Timothy Geithner’s Plan for the Financial System

Secretary of treasury Tim Geithner is absolutely the right person President Obama could have appointed to the job. He has been working for some time on a way to better regulate the financial system. It has taken form lately as a legislative proposal to congress. It will be a major step in overhauling the nation's financial regulatory system. It’s main characteristics is that it will allow better regulation of the derivatives market and, to investors, a better understanding of the impact of those products on financial markets.

New rules would discourage financial firms from taking excessive risk, prevent fraud and make sure that instruments called derivatives are marketed appropriately. Current legislation concerning derivatives, for the most part, excludes regulation of instruments that are not traded on the open market, those referred to as "over-the-counter" derivatives because they are traded privately.

I really wonder how the new tougher rules will affect hedge funds, those big, mostly unregulated pools of money that use intricate trading tactics to earn big returns for exclusive investors. The fact is that many hedge funds currently use derivatives contracts to offset risk on their other transactions. The need for improved regulation is really evident; the value of over-the-counter derivatives depends of another figure or commodity, which in turn makes verifying the real value of a derivative very complicated. The primary use of a derivative is to reduce the risk of loss from the underlying asset, not try to create huge amount of profits out of thin air. What worries me even more is that the global business world, at the end of 2008, held an overwhelming $600 trillion of such contracts; while the stock market capitalization, for all exchanges on the planet combined, was of $33 trillion at the same period.

The most well-known examples of derivatives are certainly credit-default swaps, some of them were sold by American International Group Inc (NYSE: AIG). AIG was selling the swaps to investors as a sort of insurance to protect against defaults on mortgage-backed securities, the CDOs that I talked about in a previous article. The rest is history...

Under Geithner's new plan, companies like AIG would have to prove they have a sufficient amount of reserved capital to support a continuing sale of derivatives, thus reducing the systemic risk of a company. I really hope such a plan passes because it will ensure more stability from financial companies that have the potential to impact the economy as a whole.

Full Disclosure: The author does not have a position in AIG.