Three years plus after the financial meltdown there is still little public understanding about its underlying causes.   If you want to learn in some detail the real dynamics involved you should read Yves Smith’s book Econned and former New York Times journalist Jeff Madrick’s Age of Greed.

Both books chronicle the same swirl of change that began more than 40 years ago.    In Econned, which offers more detail about the inner workings of these dynamics,  Smith goes back even further in order to explain the evolution (or devolution) in economic thought which she is convinced enabled and magnified the unintended ill effects of changes in finance.  She makes a very good case.

In any case a summation.  The Great Depression laws; FDIC insurance, stricter SEC regulation, the Glass Steagall separation of investment and commercial banking being the most notable worked pretty well.    For almost 80 years there was no run on a bank.  Recessions were relatively mild and short lived.  America grew smartly and there was almost always more than sufficient capital and liquidity to support that growth.

But as America grew, and as international growth began to accelerate, demand for financial services grew as well and this growth put pressure on the structure of American banking, particularly investment banking.   Investment banks historically were private companies where the principals had their own money at stake.   Income came from acting as middlemen in any merger or acquisition, underwriting new stock or bond issues to raise investment capital for corporate clients, or proprietary trading of financial instruments with the firm’s money.  Much of this business was fairly routine and often  awarded based on who you knew rather than what you knew.   Proprietary trading and merger and acquisition were the two most lucrative areas.

The pressure came basically because America’s largest corporations expanded dramatically around the world, opening offices and operations literally in every country.  Their banks needed to follow them, offering services everywhere their clients went.   This tremendously expanded the need for capital by investment banks.  In rapid fashion this explosion in the need for capital outstripped the private, principal owned model of investment banking.   So they all went public and became shareholder owned in order to raise the additional capital.  Goldman Sachs was the last holdout and went public in 1999.   The new capital was good, except that it was ‘other peoples’ money’ now.  That cut the risk tether imposed under the private model where the firm’s money was at stake.

The next dynamic was the one which ended up tearing down the Glass Steagall firewall between investment banking and commercial banking.  That occurred primarily due to commercial banks wanting entry into the higher margin businesses of merger and acquisition and proprietary trading.   Under Glass Steagall commercial banking was a utility.  Regulations virtually guaranteed a bank moderate profits, but those same regulations kept commercial banks out of the riskier investment bank businesses where FDIC insured deposits could end up being lost.   Investment bankers were also eager to gain access to the immense capital Glass Steagall guaranteed for the commercial side.

A third dynamic was involved.  This was the one of financial ‘innovation.’   Derivative securities in particular offered large profits.  But they are complicated and risky.

Taken together these changes produced a nightmare for management.   Decision making often got pushed down below managerial level, particularly in the derivative areas, because each required specific skills and expertise.   Because these areas were often among the most lucrative ones, traders could and often did, take out-sized bets without manager approval.  Unlike most other large businesses, profit opportunities come and go swiftly in investment banking, particularly in the numerous and often unique derivative markets.    This is not something for the faint of heart and it opened up many avenues for abuse, not least one where trader specialists could manipulate the profit margins and the timing of trades in order to boost their bonuses.  Many times these profit boosting trades were booked at inflated prices which would be paid for by customers.   And with a little bookkeeping manipulation profits could be ‘shown’ when a trade was entered into–before anyone including the trader knew whether the trade was even profitable.

Given the inability of banks to manage risk within their own ranks, it should come as no surprise that government regulators had no clue.  And even when they did make a complaint to their administrators, regulators were often told to look the other way–called ‘forbearance.’  This was not only because of the cold hard political cash forthcoming to campaigns from banks rewarding regulatory ‘forbearance,’ but also because the dominant economic/political views were that government regulation was unnecessary.   Unfettered private markets and industry would naturally smoke out the cheaters better than a government bureaucrat could.  That was the theory, anyway.

As Yogi Berra pointed out, sometimes theory and practice are different.  Unlike the experience when Great Depression regulations were in full force, this new business model has produced a long series of blowups spanning more than 40 years, each more severe than the prior.   The 2007-08 financial meltdown was the first systemic banking collapse since the one that threw America into the Great Depression in the 1930s.   It was the first ‘bank run’ since the Great Depression.

