Obama and sophisticated financial instruments

Wall Street Journal:

President Barack Obama said for the first time that the government might assess new fees against financial companies engaging in what he labeled "far-out transactions," in order to protect taxpayers from future bailouts.

Mr. Obama on Wednesday compared the possible fees to the assessments that more than 8,000 banks pay the Federal Deposit Insurance Corp. to guarantee deposits. He didn't describe what sorts of transactions might trigger the fees, though the way he described it suggests the proposal could cover exotic instruments such as credit derivatives that some believe played a key role in escalating the financial crisis. He also indicated that the fees might be levied against transactions the government wants to discourage.

"So if you guys want to do them, then you got to put something into the kitty to make sure that if you screw up, it's not taxpayer dollars that have to pay for it," Mr. Obama said in response to a question at a press conference. "It's dollars coming out of your profits."

Administration officials declined to elaborate on Mr. Obama's remarks regarding the fees. It is unclear if there is a concrete proposal pending, or what the details would be.

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It is worth noting that the institutions doing these transactions are already putting their money at risk. If fees are added to the transaction they will not come out of the financial underwriter's pocket. They will be added as a cost of the transaction that will be paid by the issuer.

The statement by the President suggest he still does not understand the underlying dynamic that caused the financial meltdown. The government forced lenders to take risks on mortgages in order to get people otherwise not qualified into homes they could not afford. In order to deal with those risks the underwriters attempted to quantify the risks using formulas devised by mathematicians, that unbeknown to them had invalid assumptions about the risks of foreclosures and the effect they would have on a pool of mortgages.

They failed to see not only the number of foreclosures, but the cascading effect it would have on other loans that would become questionable as more and more borrowers found themselves upside down on their loans. Another invalid assumption that botht he government and the institutions made was that the collateralized mortgage instruments would add liquidity to the mortgage market. But as the problems mounted they actually froze the market.

If I were advising a company in this business now, I would tell them they need to do individual due diligence on each pool of loans they package and not rely on some formula to predict which loans may go into default.