Ten ideas and actions designed to stop financial sector problems.

Based on and included in the following report:
“Sold Out: How Wall Street and Washington
Betrayed America,”

Click for a 231 page .pdf of the report "Sold Out: How Wall Street and Washington Betrayed America,"

The following is from page 109 of the report.

The notes [214] to [218] follow #10 in the right column.

Beyond undoing the deregulatory ma-
neuvers documented in this report, an af-
firmative regulatory agenda must establish a
new framework for financial sector regula-
tion. It should aim to reduce the size of the
financial sector, reduce reliance on overly
complicated financial instruments, and
provide robust and multi-faceted protections
for consumers. We, and many others, will be
proposing specific regulatory reforms over
the course of the next year. Here, we con-
cluded with ten overarching premises that
should guide the new financial regulatory
architecture.

1. The financial sector should serve and
be subordinate to the real economy.
2. Hedge funds and financial derivatives
must be regulated.
3. Enhanced standards of transparency.
4. Prohibit certain financial instruments.
5. Adopt the precautionary principle for
exotic financial instruments.
6. Limit leverage.
7. Impose a financial transactions tax.
8. Crack down on excessive pay and the
Wall Street bonus culture.
9. Adopt a financial consumer protection agenda.
10. Give consumers the tools to organize
themselves.

-------------------------------------------------------------

1. The financial sector should serve and
be subordinate to the real economy.
From 2004-2007, financial sector profits
amounted to more than a third of overall
corporate profits. This is — and should have
been treated as — conclusive evidence of a
financial system out of control, one that was
beginning to devour rather than serve the
real economy. There should be no deference
shown to Wall Street interests complaining
that a new regulatory regime will hurt their
profitability. The Wall Street operators have
destroyed their own institutions, and their
earlier profits are now revealed to be only
the froth from a bubble economy and finan-
cial sleight-of-hand. In any case, the Ameri-
can economy cannot be based on finance
and the trading of paper. Looking back, we
see that the financial economy did not
increase America’s true wealth, but just the
opposite: Wall Street siphoned profits from
the real economy, and from the checking
accounts of consumers, workers and inves-
tors, until the system collapsed, and con-
sumer, workers and investors were asked to
foot the bill.

2. Hedge funds and financial derivatives
must be regulated.
What is a hedge fund? As a legal matter, the
term references investment funds that escape
Securities and Exchange Commission
regulatory authority on the grounds that they
serve sophisticated investors. But the evi-
dence is once again overwhelming that
sophisticated investors cannot be trusted to
protect their own interests (see Bernard
Madoff). But more important, these non-
regulated entities pose systemic risks to the
financial sector, not just to the wealthy.
Cities, states, colleges, non-profit organiza-
tions, and every American turned out to be
at risk from the machinations of the so-
called sophisticated financial sector. All
investment vehicles must be subjected to the
same regulatory requirements — and those
standards must be elevated dramatically.
Finally, not all financial derivatives should
be permitted to continue to trade. But those
for which a legitimate purpose can be shown
must be brought into the regulatory system,
with guarantees of transparency, restrictions
on leverage and requirements for “skin in
the game.”

3. Enhanced standards of transparency.
Hedge funds, investment banks, insurance
companies and commercial banks have
engaged in such complicated and inter-
twined transactions that no one could track
who owes what, to whom. AIG apparently
didn’t even know who it had insured, and on
what terms, through the credit default swaps
it participated in. Moreover, the packaging
and re-packaging of mortgages into various
esoteric securities undermined the ability of
the financial markets to correctly value these
financial instruments. Baseline transparency
requirements must include an end to off-the-
books transactions, detailed reporting of
holdings by all investment funds, and selling
and trading of all permitted financial deriva-
tives on regulated and public exchanges.
Other mechanisms will enhance transpar-
ency and simplify some overly complicated
financial instruments: these include “skin in
the game” requirements and prohibitions on
certain practices (for example, tranching of
securities [214 -- see page 4] that add
complexity and confusion, but no social value.

4. Prohibit certain financial instruments.
Wall Street has proved Warren Buffett right
in labeling financial derivatives “weapons of
financial destruction.” Synthetic collateral-
ized debt obligations — a kind of credit
default swap — are among the worst abuses
of the current system, enabling legalized,
large-scale betting by entities not party to
the underlying transaction. What- ever
hypothetical benefit such instruments
have for establishing a market price for
credit default swaps is vastly outweighed by
the actual and demonstrable damage they
have done to the real economy. They should
be prohibited.

5. Adopt the precautionary principle for
exotic financial instruments.
The burden should be placed on those
urging the creation or trade of exotic finan-
cial instruments — existing and those yet to
be invented — to show why they should be
permitted. They should be required to show
the affirmative, social benefit of the new
instrument, and prove why these benefits
outweigh risks. They should be specifically
required to explain why the instrument does
not worsen financial systemic risk, taking
into account recent experience where pur-
ported diversification of risk led to its spread
and exponential increase. Regulators should
maintain a strong bias against complicated
new instruments, recognizing that complex-
ity both introduces inherent uncertainty and
is often used to obscure dangers, risks and
bad investments.