Additionally, without the Great Depression rules in force, taxpayers ended up bailing out financiers.   For the first time since the imposition of FDIC insurance, there was a devastating run on the entire banking system.  And that run ended up, for all practical purposes, forcing taxpayers to insure all types of deposits and investments–hundreds of billions of which were not even in American banks.  It was a Great Depression lesson forgotten by this generation at unimaginable cost.

The big banks are bigger now than when the 2007-08 collapse happened.  The murky, complicated derivatives are still primarily traded Over the Counter (OTC) outside of regulatory view.  Most importantly, Congress and the administration still depend upon bank campaign cash for their survival, so efforts to re-regulate finance, to restrain risk taking, are weak to non-existent.

Beezer here.  Will the next blowup be another one created by financial risk and irresponsibility?  Who knows.  There doesn’t appear to be the political will to restrain bank speculation.  Even after the last meltdown.  Apparently it takes something even worse for the public majority to do something to protect themselves.

In a speech at the Stern School at New York University today, Kansas City Fed Chief Thomas Hoenig called the TBTF banks a threat to capitalism.  TBTF is now commonly referred to as SIFIs, an acronym for systemically important financial institutions.

As we consider the topic of SIFIs, let me ask the following questions: How can one firm of relatively small global significance merit a government bailout? How can a single investment bank on Wall Street bring the world to the brink of financial collapse? How can a single insurance company require billions of dollars of public funds to stay solvent and yet continue to operate as a private institution? How can a relatively small country such as Greece hold Europe financially hostage? These are the questions for which I have found no satisfactory answers. That’s because there are none. It is not acceptable to say that these events occurred because they involved systemically important financial institutions.

Because there are no satisfactory answers to these questions, I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril….

After the Great Depression, the Federal Deposit Insurance Corp. was created to provide limited deposit insurance to protect small depositors and to further increase the resiliency of the financial system.

Then, over the past 30 years, this safety net has expanded far beyond its original intent. More recently, Glass-Steagall was repealed, giving high-risk firms almost unlimited access to funds generated through their new access to the safety net. Finally, following a series of crises during the late 1980s and 1990s, the government confirmed that because of systemic impact, some institutions were just too big to fail—the largest institutions could put money in nearly any asset regardless of risk, and their creditors would not be held accountable for the risk taken. Predictably, the industry’s risk profile increased dramatically. The SIFI was born.

Is it any wonder then that in the fall of 2008 we experienced the greatest financial crisis since the Great Depression? Financial institutions had again become irresponsible in their lending practices. They had increased their leverage ratios to unprecedented levels. They became “dry kindle” for a financial fire and, with the end of the housing boom, the match was struck.

Now, with their bailout costs amounting to billions of taxpayer dollars, SIFIs are larger than ever. Strikingly, they are arguing that they should not be held to stronger capital standards if the United States hopes to remain globally competitive. That assertion is nonsense. The remainder of my remarks today will describe how the United States can achieve a stronger, more stable financial system in order to secure its future as a global economic leader.

The speech can be read in its entirety here.

Back in the good old days commercial bankers were protected from investment bankers.  The idea was that commercial bankers weren’t supposed to be taking a lot of risks with taxpayer insured deposits. 

Investment bankers were, and still are, all about risk taking.  That meant that earnings were pretty lumpy at times.  Good years could be really, really good.  And bad years were the same.  It’s one of the reasons that the markets historically gave investment banks relatively low price/earnings multiples.

When commercial banks and investment banks were separate, investment banks cultivated relationships with commercial banks.  An investment deal was always easier to sell if a respected commercial bank signed on early to participate.  

Problem was commercial bankers often said “No” to the investment bankers pitch.  They were picky, in no small part due to their conservative bent and a responsibility to protect their depositors from unnecessary risks.  The fact is that commercial banks do take risks–they borrow short and lend long–but they try to limit this as much as possible.  The idea was to make modest amounts of money on a regular basis and to avoid the big mistake that could sink the bank.

