Four steps toward restoring investor confidence

It’s time for the incoming administration to figure out what caused the current financial crisis, how to fix it and what can be done to prevent it from ever happening again. A large portion of Main Street’s problems with Wall Street are mistrust and a lack of confidence in the financial markets.

A SOLID FOUNDATION

There are four changes that should be instituted to re-establish trust and confidence. They would establish a solid foundation for the industry and help repair our damaged economy.

First, we must restore and maintain “orderly financial markets.” This problem goes back decades, during which deregulation allowed various sectors of the financial services industry to cross over into one another’s territories. This has allowed investment banks to own commercial banks and issue Federal Deposit Insurance Corp.-insured instruments to raise funds that ultimately are used to finance inappropriately aggressive investments, one of many situations in which companies engage in dual roles.

Over a number of years, the cause of the crisis has included the bipartisan failure of Congress, the various administrations, and governmental and self-regulatory organizations to regulate the creation of securities derivatives and the relationship between the different sectors of the financial services industry.

Re-regulation of the financial services industry — along the lines of resurrecting the Glass-Steagall Act, which separated commercial banks from other investment functions — is necessary. Similar regulation is vital to separate insurance/annuity products, banking and securities from one another and from any other creations that would cloud their separation.

Further regulation within the securities industry should separate the investment-banking function from the fee-based investment advisory function, wherein anyone licensed to charge a fee for advice would be prohibited from being licensed to sell securities for a commission.

The jurisdiction of the Financial Industry Regulatory Authority Inc. of New York and Washington should be strictly limited to broker-dealers, mutually exclusive from any fee-based advice or management entity, which should be regulated by the Securities and Exchange Commission and/or the individual states. The sale of securities products, including insurance-related hybrids, should not be limited exclusively to the broker-dealer/registered investment adviser fee-based market but should be available to the RIA-only fee-based market as well.

The second change is to increase regulation of derivatives. For example, margin rules require that investors and clearing firms have the resources to stand behind their obligations, preventing financial collapse. But currently, it is possible for management companies to create structured investments committed to cloning specific portfolios without these protections. Derivatives now exist that are so complicated that even their creators have difficulty understanding or explaining them.

The essence of such regulation would be separation of the different sectors, with no crossover except for specific hybrid products, providing assurance that investments would actually be what they were represented to be.

The third change involves the desperate need for transparency to re-establish confidence. It is not clear what the Department of the Treasury is doing with all of the money granted by Congress to solve the crisis, as the targets keep moving. Throwing money at the banks can be viewed as feeding the monster that caused the mess.

Instead, the Treasury Department should use this money, in part, to help stabilize the secondary market in securities by purchasing distressed mortgages from institutions at their fair market value.

If an institution is in danger of collapse because of a drop in value of its investments, it could sell those securities to raise cash and/or reduce debt. If there is not a stable bid for a given security, the Treasury Department should purchase it at a price commensurate with the market value of the underlying property, and the credit standing and household income of the borrower. If an institution in need of cash has other securities for which a stable bid is not available, the department should bid for the institution on a similar basis. Only after an institution has run out of reasonably saleable assets should the Treasury Department provide funds in the form of either secured loans or equity.

Fourth, it has been suggested that homeowners in danger of foreclosure have their principal balance reduced commensurate with their homes’ current market value.

This can be viewed as a giveaway to some homeowners, excluding those who have already lost their homes or who have exercised good sense by not getting buried by mortgage debt in the first place.

The Treasury Department needs to approach the homeowner and renegotiate the terms of the mortgage by establishing a reasonable, market-based fixed 30-year rate, keep the present balance intact and adjust the payments to one-third of household gross income. Most likely, the payments will not cover all of the interest that accrues, and the balance will increase. However, economic recovery and future appreciation will eventually put homeowners’ equity back into the black.

Household income needs to be monitored and the payments adjusted when and if the homeowner’s income increases.

Because the principal balance would not be compromised, this would not constitute a major giveaway program. Adjusting the payments and forestalling foreclosure against a homeowner would avoid leaving the Treasury Department stuck with an empty house and prevent the homeowner from becoming a resident of a station wagon. The financial damage would fall on the distressed institution that owned it. In time, this approach would generate a profit for the taxpayer. At the moment, it appears that some of the mortgage lenders are starting to pursue a similar approach.

TIP OF THE ICEBERG

The current crisis has revealed only the tip of the iceberg. Credit risk in mortgages and money market instruments on the balance sheets of investment banks and other institutions has been recognized.

What has not yet been recognized is the interest rate risk that will become evident when, as is inevitable during an economic recovery, demand for capital starts to drive interest rates up. As this happens, the market value of fixed-income securities, along with all of the diverse derivatives that have been created to make debt and risk marketable, will be adversely affected.

Investors who have fled the real estate and stock markets to find refuge in fixed-income vehicles will question why they have been paying fees to advisers for directing them into the shell game that has emerged from the derivatives markets. Those approaching retirement or already retired will be the most adversely affected. This potential crisis would be mitigated by instituting appropriate changes.

The steps I have described here would not constitute a giveaway program for anyone. The Treasury Department, being the purchaser of last resort, would help restore the liquidity of such assets along with the ability of institutions to trade them freely at their fair market values, providing improved stability for otherwise unstable markets.

The difficulty in enacting these changes lies in the fact that each sector of the financial services industry has its own turf and special interests to protect.

While these proposals will encounter mass resistance from within the industry, they are necessary to get the job done

Jeffrey McKie runs an eponymous RIA firm in Portland, Ore. He has been in the financial advisory business for 35 years.