Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

From my column last Saturday in the Keys Weekly.

Q. What’s the latest on financial reform?

A. Last week the Senate passed major financial reform legislation that is in now being reconciled with a bill passed by the House last year. Once the differences are ironed out, it will be signed into law.

The legislation, not without controversy, contains a number of provisions intended to try to reign in banks, set up new regulatory agencies and avoid future taxpayer-funded bailouts. Among other things, the legislation would:

- Create a council of risk regulators tasked with preventing the failures of massive companies which could threaten the entire financial system;

- Establish a consumer protection division for financial products;

- Allow the government in extreme scenarios to seize and close down failing financial companies in order to protect taxpayers from future bailouts;

- Call for a one-time audit of the Federal Reserve;

- Force most derivatives to be traded on exchanges, where regulators will have more transparency and power to oversee them.

On Wall Street, most of the angst revolves around one particular aspect of the proposed reform. The Senate version of the bill directs regulators to restrict banks from proprietary trading – currently a huge source of profits for the banks. Whether or not the banks are forced to spin off, or completely separate from, their derivatives trading business remains to be seen. The Street and its lobbyists appear to be trying quite hard to derail this provision.

In general, the changes in the proposed legislation seem to imply that our financial system was sound, but the credit crisis and Great Recession were caused by a lack of regulation and oversight. As a result, the legislation will reduce the size of the industry’s profits, but will not address the size and/or political power of Wall Street. Read into that whatever you may.

One particular part of the reform that I was particularly glad to see dealt with the credit rating agencies. A system where the banks getting rated pay the firms doing the rating is hard to defend. The end of that practice alone is something to be noted.

Among the most-needed changes currently under debate in the pending financial reform bill in Congress is an overhaul of the ratings agencies. These agencies get paid by the firms whose products they rate – a rather obvious conflict of interest that has nonetheless received indirect government support for many years. The high quality ratings bestowed upon the piles of financial garbage that eventually blew up and led to the recent credit crisis came from the Big Three rating agencies – Moody’s, S&P and Fitch – a cartel, if you will.

If you have any doubt about the need for reforming the credit rating agencies, and The Great Recession wasn’t evidence enough, I’d highly recommend Michael Lewis’ The Big Short
for some perspective. And after all we just went through, it’s hard to imagine anyone in charge of managing others’ wealth expressing any kind of support for perpetuating the current system.

But then there are the mutual funds. From an article in today’s WSJ (emphasis mine):

Making this tale even stranger than fiction, S&P has said it is ready to give up its special status. The political problem now is that the mutual fund industry is lobbying to maintain the cartel. Both regulators and fund managers have figured out that doing their own analysis to decide what constitutes an “investment-grade” bond is hard work. But if some third party (such as Moody’s) has deemed a bond safe, no one can second-guess the mutual fund for owning it.

To put a finer point on it, the raters give mutual funds a shield from lawsuits if their investments go sour. All the more so because the Senate and House reform bills contain provisions that will make it much easier for plaintiffs attorneys to sue the credit raters. As long as the cartel remains, everyone is covered—except the individual investor, who loses money when the cartel members rate the next Enron as highly as they rated the last one.

The irony is that it’s the individual investors in those funds who are helping to pay for the same lobbying efforts that end up screwing them over.

Sigh. Long live Spoke Funds®.