How To Rescue Capitalism

Michael Maiello, Forbes.com

Janet Tavakoli, an expert in complex derivative securities and the author of Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street recently sat down with Steve Forbes to discuss the lingering financial crisis and the future of Wall Street's banks. Tavakoli, who saw trouble brewing way back in 2005, believes that we still need an accounting of the crisis and maybe some perp walks for bank executives.

Currently, Tavakoli is especially skeptical of prospects for JP Morgan Chase, one of the banks that has best weathered the crisis thanks to Chief Executive Jamie Dimon's "fortress balance sheet" strategy.

On Dimon, Tavakoli remarked: "He didn't talk about credit cards. He was very quick to talk about mortgage brokers and predatory practices among mortgage brokers. But we've had a lot of predatory practices in credit cards."

She then predicted that as unemployment rates continue to rise (and they will, even after the economy bottoms) people with high-interest credit cards "are going to walk away from that debt and the charge-offs will be higher than he's recommended. Furthermore, he didn't talk about predatory practices like targeting people who are in bankruptcy or people who are just exiting bankruptcy."

Card issuers actually like to give high-fee credit to people in or just out of bankruptcy because a debtor can only seek personal bankruptcy protection once every eight years.

All of this could mean more losses for banks, Tavakoli says. This is in line with predictions by analyst Meredith Whitney, a previous Intelligent Investing With Steve Forbes guest who believes that banks like Citigroup haven't adequately reserved for credit card losses.

After her interview, Tavakoli sent a short essay to Steve Forbes outlining her belief that the financial system was laid low by predatory lending and predatory securitization. Her essay expanded on the themes of the Intelligent Investing interview (you can watch it here) and we offer these relevant excerpts from her essay for those who'd like to know more about how we got here and what's to come:

"As the mortgage bubble inflated, the motivations and viability of thinly capitalized mortgage lenders were not challenged. The explosion of predatory loan products--unprecedented in the risk they posed--was unchecked by regulators. Regulators seemed to actively ignore the shocking slippage in underwriting standards by our former investment banks and other financial institutions. Furthermore, dodgy practices still pervade large pockets of mortgage lending, credit cards and auto loans. Excessive leverage combined with riskier loan products in commercial mortgage lending and corporate lending have exacerbated the crisis.

Regulators failed to make sure banks maintained adequate capital cushions, and managers of financial institutions failed in their duty of care. But the global financial meltdown is not the result of an unfortunate mathematical error or an errant model. Predatory lending and predatory securitizations combined with excessive leverage and dodgy accounting contributed to our current crisis. This was not an innocent mistake. Rather Wall Street's financiers fed models misleading data to concoct securitizations in financial meth labs that both hid losses and destroyed value. There were no outliers, just outright liars."

In her interview, Tavakoli called for the regulation and compression of the credit default swap market, something that's actually occurring as the Intercontinental Exchange works to build the first transparent CDS exchange. Until recently, these transactions were all entirely private.

But that's not enough for Tavakoli, who'd like to see stricter regulation on the securitization and issuance of credit and credit products. Without that, she says, "Capitalism as we knew it will eventually perish. It will be permanently replaced by a financial sector oligarchy that holds sway over a once democratic government that failed to protect our money."