6. Limit leverage.
High flyers like leveraged investments
because they offer the possibility of very
high returns. But, as we have seen, they
also enable extremely risky investments
that can vastly exceed an investor’s actual
assets.

This degree of leverage turns the financial
system into a game of musical chairs —
those left standing when the music stops
are wiped out. The entire financial system is
presently at risk because the amount of
leverage far exceeded the assets needed to
back it up once investors sought to convert
their holdings to cash.

There should be stringent restrictions on the
use of leverage by all players in the financial
system. These include enhanced capital
requirements for banks and investment banks
(and especially the build-up of capital in good
times); and increased margin requirements,
so that parties buying securities, futures or
options must put up more collateral.

7. Impose a financial transactions tax.
A small tax on each financial transaction
would discourage speculation, curb the
turbulence in the markets, and, generally,
slow things down. It would give real
economy businesses more space to
operate without worrying about how
today’s decisions will affect their stock
price tomorrow, or the next hour. And it
would be a steeply progressive tax that
could raise substantial sums for useful
public purposes.

8. Crack down on excessive pay and the
Wall Street bonus culture.
Wall Street salaries and bonuses are out of
control. The first and most simple demand is
to ensure no bonus payments for firms
receiving governmental bailout funds. If
they had to be bailed out, why does anyone
in the firm deserve a bonus? Even more
importantly, bonus payments with taxpayer
money is an outrageous misuse of public
funds.

Beyond the bailouts, however, there is
a need to address the Wall Street bonus
culture. Paid on a yearly basis, Wall Street
bonuses can be 10 or 20 times base salary,
and commonly represent as much as four
fifths of employees’ pay. In this context, it
makes sense to take huge risks. The payoffs
from benefiting from risky investments or a
bubble are dramatic, and there’s no reward
for staying out. Wall Street compensation
should be lowered overall, but most impor-
tant is imposing legal requirements that
compensation be tied to long-term perform-
ance. If employees had to live with the long-
term consequences of their investment
decisions, they would employ very different
strategies.

9. Adopt a financial consumer protection
agenda.
Commercial banks and Wall Street backers
have, to a considerable extent, built their
business model around abusive lending
practices. Predatory mortgage lenders, credit
card companies, student loan corporations
— all pushed unsustainable levels of credit,
on onerous terms frequently indecipherable
to borrowers, and with outrageous hidden
fees and charges. A new financial consumer
protection agency should be established;
interest rates, fees and charges should all be
capped (especially now that Americans who
are in effect borrowing their own money
from banks and credit card companies who
received bailout funds). Impediments to
legal accountability for fraud and other
unlawful conduct, such as the holder in due
course rule, preemption of state laws, and
the Private Securities Litigation Reform Act
should be withdrawn or repealed.

10. Give consumers the tools to organize
themselves.
Federal law should empower consumers to
organize into independent financial consum-
ers associations. Lenders should be required
to facilitate such organization by their
borrowers (through mailings to borrowers,
on behalf of independent consumer organi-
zations), as should corporations to their
shareholders. With independent organiza-
tions funded by small voluntary fees, con-
sumers could hire their own independent
representatives to review financial players’
activities, scour their books, and advocate
for appropriate public policies.

[214]
For further discussion of the case for prohibiting tranching, see Robert Kuttner, “Financial Regulation: After the Fall,” demos.org, January 2009.

[215]
See also this helpful discussion explaining synthetic CDOs from portfolio.com -- Felix Salmon, ... " ...Essential, synthetic CDOs involve the creation of insurance on a bond (someone pays for the insurance, and someone agrees to insure against failure of the bond), with one important condition: neither party actually holds the bond ...".

[216]
The precautionary principle is a term most frequently used in the environmental context. It suggests that, for example, before a chemical can be introduced on the market, it must be shown to be safe. This approach stands against the notion that a new chemical is presumed safe and permitted on the market, until regulators can prove that it is not.

[217]
See “Plunge: How Banks Aim to Obscure Their Losses,” An Interview with Lynn Turner, Multinational Monitor, November/December 2008, available at: multinationalmonitor.org
(“Wall Street typically designs these things so that they hide something from the public or their investors. So when you
have the CDOs [collateralized debt obligations] built on top of the other CDOs, they hide what the underlying assets are really like, or what the underlying mortgages are really like. In some of the off-balance sheet special purpose entities, like with Enron, it was to
hide their financing.”)

[218]
Pollin, Baker and Schaberg suggest a .5 percent tax on stock trades, and comparable burdens on other transactions (for example, this works out to .01 percent for each remaining year of maturity on a bond.) See Robert Pollin, Dean Baker, and Marc Schaberg,
“Financial Transactions Taxes for the U.S. Economy,” 2002, Political Economy Research Institute.