well, investing always has a risk of loss. Have a computer continuously track the value of the derivative. If the value goes to zero, immediately close out the position. This would avoid the situation we saw in 2008, where the writers of derivatives ended up deep in debt to the buyers. (Some estimates ran as high as $60 trillion!)

We can see why the mortgage bundles had to be bailed out - to prevent the defaults that created such an immense debt! Such a debt could never be serviced, let alone repaid. But it would have been far better to prevent the defaults to begin with. And regulations should be enacted to put limits on the damage derivatives can do.
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This article assumes that the reader has a general understanding of short sales of stock and of derivatives. A longer article (that includes explanations of those things) on the same subject can be seen in the following reply.

"More regulation!" isn't always the right answer any more than "Less regulation!" We need SMARTER regulation.

Regulations are supposed to prevent catastrophes. This time, a regulation helped CREATE one! The government REQUIRING lenders to issue mortgages to unqualified applicants triggered the financial crisis. A LACK of regulation of derivatives allowed Wall Street to be in a condition to collapse in a chain reaction once the crisis got started.

If we want more people to own their own homes (certainly a worthy goal) we need to GROW THE ECONOMY so more people will qualify, instead of sabotaging the economy by requiring lenders to lend to unqualified applicants. (Examples of politicians sabotaging the economy would fill an encyclopedia! This is just one example. Whether the sabotage is intentional or just incompetent, the effects are the same.)

One would think that Wall Street managers would be smart enough to not let their companies create securities that would cause their own companies to collapse. But they did. Many of them issued derivatives that could create losses many times the entire value of their company!

The real estate market was OBVIOUSLY in a bubble condition. ANYONE could see that prices were going to have to start going down soon. Some real estate investors bought derivatives that would serve as a hedge when the market reverses. Other investors simply bought such derivatives to directly profit, knowing that the real estate market would HAVE to start going down soon.

Several large financial institutions gladly sold these derivatives to all comers, disregarding the obvious fact that these derivatives will soon generate many TRILLIONS of dollars in losses! Why would such "experts" at these institutions do something so astronomically stupid? These "Experts" with advanced degrees in finance, economics, etc. failed to see what every Joe Schlub in the country saw coming! These experts apparently were so obsessed with this quarter's balance sheet that they chose to go ahead and sell billions in derivatives right now, choosing to ignore the TRILLIONS in losses that they COULD NOT FAIL to produce soon!

One would hope that market forces would prevent such catastrophes. A company that engages in unsound business SHOULD cease to exist! It would be replaced by other companies with COMPETENT managers. But when one company gets to be "too big to fail" because its failure would seriously damage the entire economy, that reveals a failure to enforce the antitrust laws (in place for over a century) that exist for just that reason.

Unsound businesses SHOULD be allowed to fail! Bail out the depositors, not the companies that mismanaged their money!

But when MANY financial institutions engage in similar unsound practices, new regulations are probably needed. In this case, the new regulations should be similar to the existing regulations that govern short sales of stock.
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"Don't sell it short!" is an expression in common use that came from the financial world. Many people have no idea what it really means. Here, you can find out.

Selling a stock short is something you do when you expect the price to go down. It's a way to get the effect of owning a NEGATIVE number of shares! Here's a made up example:

You tell your broker that you want to go short 100 shares on XYZ Corporation, which is now trading at $100/share. The broker sells that much XYZ stock that another client owns. The $10,000 brought in by that sale is kept on deposit. You can't have it yet. If the price goes down 10 percent, you can buy the stock for $9,000, the other client gets his stock back, and you've made a $1,000 profit. If the price goes UP 10 percent, you could buy the stock for $11,000. You've suffered a $1,000 loss.

