Thought of the Day

                                                                                                                                                                                    Sydney M. Williams

Thought of the Day

January 22, 2010

The image of President Obama staring down Wall Street banks with Paul Volcker behind him, and with grinning Joe Biden standing slightly off center, may have provided some succor to those who see banks as solely responsible for the mess we found ourselves in two years ago, but his two proposals don’t appear to have much bite, and, in his interest in appearing populist, he does not put the problem within the perspective it deserves.

The President, yesterday, proposed two reforms.  The first, which he Christened the Volcker Rule, was that commercial banks (which, as of September 2008, include both Goldman Sachs and Morgan Stanley) could not operate hedge funds, private equity funds or proprietary trading accounts, if those operations are “unrelated to serving their customers.”  His second proposal was to prevent any further consolidation among the large banks.

John Carney, editor of ClusterStock, pointed out that the key words in the first proposal are the ones I put in quotations.  He argues, reasonably it seems to me, that the banks are likely to be able to demonstrate - fairly or not - that customers are served by those three products.  The President’s proposal, in my opinion, seemed an elevation of naivete over reality.  I agree with the President that depositors money (a key liability of most commercial banks) should not be invested in high-risk assets.  Why not simply revoke the “commercial bank”  status of Goldman and Morgan Stanley?  Or why not reinstate an updated version of Glass Steagall?  As to his second proposal, we will have to see.  I happen to be a believer in the notion that if a bank is too big to fail, it is too big.

Eighty years ago, the conflict of interest within banks, and what led to the Glass Steagall Act, was  that banks were underwriting securities and placing them in accounts over which they had investment authority - an obvious conflict of interest.  Today the problem is the leverage banks carry on and off their balance sheets and that the risk assets they carry often seem designed to  generate returns to the employees while providing little economic value.  The leverage they employ and the interlocking nature of those assets between banks brings risk to our system, as we found out so devestatingly in September-October 2008. 

The financial crisis that brought us to our knees has many fathers, not the least of which is government.  Banks basically accept deposits and make loans.  They have been doing this for hundreds of years.  From time to time, in the interest of generating bigger profits, they take foolish risk.  When that happens, they fail; others learn from their mistakes.  Failure is a good master.  However, during he Depression, amid hundreds of banks failing, to protect depositors the Federal Deposit Insurance Act was created (under the Glass Steagall Act), providing a government guarantee against failure.   A bank may fail, but the depositors would be protected. 

In 1977 Congress passed the Community Reinvestment Act of 1977 which was designed to “encourage commercial banks and savings associations to meet the needs of all borrowers in all segments of their communities, including low-income and moderate-income neighborhoods” to obviate a practice known as “red lining.”  To ensure banks were in compliance of this Act, federal regulators regularly examined their books.

Under Presidents Clinton and Bush two, the push for homeownership became part of policy.    A slew of creative mortgages were created that could satisfy any purchaser; they were sliced, diced and securitized and sold to investors around the world - often carrying triple A credit ratings, thanks to friendly rating agencies. Freddie Mac and Fannie Mae, the two large GSEs (Government Sponsored Entities), were implicit in what amounted to a scam - purchasing high risk mortgages from the initiating banks to provide the funds so that he game could continue.  Their sponsors in Congress aided and abetted them, by encouraging a greater use of leverage.  Efforts, during the early and mid 2000s, to rein them in by the Bush administration failed.    

There were many others responsible for the problems, from consumers who lost all sense of responsibility to crooked brokers and mortgage bankers.   Rating agencies neglected their responsibilities.  Regulators failed to understand the monster that derivatives and leverage had created.  Bankers put bonuses ahead fiduciary responsibility.  And members of Congress were bought off.

A failure on the part of President Obama to acknowledge the role played by Congress makes his recommendations appear insincere and partisan.