The economic house of the United States is ready to collapse upon itself, leaving us exposed and defenseless against the next Great Depression. Bureaucratic handymen with a staple gun and a trillion-dollar roll can’t paper over holes in bank balance sheets or fill in the others created by plunging consumer spending.

It won’t work.

What is needed – and what would arrest the slide in U.S. housing prices – is a renewed general confidence in protective regulations, and tax incentives for investors to buy troubled assets and to make equity investments in banks.

Understanding just what brought the economies of the United States, as well as the rest of the world, to the brink of depression is important. But even more important is the realization that the regulations that could have prevented this have been systematically dismantled, such that none of the regulatory bodies charged with safeguarding the public, the capital markets or the systems and institutions we rely on were adequately empowered, properly managed or diligent enough to do their jobs.

Just this month, the U.S. Chamber of Commerce’s Center for Capital Markets report highlighted a number of places the recently much-maligned U.S. Securities and Exchange Commission (SEC) came up short during the crisis.

While the report is enlightening in detailing problems and in proposing practical solutions to internal operations and procedures, the study doesn’t go far enough. An extreme makeover of our economic house requires a brand new regulatory foundation.

As a 30-year veteran of Wall Street, having owned an exchange seat and a broker/dealer and having run my own hedge funds, I know a great deal about regulation; including what works and what doesn’t. Trading derivatives, stocks, futures, bonds and pooled-securities also gives me a unique perspective. The good folks follow the path, but I’ve seen plenty who look at the path and look for ways around it. Why? Because they know "thar’s gold in them thar hills."

And, in the words of Pink Floyd: "We’ve got to keep the loonies on the path."

The Four Point Regulatory Turnaround Plan

Believing that simple solutions are often the most powerful, here is a four-point plan for restoring the regulatory protections that largely shielded investors from harm, and that would rebuild needed confidence in our capital markets:

• First, throw out all the old regulatory guards; they weren’t watching the henhouse.
• Second, merge the hodgepodge of existing regulatory agencies into one body – not just for budgetary reasons, but also to make sure there is no more "regulatory arbitrage, turf wars, or cracks in the foundation.
• Third, create a performance-based "civil service" to oversee and enforce rules and regulations promulgated by a transparent management structure that includes public and private citizens.
• Fourth, and last, create a national council responsible for watching over the regulators.

In order to regulate the regulators, first create and establish "The United States Economic Council" under the federal government’s Executive branch. The Economic Council would oversee and have approval and veto power over all rules and regulations established by a new single regulatory agency, "The United States Capital Markets Commission." The U.S. Economic Council would represent the U.S. in global regulatory agreements and disputes. The U.S. Economic Council would represent the United States in global regulatory agreements and disputes and be comprised of the following members:

The United States Economic Council:

• U.S. Treasury Secretary  (Chairman of the Council).
• Chairman of the U.S. Federal Reserve Board.
• President of the New York Federal Reserve Bank.
• Comptroller of the Currency.
• Chairman of the Federal Deposit Insurance Corp. (FDIC).
• Chairman of the National Association of Insurance Commissioners.
• Chairman of the U.S. Capital Markets Commission.

By forming the The United States Capital Markets Commission, the country gains a single effective regulatory body. This commission would simply consolidates the offices, personnel and resources of the U.S. Securities and Exchange Commission  (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange and Nasdaq Regulation.

Together, these organizations already employ more than 7,000 officers and staff. The Capital Markets Commission would have regional offices run by career-oriented regulatory professionals. Commission personnel holding an executive post – or a position with the ability to make or influence findings of guilt or innocence, or to levy fines or penalties – would be ineligible to be hired or compensated by any company or individual subject to commission oversight for two years subsequent to their commission employment.

The Capital Markets Commission would derive its budget from charges levied upon regulated companies, markets, transactions and licensed professionals.

The mandate of the commission would be to establish market efficiencies and opportunities enforced by rules and regulations for transparency in product creation, ratings integrity, public protection, fair and orderly markets, and systemic risk mitigation.

The Capital Markets Commission would exercise its mandates by empowering eight committees:

• A Transparency-and-Accounting Committee.
• A Products Committee.
• A Ratings Committee.
• A Licensed Persons Committee.
• A Public-Trust Committee.
• A Fair-and-Orderly Markets Committee.
• A Systemic Risk Oversight Committee.
• And an International Regulatory Coordinating Committee.

Each committee’s rules, regulations, findings and determinations would be subject to peer-committee review and comment, and publicly posted on the Commission’s website. A department that we might call the "Division of Compliance, Examination and Investigation" would act as the commission’s executive and judicial branches.

Six commissioners would govern the Capital Markets Commission. Five commissioners would be industry professionals with demonstrable records and an expertise in their respective market segments. Industry commissioners would be elected by a vote of registered individuals licensed to transact business in their markets. Industry commissioners would serve two-year terms, and their service time would be capped at two terms. These commissioners would execute their duties as unpaid public servants.

The chairman of the Capital Markets Commission would be an established-and-recognized "academic," and would be elected by a vote of the U.S. Economic Council.
The Capital Markets Commission chairman would serve a four-year term and could serve no more than three terms. The chairman’s compensation would be market-based.