This is why the regulations exist. You can't just go around selling other people's stock! If you want to sell a stock short, you have to first put up a 50 percent margin. In our example, you would have to give the broker $5,000 before he can sell the stock. That $5,000, plus the $10,000 from the sale of the stock, is kept on deposit. If XYZ goes down 10 percent, you can withdraw $1,000. The other $14,000 is kept on deposit. If XYZ goes UP 10 percent, the broker calls you and tells you to give him another $1,000 to maintain the 50 percent margin. That's called a "margin call." If you don't give him $1,000, he buys the stock for $11,000 and puts it back into the owner's account, and gives you back the $4,000 remaining in your deposit. (While you hold the short position, you have to pay the owner of the stock any dividends that XYZ Corporation pays during that time. That money comes out of the $5,000 you deposited.)
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Regulations governing derivatives should embody the same principle as regulations governing short sales. But first, some readers might need to learn what derivatives are.

A derivative is a security whose value is derived from the value of other securities. There is no limit to the complexity a derivative might have. A derivative is a contract to pay money on demand, according to some formula. Each formula is different for each derivative. It might be something like "the price of XYZ stock divided by the Treasury bill rate, divided by the price of GM stock divided by the Dow Jones Industrial Average." The value of a derivative goes up or down based on the relative movement of its component securities.

Suppose an investment company (we'll call it INV) writes a derivative, a contract to pay on demand an amount calculated by a certain formula. At the time it sells the contract to an investor, the contract is worth one million dollars. So the investor pays the million dollars. There should be a regulation to require INV to keep the million dollars on deposit, plus a fifty percent margin to cover potential losses in case the value of the derivative goes up. INV should be allowed to count the money on deposit as an asset, and should be required to count as a liability the price it would have to pay if the investor exercises the contract. The money on deposit could be invested in money market accounts, or some similar instruments.

The investment company hopes that the total value of all the derivatives it writes will go down. Each investor hopes that the value of the derivative he bought will go up. Investment companies should be required to continuously track the value of all the derivatives it has written, and to always have on deposit enough money to pay all of the investors if they choose to exercise the contracts (plus enough to meet the margin requirement).

The moment an investment company becomes unable to fund ALL of its requirements, it should be required to automatically start closing out contracts, starting with the ones that had the largest percentage movement adverse to the investment company.

Here's an example: INV sells three derivatives, each worth one million dollars. INV would have to keep on deposit the three million dollars, plus another $1.5 million for margin. Suppose the value of one derivative goes to $1.5 million. INV would be required to add $750,000 to the deposit – $1/2 million additional liability plus $1/4 million margin on the new liability. Suppose INV can't make the deposit. Then it should be required to close out the $1.5 million derivative (pay the investor his $1.5 million), leaving the two other derivatives of $1 million each, and $3 million on deposit (enough to meet the margin requirement).

The investor who bought the derivative that appreciated might say, "I was making money! I shouldn't be required to sell!" The answer to that is, "You made as much money as INV can afford to pay you. If you want more profit, find another place to invest your $1.5 million."
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My proposed regulation would have prevented the situation we now have, with financial houses having MANY TRILLION dollars worth of unfunded liabilities on their books!

What can we do about those liabilities? Look back in time at the data, find out when each financial institution became unable to pay its liabilities, and pay each investor the amount the institution owed him on that date.

What about investors' profits that accrued since that date? Those profits never really existed. The financial house was broke. (It's like suing somebody who is poor. You might win a judgement, but you'll never get paid.) The investors will have to just accept the profits they already collected (which in most cases would still be quite handsome!) and start fresh from there.

Don't expect the taxpayers to pay off any promises the financial houses made that they can't keep! The investors put their money into unsound institutions! They should be glad just to get their investment back!

What about people who invested in an institution AFTER the date determined to be the date it went broke? Those investors could be bailed out – the amount they invested restored to them – but don't pay them any profit.

What about the institutions? They could raise enough money to start operating again by selling stock. The government could let them issue additional shares, if necessary. If the institutions are required to follow the regulations I have proposed in this article, they would once again be sound investments.

Who might possibly buy that stock? The investors who made all those handsome profits by buying those derivatives! They were smart enough to see which way the market was going to move! These investors would be FAR better owners of the institutions than the previous owners, who were foolish enough to create and sell all those doomed derivatives!