Unfortunately the effort to downsize large bank holding companies has failed, 61-33, with the defeat of the Safe Banking amendment by Senators Sherrod Brown and Ted Kaufman.   Given that the administration opposed the amendment, it’s refreshing that the amendment still gained 33 votes, including three Republicans.

So if Congress isn’t going to restore this separation–referred to as Glass Steagall because that was the Great Depression legislation that imposed the separation but was discontinued in 1999–what is a second best effort?

Prohibit the commercial bank division of a large bank holding company from investing in any deal of the investment bank division of the same holding company.   Not as effective as Glass Steagall, but this prohibition would (if enforced) at least remove the obvious conflict of interest posed by both banks being part of the same corporation.

That means the investment bank would have to make its pitch to a commercial bank that, quite likely, would have its own investment bank.   Not ideal, but it at least somewhat restores some form protection to commercial bankers.

In my previous post I recommended reading “13 Bankers,” written by Simon Johnson (a former IMF Banker) and his partner at the blogsite Baseline Scenario, James Kwak, a PhD, soon to be lawyer, and successful software entrepreneur.

In the introduction to that book, the authors repeated reports that the President, during a private meeting with the CEOs of America’s 13 largest banks, told them “My administration is the only thing between you and the pitchforks.”  The time was Friday, March 27, 2009.  The stock market had fallen 40%, the economy had lost 4.1 million jobs (on its way to losing more than 8 million) and the public was pretty sure these big bankers had a lot to do with all the misery.  Everything that’s transpired since has solidified the public opinion of who the bad guys are.

Figuratively if not literally the pitchforks were definitely out.  And they still are.

At bottom, reducing the size of so-called too big to fail (TBTF) banks is a political problem.  It’s time the President step aside and let loose the pitchforks.  The political will to do what is right has arrived (watching the Senators skewer Goldman Sachs last week should leave no doubt) and the President should no longer stand in the way. Better, he should grab a pitchfork himself.

From “13 Bankers:”

“In the long term, the most effective constraint on the financial sector is public opinion.  Today, anyone proposing to end the regulation of pharmaceuticals or to suspend government supervision of nuclear power stations would not be taken seriously…The best defense against a massive financial crisis is a popular consensus that too big to fail is too big to exist..The megabanks used political power to obtain their license to gamble with other people’s money; taking that license away requires confronting that power head-on.  It requires a decision that the economic and political power of the new financial oligarchy is dangerous both to economic prosperity and to the democracy that is supposed to ensure that government policies serve the greater good of society.”

TBTF banks are not only not necessary for economic prosperity they are demonstably bad for the nation’s economic prosperity.  They stifle competition with more than half their profits coming from a 78 basis point advantage in borrowing costs over competitors:  An advantage created by their bailout which confirmed investor beliefs that the administration simply won’t allow them to fail–no matter how poorly they invested other people’s money.

We don’t need TBTF banks, we need more competition at the top of the food chain.  We need to dismember TBTF holding companies, separating safer, more stable commercial banks from their riskier investment bank brethren.  That’s the way it was for more than 40 years of terrific economic growth in America.  Forty years of growth without a single financial crisis.

Obama wants to walk a fine line of regulatory reform without disturbing the near monopoly enjoyed by these 13 banks.  The public wants much more.  It wants to eradicate TBTF and it senses the nation’s economy, far from being circumscribed, would better flourish without the obvious mal-investment TBTF banks made.  Mal-investment made with complex, risky securities that hid from regulators the huge leverage being made by TBTF bankers, magnifying a housing slump into the worst recession since the Great Depression of the 1930s.

Stand aside, Mr. President.  Once again, the public is ready to lead the politicians.  As FDR replied to a woman badgering him to do more to fight the Great Depression “Miss.  You must force me to do it!”

So do it, Mr. President.

When it comes to financial regulatory reform, Senator Ted Kaufman is a breath of fresh air and common sense.   Kaufman replaced Sen. Joe Biden when Biden became Vice President upon the election of President Obama.   He received his undergraduate degree in mechanical engineering at Duke University, and an MBA from Wharton School of the University of Pennsylvania.

