The time has come for new year's resolutions. The House passed the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) on December 11, 2009. It gives $4 trillion in "emergency funding" to our largest banks during the next financial crisis. Instead of reform, Congress offers even bigger bailouts. Unless we change direction, we will have another crisis by 2015. Congress has made all the wrong moves to guarantee it.
The economy did not just have a heart attack; we are suffering from financial appendicitis. Instead of doing the necessary surgery, Congress is prescribing potent addictive painkillers.
How did we get here? Housing is the largest component of our economy. Cheap money from the Federal Reserve, crippling of states rights to reign in mortgage lenders, and failure to enforce securities laws allowed the largest Ponzi scheme in the history of the capital markets to flourish.
Wall Street's shadow banking system gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private-label residential mortgage backed securitizations. Most of each deal was rated "AAA," since subordinated investors absorbed the risk of a pre-agreed amount of loan losses. But hundreds of billions of dollars in private-label deals were backed by portfolios comprising risky fraud-riddled loans. Most of the "AAA" investment was imperiled, and subordinated "investment grade" components were worthless. Wall Street disguised these toxic "investments" with new value-destroying securitizations* and related credit derivatives.
Meanwhile, collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors (perhaps your pension fund) in doomed securities. New money allowed Wall Street to temporarily hide losses and pay enormous bonuses. This is a classic Ponzi scheme.
When you leverage fraud riddled fixed income securities priced at 100 cents on the dollar, there is nowhere to go but down in a hurry. Confusion after the fraud fell apart led to a vicious cycle of selling as investors and lenders shunned both good and bad assets. The deflating debt bubble was followed by a classic liquidity crunch resulting in a global crisis.
Wall Street protests that it sold toxic assets to sophisticated investors obliged to perform independent investigations of the risk. That argument no longer applies. U.S. taxpayers became unwilling unsophisticated investors funding Wall Street's bailout.
Other parties--mortgage bankers, credit rating agencies, hedge funds, credit rating agency, insurers, mortgage brokers, regulators, Congress, and the Federal Reserve Bank--were supporting actors. If Wall Street's financial meth labs had been shut down earlier, the money machine would have stopped running.
Recent arguments blame Fannie Mae and Freddie Mac, the indirect mortgage lending giants. This is misguided. The largest slug of new risky products and bad loans were created to fuel Wall Street's private-label securitizations. Fannie and Freddie were more at the effect than the cause (not blameless, but not the largest cause of the housing bubble). Now that shadow banking is dead, they are being stuffed with even more bad product to pick up the slack.
Fannie Mae and Freddie Mac are the new motor for no-money-down mortgage loans and a host of new problems. The fraudsters involved with our last crisis went unpunished, and they will help create our next crisis. This brewing fraud fest will result in greater misery and systemic risk. Instead of reform, Congress responded on Christmas Eve by agreeing to cover unlimited loan losses.
Bank depositors' money is guaranteed, if deposits are below the current FDIC deposit insurance limits. Banks did not need to be bailed out to protect depositors. We bailed out banks' other creditors with public money. We are printing so much money that now depositors should worry about inflation.
Inflation is the great destroyer. Inflation will wipe out investment gains (and more) much more quickly than taxes. If you earn, say, 5% on your deposits, 5% inflation will wipe out your gains, (and you aren't earning 5% on your deposits or treasury notes in the first place). That is worse than any current or proposed tax rate, since that would translate to a 100% tax rate.
Wall Street, Fannie Mae, and Freddie Mac supply a swinging door of jobs and paid projects for its financial regulators, Congressmen, appointed administration officials, and investigation committee staffers. Many members of Congress and our Presidents have received massive campaign contributions funded by Wall Street. This dependence is known as "capture," and the result is that instead of reigning in Wall Street, dependent thinking enables mayhem.
We have an alternative to bailouts, one that does not violate the spirit of democracy. Troubled financial entities should be put into receivership and restructured. Old shareholders will be wiped out. Debt-holders will take a haircut (discount) along with a debt for new equity swap to recapitalize the entity. But the job won't be complete until we separate high risk activities from traditional banking in return of Glass-Steagall, indict fraudsters, snuff out systemic fraud, and allow honest bankers to prosper.
After the Savings and Loan crisis of the late 1980's, there were more than 1,000 felony indictments of senior officers. Recent fraud is much more widespread and costly. The consequences are much greater. Congress needs to fund investigations. Regulators need to get tough on crime.
The fact that many U.S. banks stuck to traditional banking and protected shareholders during this crisis is under-publicized, but their prudence worked.
We have the solutions. We need the political will to implement them.
* Collateralized Debt Obligations (CDOs and CDO-squared), Structured Investment Vehicles (SIVs), Real Estate Mortgage Investment Conduits (REMICs and Re-REMICs), Asset Backed Commercial Paper (ABCP), and related credit derivatives. Wall Street also engaged in suspect securitizations of some credit card receivables, auto loans, bank trust preferred securities, commercial real estate loans, and a variety of corporate loans.
**When asked whether or not certain individuals had done anything illegal, I responded that I did "not think anyone did anything illegal, because Congress did not pass laws to make it so," because I did not want to scapegoat individuals. I should have said: "That is up to the Department of Justice to determine."