The membership of The U.S. Capital Markets Commission would look like this:

The U.S. Capital Markets Commission:

• Chairman of the Capital Markets Commission.
• Equity Markets Commissioner.
• Credit Markets Commissioner.
• Commodities Markets Commissioner.
• Derivatives Markets Commissioner.
• Currency Markets Commissioner.

Unlocking the Credit Crisis

While working on a transparent-and-effective regulatory foundation, we must simultaneously address the framework of banking institutions and credit facilitation. As I noted in Money Morning earlier this month, the new bank-rescue plan outlined by U.S. Treasury Secretary Timothy F. Geithner is flawed from the outset, for it essentially relies on some of the same ingredients that caused the financial crisis in the first place – and it lacks the details that a plan must have to succeed.

The credit crisis is not simply a matter of getting banks to lend again. The actual credit-creation algorithm incorporates a greater than 50% reliance on securitization and the sale to receptive investors of pooled packages of residential and commercial mortgages, credit-card receivables, car loans, student loans, small business loans and many other pooled debts.

When investors buy these security pools, the purchase price they pay to become the recipients of the "pass-through" cash flows from the underlying borrowers, goes back to the originators of all these loans, who then have more money to make more loans. If investors aren’t willing to buy these packaged pools of consumer and institutional debts, banks and loan originators have to keep these loans on their books and set aside "reserve requirements," the result is they have less money to make future loans.

Better regulation over the creation and structure of investment products, greater efficacy in the ratings that new and old products are assigned, and more-effective protections for investors willing to buy packaged pools of debts (both old and new) is the only way to fix the securitization side of the equation.

If investors were willing to buy mortgage pools again, banks could start making mortgages to homebuyers, a change that would undoubtedly firm up falling prices,. It’s high time that U.S. banks adopted the European "covered bond" model for securitizing and selling mortgage bonds and other asset-backed pools.

With a covered bond, the bank continues to hold the underlying mortgages, but gets to sell the "pass-through" cash flow. It’s safer for investors because the underlying mortgages are "ring-fenced" on the balance sheets of issuing banks; thus, if anything happens to the bank, the mortgages actually serve as investors’ collateral. In the meantime, banks get to "borrow" cheaply by selling the cash flow, and can make more loans with the borrowed money. Under this model, banks retain skin in the game and would be far more inclined to exercise greater diligence in originating mortgages and loans.

Eight Steps to a Better Banking Plan

Fixing the banking system will be infinitely easier if banks’ securitization efforts are actually backstopped by their repaired balance sheets.

The U.S. Treasury Department and the U.S. Federal Reserve have been juggling all the pieces necessary to fix the crisis. They simply need to stop juggling the pieces separately and embrace a total solution. If the government is going to nationalize some banks, which it says it doesn’t want to do, or if it is going to buy troubled assets, which it says it wants to do, it’s going to take more money. Even then we won’t know which banks are dead or alive. There’s an easier way to manage the crisis that has the potential of being far less costly and far more efficient. To do that, the government needs to:

1. Create classes of "eligible securities" that constitute troubled assets. Leave all such eligible securities on the books of existing holders.
2. Create a new accounting domain where eligible securities can reside, segregating them from institutions’ healthy assets.
3. Have the Fed establish and manage transparent pricing models for eligible securities based on actual cash flow measures and model specific criteria.
4. Mandate all holders of eligible securities mark-to-market inventories on a predetermined valuation date, using the Fed’s pricing models.
5. Create demand for eligible securities by offering public and private investors who buy eligible securities tax advantages on gains and losses.
6. Arrange three consecutive quarterly auctions. In the first auction, give investors a five-year grace period with no capital gains tax due on any appreciation, and an indefinite loss carry forward, with no limit on yearly deductions. In the second auction, reduce the grace period to three years; and in the third auction reduce the grace period to 18 months.
7. Have the Fed and Treasury determine, on a pro-rata basis, which banks’ eligible securities are sold to investors. No banks that have received bailout money, or whom the Fed, Treasury and FDIC determine are at risk after being "stress-tested," would be allowed to opt out of inventory liquidation. After the third auction, determine a liquidation or receivership outcome for remaining eligible securities holders suffering from insolvency.
8. Immediately, after each auction, have the Fed disclose which banks’ troubled inventories have been reduced and by how much and allow all banks to sell equity capital to investors. Make dividends to all equity holders exempt from any tax for five years for all holders of record as of the first equity sale date; for three years for any equity holders of record on the second allowable equity sale date; and 18 months for holders of record on the third equity sale date.

By encouraging investors to shoulder the risk of banks’ troubled assets, we would forsake some potential tax revenue on the appreciation of those assets. However, we would be infinitely better off encouraging private investment as opposed to the continuing threat of nationalization and even more taxpayer money being wasted. And, if by encouraging private investment in bank equity we recapitalize our banks quickly and efficiently, wouldn’t the byproduct of stimulating credit and rewarding risk-taking investors be worth the forsaken tax receipts on dividends that otherwise would never have been possible?

There are, of course, more details to be vetted, including not allowing banks to borrow to pay dividends and making sure that reserve requirements and other stress tests are met before dividends are authorized. Additionally, there should be mutual-fund-like pools created for small investors to participate in this potentially lucrative economic fix.

And if in the process shareholders become more active and boards held to higher standards, we will be farther along on the road to recovery and prosperity than slogging it out at our current pace. It’s high time we began building a better home for ourselves, let’s start now.

By Shah Gilani
Money Morning