The following is the complete text of a speech on regulatory reform Kaufman made on the Senate floor.

U.S. SENATOR TED KAUFMAN
April 19, 2010

Mr. President, as we continue to learn more facts from various investigations into the 2008 financial meltdown, a certain picture is becoming increasingly clear.  Like a jigsaw puzzle slowly taking shape, we can begin to see the outlines of many of the causes of the crisis — and the solutions that they demand.  
 
In my view, it is a picture of Wall Street banks and institutions that have grown too large and complex and that suffer from irreconcilable conflicts between the services they provide for their customers and the transactions they engage in for themselves. It is also a picture of management that either knew about the lack of financial controls and outright fraud at the very core of these institutions — or was grossly incompetent because it did not.  And the picture includes regulators who failed miserably as well, due to malfeasance or incompetence or some combination of the two.
 
Until Congress breaks these gigantic institutions into manageably sized banks and draws hard, clear lines for regulators to ensure that effective controls remain in place, we will have done neither that which is necessary to restore the rule of law on Wall Street nor that which will ensure that another financial crisis does not soon happen again.
 
What have we learned in just the past five weeks?  On March 15th, I came to the Senate floor to discuss the Bankruptcy Examiner’s report on Lehman Brothers and said — as many of us have suspected all along — that there was fraud at the heart of the financial crisis.  The examiner’s report exposed the use of so-called Repo 105 transactions and what appears to have been outright fraud by Lehman, its management and its accounting firm, who all conspired to hide $50 billion in liabilities at quarter’s end to “window dress” its balance sheet and mislead investors.  And this practice does not appear to be unique to Lehman Brothers.
 
I went further and noted that questions were being raised in Europe about whether Goldman Sachs had an improper conflict of interest when it underwrote billions of Euros in bonds for Greece.  The questions being raised include whether some of these bond-offering documents disclosed the true nature of these swaps to investors, and, if not, whether the failure to do so was material.
 
Last week, we learned about more alleged fraud at the heart of the financial crisis.  On Friday, the Securities and Exchange Commission filed charges against Goldman Sachs and one of its traders for alleged fraud in the structuring and marketing of collateralized debt obligations tied to subprime mortgages.  Goldman allegedly defrauded investors by failing to disclose conflicts of interests in the design and structure of these collateralized debt obligations.  The SEC says this alleged fraud cost investors more than $1 billion.  While I will not prejudge the merits of the case, the SEC’s complaint alleges that Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and that the hedge fund had taken a short position against the CDO.  
 
Robert Khuzami, Director of the SEC Division of Enforcement, said “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.”  Kenneth Lench, Chief of he SEC’s Strucured and New Products Unit, added “The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress.”  Goldman Sachs has denied any wrongdoing and has said it will defend the transaction.
 
This particular case involving Goldman Sachs was almost certainly not unique.  Instead, it was emblematic of problems that occurred throughout the securitization market.  Late last month, Bob Ivry and Jody Shenn of Bloomberg news wrote about the conflicts of interests present in the management of CDOs, a topic also discussed at length in Michael Lewis’ book The Big Short.  The SEC should pursue other instances of conflicts of interest in the CDO market that led to a failure to disclose material information.  
 
Mr. President, last year Senators Leahy, Grassley and I, along with many others in the Congress, worked to pass the bipartisan Fraud Enforcement and Recovery Act, so that our law enforcement officials would have additional resources to target and uncover any financial fraud that was a cause of the financial crisis.  However long it takes, whatever resources the SEC needs, Congress should continue to back the SEC and the Justice Department in their efforts to uncover and prosecute wrongdoing.  
 
I applaud SEC Chairman Mary Schapiro and especially Rob Khuzami and the team he has reshaped in the Enforcement Division. They deserve our steadfast support as the leadership of the SEC continues its historic mission of revitalizing that institution and making it clear to all on Wall Street that there’s a new cop on the beat.
 
