World financial system shaky as ever

COMMENTARY A famed riverboat gambler, ex-MF Global CEO Jon Corzine, loses his shirt. Opaque financial instruments. A daisy chain of big banks in Europe and the U.S. gird against disaster as sovereign-debt losses start rippling through their tightly coupled balance sheets. Dozy financial regulators.

Haven't we heard this song? More than three years after Lehman Brothers blew up and despite stabs at financial reform on both sides of the Atlantic, the global financial system still creaks louder than a wooden roller-coaster.

Take MF Global's October collapse. Corzine's game of choice -- using credit derivatives to bet on whether the eurozone would sort itself out. Writes the NYT's Gretchen Morgenson:

MF Global's debacle was a result of complex swaps deals it had struck with trading partners. While those partners owned the underlying assets -- in this case, government debt -- MF Global held the risk relating to both market price and default....

These are the same market flaws that helped hide the problems at the American International Group -- problems that arose from insurance that AIG had foolishly written on crummy mortgage securities.

Fear that credit default swaps may not protect owners of European debt is also contributing to the growing malaise in the region. Simply, these financial instruments may not be worth what investors thought they were. (You're shocked, I know.) No surprise that Italian bond yields are soaring, raising the country's borrowing costs and stoking concerns that the world's eighth-largest economy could seize up. As we learned three years ago, it's not only banks that are wired together -- so are national economies.

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Derivatives dial up that anxiety by obscuring the value -- and riskiness -- of financial assets. Just as CDS sold against mortgage-backed securities fueled the housing bubble, such swaps have fed the latest crisis in European government debt. The result? Rising credit insurance costs across the continent. As one expert tells Morgenson

"The problems that we've had since the inception of the credit derivatives market have never been solved in any meaningful way," said Janet Tavakoli, president of Tavakoli Structured Finance and an authority on these instruments. "How many times do we want to live through this?"

Back to the future

Other factors implicated in the housing crash that remain symptomatic of our troubled financial system:

- Financial rewards on Wall Street, including at Fannie Mae (FNMA) and Freddie Mac (FMCC), that mock quaint notions about paying execs for performance

- "Too big to fail" banks, this time in Europe, choking on billions of euros in toxic mortgage-related assets

- Weak financial regulation, with the SEC failing to rein in MF Global's risk-taking before the company blew itself up and the Commodity Futures Trading Commission buckling to financial industry pressure to drop proposed rules for brokerage firms

- The ongoing rear-guard action by Republican lawmakers, aided by Wall Street firms, to block mandated financial reform

- The continuing role of credit rating agencies as key cogs in the financial system, even as the firms obstruct efforts to regulate them

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Not that there hasn't been progress. Republicans may continue to thwart government efforts to install a director of the new Consumer Financial Protection Bureau, but at least that agency exists. And in principle, the so-called Volcker rule passed under the 2010 Dodd-Frank Act could discourage large investment banks from rolling the dice (Hey, anything is possible.)

Or not. The Volcker rule's proposed ban on banks owning more than a small stake in hedge and private equity funds doesn't seem to scare Citigroup (C). Bloomberg reports that during the third quarter the financial giant poured roughly $800 million into such funds. For its part, Bank of America (BAC) has recently moved derivatives out of its investment banking unit into a part of the bank backed by the full faith and credit of American taxpayers. Bailouts never get old, either.