How do we Prevent Another Financial Crisis?

The Debate on how to Prevent Another Wall Street Meltdown

US Markets Open After Global Stocks Slip
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In the fall of 2008, the U.S. economy stood on the brink of collapse. Part of the reason is that the financial system, particularly the commercial and investment banks, had been deregulated starting in 1980 and culminating in 1999. In 1999, the Glass-Steagall Act was repealed. The Glass-Steagall Act separated the powers of commercial and investment banking, which ensured that banks would not take too much risk with depositors' money.

Republican Senator Phil Gramm helped write and pass the Gramm-Leach-Bliley Act of 1999 that repealed the Glass-Steagall Act. Another key player was long-time Federal Reserve Chairman Alan Greenspan, who was also a champion of bank deregulation.

After the repeal of Glass-Steagall, greed won out over prudence and banks took too much risk with their depositors' money. Between 1999 and 2008, Wall Street became less like the fabled financial district and more like the Las Vegas Strip. Even the regulation that still existed didn't seem to be working.

The financial reform bill put forth by the Obama Administration is, first, about preventing another collapse of the Wall Street firms and re-regulating the financial industry to some degree.

Derivatives, Securitization, and the Housing Bubble

The housing market, before the Great Recession, was moving full steam ahead and borrowers who couldn't really afford large home mortgages borrowed money anyway.

Big banks put these mortgages together into packages of securities of derivatives, called credit default swaps, which became the toxic assets that we would later hear so much about. The derivatives market is not regulated so banks could slice and dice these home mortgages into packages of derivatives just about any way they wanted.

Enter Senator Phil Gramm once again. In 2000, Senator Gramm put a provision in the legislation that was passed, the Commodity Futures Modernization Act, exempting credit default swaps from regulation.

A perfect storm ensued with a phenomenon called sub-prime mortgages. Even those people who really didn't qualify for large mortgages started being approved for those mortgages. Countrywide Mortgage and its founder, Angelo Mozilo, was one of the biggest offenders. The traditional disclosure required from borrowers was not required and Countrywide was making mortgages to just about anyone who walked in the door. Dick Fuld, who was at the helm of Lehman Brothers when it failed, invested huge amounts in subprime mortgages as did the government agencies, Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were later bailed out because of this decision. Lehman Brothers was one of the largest failures of a financial firm in history.

Even homebuilders got in on the act. They were selling houses as fast as they could build them and some helped potential homeowners get mortgages by lying about their qualifications.

Gradually, sub-prime borrowers began to default on mortgages they could not afford in the first place.

This put the banks that held large amounts of these mortgages in a poor financial position as they suffered steep losses in their loan portfolios.

The Bailouts

In order to stabilize the biggest of the Wall Street firms, for fear of their failure, a bailout fund of $700 billion was established, the infamous TARP fund. The reason for TARP was that letting some of the bigger firms, like Citigroup and AIG fail would further destabilize the economy. The current financial reform bill essentially assesses a tax on the large firms creating a fund to use if any of them become unstable. This is one of the key points of disagreement in the financial reform bill.

The proposed financial reform bill also sets capital and liquidity requirements for the large banks, requirements that were formerly set under the repealed Glass-Steagall Act.

It also specifies that the large banks cannot have a debt to equity ratio of more than 15 to 1. When the Wall Street meltdown happened, the debt to equity ratio of many of the large banks was much higher than that.

Credit Rating Agencies and Existing Regulations

There is some regulation left regarding banks and other financial institutions even though the Glass-Steagall Act was repealed. We have to ask where those regulatory agencies were during this meltdown, however. For example, the Securities and Exchange Commission (SEC) had the power to ask for better disclosure of the securitization process of the credit default swaps. Under former Director Chris Cox, it did not.

The Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) both regulate commercial or retail banks. Where were they when these banks were making questionable mortgage loans to sub-prime borrowers?

Other regulatory players are the bond credit rating agencies that rate bonds issued by the large banks. There are three primary bond rating agencies -- Moody's, Standard and Poor's, and Fitch Ratings. They gave the large banks who were putting these loan packages together their highest credit ratings even though the toxic assets comprising the loan packages were incredibly risky. Of course, the credit rating agencies are paid by the banks who employ them which seems to scream conflict of interest. There has since been some talk of nationalizing the credit rating agencies.

Ethics and Corporate Governance

One of the complaints is that the large Wall Street banks did not practice financial ethics. Instead of practicing prudence with depositors' money, the large banks bet against its customers using risky credit default swaps during the subprime housing mortgage crisis in order to chase short-term profitability.

Short-term profitability should not be the goal of any firm in a capitalist society. A publicly-traded firm has shareholders to satisfy. Shareholders are satisfied through maximization of the price of the stock of the firm. It seems that the large Wall Street banks forgot this before and during the Wall Street meltdown. A component of maximization of shareholder wealth is social responsibility. If large companies aren't socially responsible, in the long run, they won't maximize their share price and shareholders won't want to own their stock. That's exactly what is happening with the large banks right now.

University curriculums are already changing because of the financial crisis. Business schools are putting a heavier emphasis on business and financial ethics. Perhaps if there had been more emphasis on ethics in business curriculums in the past, there would have been more financial managers who understood what ethics really meant.

It will be interesting to see how financial reform shakes out on the floor of Congress. Some form of bank regulation needs to be put back into place in order to get the risky behavior of large banks back under control. There is a place for derivatives in our economy, but it is not in our banks.