Also last week, our colleague, Chairman Carl Levin, Ranking Member Coburn and the staff on the Permanent Subcommittee on Investigations began a series of hearings on the causes of the financial crisis.  It is a testament to the professionalism and dedication of Chairman Levin that he has brought the Subcommittee’s resources to bear in such an effective and thorough manner.  I also want to commend Ranking Member Tom Coburn for his dedication and effort as a partner in this effort.  Chairman Levin and the Subcommittee staff deserve credit and our deep appreciation for the work that they have put into this series of hearings on Wall Street and the financial crisis.  Since November 2008, Subcommittee investigators have gathered millions of pages of documents, conducted over 100 interviews and depositions, and consulted with dozens of experts.  It is truly a mammoth undertaking and the fruits of their labor were evident in last week’s two hearings on Washington Mutual Bank. I look forward to the Subcommittee’s remaining two hearings on this subject, including this Friday’s hearing on the role of the credit ratings agencies.  I urge my colleagues to watch.
 
The Levin hearings deserve comparison to the legendary Pecora investigations of the 1930s, which were held by the Senate Committee on Banking and Currency to investigate the causes of the Wall Street Crash of 1929.  The name refers to the fourth and final chief counsel for the investigation, Ferdinand Pecora, an assistant district attorney for New York County. As chief counsel, Pecora personally examined many high-profile witnesses, who included some of the nation’s most influential bankers and stockbrokers.  The investigation uncovered a wide range of abusive practices on the part of banks and bank affiliates.  These included a variety of conflicts of interest, such as the underwriting of unsound securities in order to pay off bad bank loans as well as “pool operations” to support the price of bank stocks.  
 
The Pecora hearings galvanized broad public support for new banking and securities laws.  As a result of the Pecora investigations’s findings, the Congress passed the Glass-Steagall Banking Act of 1933, to separate commercial and investment banking; the Securities Act of 1933, to set penalties for filing false information about stock offerings; and the Securities Exchange Act of 1934, which formed the SEC, to regulate the stock exchanges. Thanks to the legacy of the Pecora hearings and subsequent legislation, the American financial system rested on a sound regulatory foundation for roughly half a century. That is, until we began the folly of dismantling it.
 
The Levin hearings have shined a much-needed spotlight on the role of potential outright fraud by financial actors as well as the incompetence and complicity of bank regulators in the financial crisis.  There is no better example of the danger that fraud and lax regulation poses to our financial system than the collapse of Washington Mutual, known as WaMu.  
 
Far too often, the failure of institutions like Washington Mutual is blamed on high-risk business strategies. While such strategies are clearly part of the problem, they should not be used to mask other causes, such as fraud and malfeasance, which played a significant role in the collapse of WaMu. Evidence developed by the subcommittee demonstrates that WaMu officials tolerated, if not outright encouraged, fraud as a byproduct of promoting a dramatic expansion of loan volume.
 
The most blatant example of WaMu’s culture of fraud was its widespread use of “stated income” loans – a practice of lending qualified borrowers loans without any independent verification of their income.  Approximately 90 percent of WaMu’s home equity loans, 73 percent of its Option ARMs, and 50 percent of its subprime loans were “stated income” loans.  As Treasury Department Inspector General Eric Thorson said last week, WaMu’s predominant mix of stated income loans created a “target rich environment” for fraud.
 
Because WaMu made these stated income loans with the intent to resell them into the secondary market, it was less concerned whether borrowers would be able to repay them.  WaMu created a compensation system that rewarded employees with higher commissions for selling the riskiest loans.  In 2005, WaMu adopted what it called its “High Risk Lending Strategy” because those loans were so profitable.  In order to implement this strategy, it coached its sales branch to embrace “the power of yes.”  The message was clear.  As one industry analyst said, “if you were alive, they would give you a loan . . . if you were dead, they would still give you a loan.”  
 
