One Very, Very Good Thing About the Financial Reform Bill That Just Passed Congress

I don’t care what anyone tells you, I want you to listen to me very, very carefully: Although I cannot give an opinion on the financial reform act that just passed Congress because I haven’t read it yet, I can say that the provision that requires all derivatives other than those used for “commercial purposes” to be traded on a regulated exchange is absolutely, positively, 100% required if we have any hope of avoiding a collapse like we had following the failure of Lehman Brothers.

I realize, as The Wall Street Journal points out, that this could theoretically increase the cost to small farmers that wish to hedge their crops.  Unfortunately, if that is the case, so be it because right now the low prices are only possible because derivative book makers aren’t required to keep enough collateral on hand to avoid liquidity problems in the event of a meltdown so the taxpayer has to step in and save the day. The current system puts the taxpayer on the hook without any of the reward.  In effect, these low hedging prices that farmers are taking advantage of are only possible because the markets have mutated to the point where 30-1 leverage is considered normal in some places!  Higher liquidity requirements will cause costs to increase but it will greatly lessen the probability that we, as citizens, will have to step in and cover derivative contracts not sufficiently collateralized.

For longer than my lifespan, stock options have been traded on regulated exchanges with a small portion of each transaction going to cover the potential of failure (basically it is a self-created insurance pool).  If one of the parties fails to live up to its obligations it doesn’t matter because everyone has transacted with the exchange itself.  It builds a measure of conservatism and safety into the overall system.  And here is the important thing: That hasn’t stopped a lot of us from making a hell of a lot of money using stock options!

The net effect is that this requirement should drastically reduce the total leverage individual trading houses and corporations are able to use, turning $1 into $30 so there is no cushion against a downfall.  Disasters can still happen (and probably will).  The point is, this makes them less likely to happen as frequently.  It is also going to mean reduced profits until traders get used to the new norm, which is how it was up until about 10 years ago before people foolishly convinced themselves that we had managed to master volatility.

I despise using leverage, anyway, so this won’t directly hurt or help us other than to the degree is causes more money to stay on the balance sheet of companies in which we have an investment such as General Electric and Berkshire Hathaway.  So, I have nothing to gain by telling you this.  Just realize that if you hear complaints about this section of the bill you are being sold a lie.  This part is good.  Very, very good if you don’t think the taxpayer should be responsible for cleaning up other peoples’ messes.

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