The constitution forbids any retroactive laws, but maybe the above plan could be carried out under Chapter 11 bankruptcy.
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No doubt this plan would make me very unpopular with the "expert" managers on Wall Street who caused this debacle. Today's managers HATE being required to act responsibly! They'd rather play fast and loose, and then bribe their cronies in government to bail them out!

By the way, it is mostly DEMOCRATS who voted for the bailout – no, let's call it what it is: the 700 billion dollar SLUSH FUND! It is DEMOCRATS who receive the majority of campaign contributions from Wall Street! And it is DEMOCRATS who blocked the reining in of Fannie Mae and Freddie Mac two years ago when the Republicans blew the whistle and tried to stop the madness before it could become the catastrophe it did!

The DEMOCRATIC Party truly is The Party Of The Corrupt Fat Cats! And half the Republicans, too! There are a LOT of bums that need to be thrown out!

A pervasive culture of cronyism and special favors is what encourages financial misbehavior. Insiders are confident that they will be bailed out, no matter how irresponsibly they act. The proper role of government is to set rules that ensure honesty and integrity in people's dealings with one another, so that everyone will receive the just rewards or punishments resulting from their own behavior.

Trouble is, special favors are exactly what politicians use to build their careers. "I want my benefits!" is exactly the mindset that keeps voters re-electing the same old corrupt officials of BOTH parties! As long as the people keep demanding the government to steal FOR them, they'll keep getting a government that steals FROM them!

I have no idea where all this came from or if it's a copyright violation.

QuoteGenerally, four paragraphs or text not exceeding 200 words is considered fair usage, it is always best to credit the original source.

I think it's JE's work.

Quote from: Solar on July 05, 2016, 06:58:38 PM
I think it's JE's work.

I was hoping so that's why I did not Modify it. 

Quote from: je_freedom on July 05, 2016, 05:10:12 PM
"More regulation!" isn't always the right answer any more than "Less regulation!" We need SMARTER regulation.
............
A pervasive culture of cronyism and special favors is what encourages financial misbehavior. Insiders are confident that they will be bailed out, no matter how irresponsibly they act. The proper role of government is to set rules that ensure honesty and integrity in people's dealings with one another, so that everyone will receive the just rewards or punishments resulting from their own behavior.

Trouble is, special favors are exactly what politicians use to build their careers. "I want my benefits!" is exactly the mindset that keeps voters re-electing the same old corrupt officials of BOTH parties! As long as the people keep demanding the government to steal FOR them, they'll keep getting a government that steals FROM them!

It takes a detective to unravel the finances of the politicians, "How do they leave office so wealthy, on such a meager salary?".  Interesting read - too bad for the rest of us.

The latest housing bubble has my residence "worth" - in my guess, twice what I think it should be... which helps the tax assessor, not me.  The temptation is to bail out, sell and find a bare plot of land, build something reasonable.

And, speaking of short selling, we got these guys offering training for investing - really margins - something that would make me quite nervous.  When we hear the stock market is legalized gambling, shorting comes to mind.

Years ago, a company was buying back stock to keep the prices up.  They were borrowing to buy it back.  A few of guys "guessed" the target price (and cycle), and hit it close enough to double every 3-5 months.  Figured out the price they would start buying (a low price), and where they would stop and start selling.  Eventually they went bankrupt, the company founder went to jail along with several of his kids.
The employees who were encouraged (illegal) to buy stock by management got shafted with completely worthless stock.  Toilet Paper is worth more.

Those investors who played the game and walked away before the collapse, MEH, they were smarter than the rest.  What really bothers me, the whole retirement scheme seems to be centered around the Stock Market.  If your company offers a 401K, and a match, it's always the stock market... nothing tangible, just "stock".

Even worse, we've gotten to accustom to a rising market, what happens when it goes FLAT or starts a steady decline - as predicted when the Boomers start drawing down investments?