That this culture led to fraud on a massive scale should have surprised no one.  An internal review of one Southern California loan office revealed that 83% of loans contained instances of confirmed fraud.  In another office, 58% of loans were confirmed to be fraudulent.  And what did WaMu management do when it became clear that fraud rates were rising as housing prices began to fall?  Rather than curb its reckless business practices, it decided to try to sell a higher proportion of these risky, fraud-tainted mortgages into the secondary market, thereby locking in a profit for itself even as it spread further contagion into the capital markets.
 
In order for WaMu and institutions like it to sell these low-quality loans to the secondary market, they needed a AAA rating from the credit rating agencies.  So what did these institutions do?  They gamed the system and manipulated the agencies by engaging in a practice called “barbelling.”  Apparently, the credit ratings agencies did not examine individual FICO scores when rating mortgage-backed securities, and instead relied on average FICO scores.  As revealed at the hearing by a WaMu risk officer, and detailed in Michael Lewis’ The Big Short, lenders could create the requisite average score by pairing loans whose borrowers had relatively high scores with borrowers whose scores were far below levels that would normally warrant a loan.  So if the raters wanted an average FICO score of 615, a lender could pair scores of 680 with scores of 550, even though borrowers with scores of 550 were almost certain to default.  This “barbell” effect satisfied the rating agencies, even though half the loans had little chance of success.  At the hearing, WaMu CEO Kerry Killinger effectively admitted to barbelling, while saying “I don’t have the barbell numbers in front of me.”
 
To make matters worse, WaMu secured high FICO scores by seeking out borrowers with short credit histories.  Such borrowers often have high FICO scores even though they have not demonstrated the ability to take on and pay off large debts over time.  These borrowers were called “thin files” borrowers.  According to a report in The New York Times, WaMu encouraged “thin file” loans, even circulating a flier to sales agents that said, “a thin file is a good file.” The Big Short even discusses “a Mexican strawberry picker with an income of $14,000 and no English” that was ostensibly given a $724,000 mortgage on the basis of his “thin file.”  
 
Plainly, the Office of Thrift Supervision failed miserably in its responsibility to regulate WaMu, and to protect the public from the consequences of WaMu’s excessive and unwarranted risk taking, including the toleration of widespread fraud.  Although WaMu comprised fully 25% of OTS’ regulatory portfolio, OTS adopted a laissez-faire regulatory towards WaMu.    Although line bank examiners identified the high prevalence of fraud and weak internal controls at WaMu, OTS did virtually nothing to address the situation.  In fact, OTS advocated for WaMu among other regulators and even actively thwarted an FDIC investigation into WaMu during 2007 and 2008.  The complete abdication of regulatory responsibility by OTS may find sad explanation in the fact that OTS was dependent upon WaMu’s user fees for 12-15% of its budget.
 
The regulatory failures of OTS were not unique. The overall regulatory environment at the time was extremely deferential to the market, based on the widespread but faulty assumption that markets can and will effectively self-regulate.  At last Friday’s hearing, the testimony of the Inspector General of the Department of the Treasury was particularly noteworthy.  He said that banking regulators “hesitate to take any action, whether it’s because they get too close after so many years or they’re just hesitant or maybe the amount of fees enters into it . . . I don’t know. But whatever it is, this is not unique to WaMu and it is not unique to OTS.”  Let me repeat, it was the conclusion of our Treasury Department’s inspector general that the failure of regulators to harness the lawless nature of conflicted institutions was not unique to Washington Mutual or to the Office of Thrift Supervision.
 
Mr. President, I have said before and I will say it again:  it is time that we return the rule of law to Wall Street, where it has been seriously eroded by the deregulatory mindset that captured our regulatory agencies over the past 30 years.  We became enamored of the view that self-regulation was adequate, that “enlightened” self-interest would motivate counterparties to undertake stronger and better forms of due diligence than any regulator could perform, and that market fundamentalism would lead to the best outcomes for the most people.  Transparency and vigorous oversight by outside accountants were supposed to keep our financial system credible and sound. The allure of deregulation led us instead to the biggest financial crisis since 1929, and to former Federal Reserve Chairman Alan Greenspan’s frank admission that he was “deeply dismayed” that the premise of enlightened self-interest had failed.  And now we’re learning, not surprisingly, that fraud and lawlessness were key ingredients in the collapse as well.
 
