Wall Street Reform Misses Mark

While our leaders in Washington believe they have addressed the root causes of the recent financial crisis, the truth of the matter is they haven't got a clue. There were three major issues surrounding the financial crisis of September 2008, and they haven't solved any of them.

Some companies had their investments go bad and others made too many bad loans. These and other companies (e.g. FNMA, AIG, Citicorp) were considered too big to fail. That is, if the government allowed them to fail on their obligations and go bankrupt, the bankruptcy of them could have taken down the entire financial system.

Unfortunately, the “Too big to fail” issue was not solved by the Wall Street Reform law. Lehman Brothers, which was allowed to fail and go bankrupt in September 2008, nearly brought down the financial system. It had about $700 billion in assets.

FNMA had $882 billion, AIG had $1.1 trillion and Citicorp was $2.1 trillion. Surely, if any one of them were allowed to go under, the system would have been brought down. Likely an economic depression would have followed. As a result, a US taxpayer bail out was needed for each one of those companies and other too big to fail firms.

Today many companies are still too big to fail (e.g., Bank of America has $2.3 trillion in assets, JP Morgan $2.1 trillion, Citicorp 2.0 trillion, Goldman Sachs $1.2 trillion, and the list goes on), and they will be just as big after this law is fully implemented.

For example, if Bank of America spends the next year making bad loans and they become insolvent, US tax dollars will again be needed to bail them out. Why? They are still too big. If B of A was then allowed to fail, it would drag down other banks and the entire financial system.

While many of the troubled banks made bad loans, other significant losses were due investments in such things like derivatives. There is a problem with banks trading such risky investments. If those investments go bad, their deposits are put at risk and this weakens the banking system. Banks are still allowed to own risky investments like stocks, derivatives and options. This law has not changed that.

The reason many banks and lending institutions got in trouble is they made loans to people who did not have the financial where-with-all to pay them back. No money down and no income check loans were rampant leading up to the crisis. This new law doesn’t set a minimum standard for loans. It didn’t even address the issue.

While lending standards have voluntarily been tightened by the banks, to get credit flowing again, using FNMA and Freddie Mac and a jawboning Federal Reserve Bank, the government will pressure banks to standards once again. I suspect with interest rates this low, another bubble in the housing market will follow in a decade or two.

To solve the too big to fail problem, we should revert back to intrastate banking. That is, under the Alex Saitta Reform Act, a bank would only be allowed to operate in one state. This will shrink and limit the size of banks, so if any one or group happens to fail, the chances of that bringing down the entire system would be reduced.

To solve the trading risk many of the big banks still face, we should limit banks to only taking deposits and making loans — commercial banking only. All banks would have to sell off their trading operations, their brokerage arms and their investment banking departments.

Concerning the bad loans and the national problem of too much debt, for starters, the Reform Act should limit loans to those who can prove they have the finances to pay them back. The law should require all homeowners to put down 20% cash, limit their mortgage payment to 28% of household income, and limit their total debt payments to 36% of household income.

From the 1933 until the 1990’s, banks were limited to commercial banking, banks were confined to one state and the 20% - 28% - 36% rule was the lending standard for a mortgage. It worked well. It is time to bring all those rules back.

Heck no! First, these big banks are politically powerful. There is no way politicians will force them to divest assets in other states or spin off their trading, brokerage and investment banking operations. There is just too much money in those traditional Wall Street businesses. Now that the banks have gotten a hold of them (like they did in the 1990’s), they will not give them up.

Also, ours is a consumer based economy. (70% of GDP is due to consumption.) Easy credit funds the consumer. Those in Washington know this, that’s why they didn’t try to curb lending by raising standards.

The Federal Reserve or The Fed has contributed greatly to the financial mess we are in now. Individuals, companies and governments all around the country have way too much debt. This is due in large part to unwise borrowing and unwise lending. However, The Fed has contributed to the excessive debt by keeping interest rates artificially low.

Do you think anyone would lend money for one year at 0.25%, when the inflation rate is five times that at 2.5%? No! The lender would lose money. Yet, The Fed has pushed short-term rates below the inflation rate in order to get a debt drunken public to start borrowing again.

As a country, we can never expect to shed this staggering debt if we fail to raise lending standards and insist on keeping borrowing rates artificially low.