Financial Reform: Symptoms vs. Root Cause

The grilling of the executives at Goldman Sachs in Senate hearings was a display of Congress trying to deflect focus from their own bad behavior while pointing out bad behavior on Wall Street.  Two wrongs don't make it right, but if not for the existence of bad loans whose creation was driven by Congressional financial and social engineering policy initiatives, there wouldn't be any hearings since the financial products produced by Goldman Sachs would not have existed. If there were no subprime mortgages, there would not be any derivatives, real or synthetic, on subprime mortgages.

Since the smoke has cleared over the subprime landscape, several factors are acknowledged to have caused the housing bubble whose bursting compelled the credit crisis. The Federal Reserve kept interests too low for too long after the bursting of the dotcom bubble and subsequent recession. Couple low interest rates with the reduction in lending standards encouraged by the Community Reinvestment Act in 1977 and later The 1992 Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) mandated that the GSEs (read: Fannie Mae and Freddie Mac) increase their acquisition of primary-market loans made to lower income borrowers, which fueled the growth in subprime and Alt-A loans. The social engineering experiment of increasing home ownership by writing mortgages to people who either did not have the income to pay the mortgage, or to speculators in housing at the time that the housing bubble peaked. Without Congress and their sidekicks Fannie Mae and Freddie Mac enabling bad credit assessment, the resulting misallocation of capital in housing and the resulting housing bubble would not have occurred.

Meanwhile, back at the Goldman Sachs hearing, Carl Levin laid down S-bombs to point out that the derivatives promoted aggressively by Goldman were bad investments. Goldman had used unethical business practices in promoting these investments. Senator McCaskill correctly pointed out that these derivative investments were gambling. They were side bets made on the subprime mortgage market, and in fact, the size of these side bets exceeded the size of the subprime mortgage through the miracle of leverage. The federal bailout of Wall Street made the players in these side bets whole.

While there is great public anger directed at the Wall Street as a cause of the credit crisis and for being bailed out by the federal government, the hearings did nothing to add clarity to the root causes of the problem. 

Congressional mandates encouraged reducing lending standards and were supported by Freddie and Fannie. The side bets and derivatives plays became a systemic risk to the credit markets because the abolition of Glass-Steagall in 1999 eliminated the separation of the investment banking (companies that use of their own risk capital) from commercial banking (companies that make commercial loans and are regulated by the Federal Reserve). With this banking barrier broken, and the reduction in lending standards, it became possible now for banks to act like poorly behaved adolescents and take the milk money to the track and bet on the ponies.

Real financial reform will occur when Congress has an honest discussion of root causes and symptoms. Goldman Sachs was not the cause of the credit crisis, but they did behave badly.

Real reform will address the following.

  • Bring back Glass Steagall and the separation of commercial and investment banking.
  • With commercial and investment banks separated, then there is no need for too big to fail treatment of banks. If investment banks gamble big and lose, then bankruptcy court can deal with cleaning up that mess.
  • Regulate derivatives market on an open and transparent trading system just as is done with stocks.

Lastly, Congress needs to recognize that social policy can create distortions in the market resulting in poor capital allocation resulting in asset bubbles. Federal debt is becoming the next bubble. This last reform will need to be initiated by the voters at the ballot box this November.
The grilling of the executives at Goldman Sachs in Senate hearings was a display of Congress trying to deflect focus from their own bad behavior while pointing out bad behavior on Wall Street.  Two wrongs don't make it right, but if not for the existence of bad loans whose creation was driven by Congressional financial and social engineering policy initiatives, there wouldn't be any hearings since the financial products produced by Goldman Sachs would not have existed. If there were no subprime mortgages, there would not be any derivatives, real or synthetic, on subprime mortgages.

Since the smoke has cleared over the subprime landscape, several factors are acknowledged to have caused the housing bubble whose bursting compelled the credit crisis. The Federal Reserve kept interests too low for too long after the bursting of the dotcom bubble and subsequent recession. Couple low interest rates with the reduction in lending standards encouraged by the Community Reinvestment Act in 1977 and later The 1992 Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) mandated that the GSEs (read: Fannie Mae and Freddie Mac) increase their acquisition of primary-market loans made to lower income borrowers, which fueled the growth in subprime and Alt-A loans. The social engineering experiment of increasing home ownership by writing mortgages to people who either did not have the income to pay the mortgage, or to speculators in housing at the time that the housing bubble peaked. Without Congress and their sidekicks Fannie Mae and Freddie Mac enabling bad credit assessment, the resulting misallocation of capital in housing and the resulting housing bubble would not have occurred.

Meanwhile, back at the Goldman Sachs hearing, Carl Levin laid down S-bombs to point out that the derivatives promoted aggressively by Goldman were bad investments. Goldman had used unethical business practices in promoting these investments. Senator McCaskill correctly pointed out that these derivative investments were gambling. They were side bets made on the subprime mortgage market, and in fact, the size of these side bets exceeded the size of the subprime mortgage through the miracle of leverage. The federal bailout of Wall Street made the players in these side bets whole.

While there is great public anger directed at the Wall Street as a cause of the credit crisis and for being bailed out by the federal government, the hearings did nothing to add clarity to the root causes of the problem. 

Congressional mandates encouraged reducing lending standards and were supported by Freddie and Fannie. The side bets and derivatives plays became a systemic risk to the credit markets because the abolition of Glass-Steagall in 1999 eliminated the separation of the investment banking (companies that use of their own risk capital) from commercial banking (companies that make commercial loans and are regulated by the Federal Reserve). With this banking barrier broken, and the reduction in lending standards, it became possible now for banks to act like poorly behaved adolescents and take the milk money to the track and bet on the ponies.

Real financial reform will occur when Congress has an honest discussion of root causes and symptoms. Goldman Sachs was not the cause of the credit crisis, but they did behave badly.

Real reform will address the following.

  • Bring back Glass Steagall and the separation of commercial and investment banking.
  • With commercial and investment banks separated, then there is no need for too big to fail treatment of banks. If investment banks gamble big and lose, then bankruptcy court can deal with cleaning up that mess.
  • Regulate derivatives market on an open and transparent trading system just as is done with stocks.

Lastly, Congress needs to recognize that social policy can create distortions in the market resulting in poor capital allocation resulting in asset bubbles. Federal debt is becoming the next bubble. This last reform will need to be initiated by the voters at the ballot box this November.

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