The incoming administration should consider the regulatory reforms for the financial markets that it will propose to Congress and the regulatory agencies when it takes office in January.
The incoming administration should consider the regulatory reforms for the financial markets that it will propose to Congress and the regulatory agencies when it takes office in January.
Indeed, such questions should be on the minds of the economic team President-elect Barack Obama announced last week.
He picked a brilliant and experienced financial team that includes two top economic thinkers, Lawrence Summers and Christina Romer. Mr. Obama also selected a very smart hands-on technician in Timothy Geithner.
First and foremost, now that Fannie Mae and Freddie Mac have been nationalized by the government, new restraints must be placed on their ability to buy and securitize subprime mortgages.
Fannie of Washington and Freddie of McLean, Va., encouraged by the Clinton and Bush administrations, as well as Congress, continually lowered the standards for mortgages they bought in a bid to increase homeownership. This helped spark the housing bubble.
And the housing bubble was the root cause of the current financial crisis.
At the very least, limits must be placed on how many mortgages they can buy, especially non-traditional, low-down-payment mortgages.
The Obama team should also be considering ways to require more transparency in mortgage-backed securities and collateralized debt obligations. The lack of transparency has contributed to the freezing of the credit markets.
Next, the Securities and Exchange Commission must be urged to take a fresh look at short selling.
There is no doubt that covered short selling helps determine the correct prices of stocks in the market, but the value of naked shorting is less clear.
There is evidence that naked shorting contributed to the demise of organizations such as The Bear Stearns Cos. Inc. and Lehman Brothers Holdings Inc., as well as the sale of Merrill Lynch & Co. Inc. and the near death of Citigroup Inc.
Perhaps naked shorting should again be permanently banned so that the amount of stock that can be sold is limited by the willingness of investors to lend the stock, and the SEC should consider reinstituting the uptick rule.
The Obama team should also examine the role of credit default swaps in the financial crisis. Clearly, some sellers of credit default swaps, American International Group Inc. of New York, for example, sold too many and underpriced them be-cause they underestimated the risks they were taking.
At the very least, regulators must demand more disclosure of the value of credit default swaps that a bank or an insurance company has sold — and the debt that is being guaranteed.
Given enough information, the market will correctly price the risks of credit default swaps and place limits on how much any institution can sell.
Finally, the new administration should urge the SEC and the Financial Accounting Standards Board of Norwalk, Conn., to revisit the rules that require all assets be marked to market.
Perhaps the mark-to-market requirements should be suspended for long-term fixed-income securities that financial institutions hold for the duration of the financial crisis.
The requirement that fixed-income securities, particularly mortgage-backed securities, be marked to market has also contributed to the failures of several large banks and to the freezing of all lending.
That is because the forced sale of some of these securities by troubled institutions has pushed down the market value of all such securities, wiping out bank capital reserves.
Perhaps a discounted cash flow valuation could be substituted during the suspension of mark to market, which could be reintroduced gradually as the economic situation improves.
Besides a short-term fix to the country's economic woes, the new team should work on the longer-term regulatory fixes that can contribute to the repair of the financial system and prevent another breakdown.
