Here's Some Real Financial Reform

04/27/2010 12:00 pm EST

Focus: MARKETS

John Mauldin

Chairman, Mauldin Economics

John Mauldin, editor of Thoughts from the Frontline, says that as Congress debates a financial reform bill, it must fix the things that actually caused the crisis.

We are in danger of experiencing another credit crisis, but one that could be even worse, as the tools to fight it may be lacking when we need them.

With attacks on the independence of the [Federal Reserve], no regulation of derivatives, and allowing banks to be too big to fail, we risk a repeat of the credit crisis. The bank lobbyists are winning, and it's time for those of us in the cheap seats to get outraged.

There are bills in Congress that would take away or threaten the current independence of the Fed. I do not want the same people who gave us Freddie and Fannie and now $400 billion in taxpayer losses, who pass entitlement bills that we cannot pay for, to have the power of the printing press.

What happened in the last credit crisis was that interlocking credit default swaps among so many banks made the entire system too big to fail. I am not against CDSs, per se. CDSs are good things, just like futures.

But they must go to a transparent exchange. There need to be position limits, just as in futures and commodities. There needs to be very transparent pricing and commissions. And someone needs to monitor who owns them and what risks they are taking. The good news is that there is some effort to regulate these derivatives in Congress.

We [also] have large banks that take massive risks, which allow them to pay huge bonuses to management and traders; and then if they have problems, the taxpayer has to take the losses. I can see why the banks like it. I don't get this business model from a taxpayer's point of view.

When I put on my taxpayer hat, I don't want to be taking the risk so some big bank can have a trading desk and make large profits that only benefit their shareholders and management. Separate traditional banking and investment banks. I want my commercial banks to be boring—you know, traditional lending to customers, services, that type of thing.

The problem of “too big to fail” is ultimately one of leverage. I have a simple proposal to mitigate the problem.

Why not reduce the allowable leverage the larger a bank gets? This would clearly reduce their risk and encourage them to only make prudent bets (otherwise known as loans), as their risk capital would be limited. If they wanted to make more loans, then they could raise more capital or retain more earnings.

Would that hurt earnings and shareholders and limit share prices? Yes. And I don't care. If I'm not getting the dividends, then I don't want to be made to pick up the tab if there is a crisis. The world of privatizing the gains and socializing the risks must become a thing of the past.

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