As we turn to financial regulatory reform, we must remember that effective regulation requires not only motivated and competent regulators but also clear lines drawn by Congress. Based on what we have learned, what must we do?
 
First, we must undo the damage done by decades of deregulation.  That damage includes financial institutions that are too big to manage and too big to regulate (as former FDIC Chairman Bill Isaac has called them), a “wild west” attitude on Wall Street in which conflicts of interest are rampant and lead to fraudulent behavior, and colossal failures by accountants and lawyers who misunderstand or disregard their role as gatekeepers. The rule of law depends in part on having manageably sized institutions, participants interested in following the law, and gatekeepers motivated by more than a paycheck from their clients.
 
That’s why I believe we must separate commercial banking from investment banking activities, restoring a modern version of the Glass Steagall Act to end the conflicts of interest at the heart of the financial speculation undertaken by megabanks that are “too big to fail.”  We further should limit the size of bank and non-bank institutions, something Senator Sherrod Brown and I will propose in legislation we plan to introduce this Wednesday. Otherwise we will continue to hear these mega-banks claim they are merely “market-makers,” and no one who deals with them should trust whether the very creator of a financial product they sell is secretly betting against its success.
 
Second, we must help regulators and other gatekeepers not only by demanding transparency but also by providing clear, enforceable rules of the road wherever possible.  One clear lesson of the Goldman allegations is that we need greater transparency and disclosure of counterparty positions in over-the-counter derivatives.  We should mandate that derivatives are traded on an exchange or at least centrally cleared.  The rare exemption should carry with it a reporting requirement so that all counterparties understand the positions being taken by other clients of the dealer firm.
 
Clearly, we need to fix a broken securitization market.  No market, regardless of how sophisticated its participants, can function without proper transparency and disclosure.  While I am pleased that the current reform bill would direct the SEC to issue rules requiring greater disclosure regarding the underlying loans in an asset-backed security, I believe that we must go further still. Requirements for disclosure should not merely begin and end at issuance.  Instead, disclosures should be automated, standardized and updated on a timely basis, providing investors with relevant information on the performance of the loans, their compliance with relevant laws (fraudulent origination, for example, is generally uncovered after the fact), and their replacement by new collateral.  This information would empower investors and countervail the malfeasance of issuers looking to “adversely select” dodgy collateral that they are also shorting on the side.  Moreover, such real-time monitoring by investors would also have beneficial effects further up the securitization supply chain.   If originators know that they can’t get away with selling fraudulent or poorly underwritten loans, they will also be forced to improve their standards.

While not a silver bullet, I am also generally supportive of requirements that those who originate and securitize loans retain risk by keeping some percentage on their balance sheets.  WaMu, for example, developed, in Senator Levin’s words, a “conveyor belt” that originated, packaged and dumped toxic mortgage products downstream to unsuspecting investors.  Their lack of “skin in the game” allowed them to make a mockery of the “originate to distribute” model.  And while Bear Stearns, Lehman Brothers and other firms faltered due to their excessive retention of risk, this basic requirement will better align the interests of originators and securitizers with those of investors.
  
Moreover, a clear lesson of the Levin hearings is that Congress must ban the widespread issuance of stated income loans.  I understand Senator Levin is developing further reform proposals based on his conclusions from the hearings.
 
Third, we must concentrate law enforcement and regulatory resources on restoring the rule of law to Wall Street.  We must treat financial crimes with the same gravity as other crimes because the price of inaction and a failure to deter future misconduct is enormous.  That’s why I’m pleased the SEC is turning the page on its recent history and sending a message throughout Wall Street:  fraud will not pay.
 
Mr. President, last week’s revelations about Washington Mutual and Goldman Sachs reinforce what I’ve been saying for some time.  Deregulation was based on the view that rational actors would operate in their own self-interest within a framework of law.  But even with the most rigorous regulators, it is impossible to trace the financial self-interest of convoluted financial conglomerates, much less constrict their behavior before it runs afoul of the law.  WaMu made loans they knew could not be paid back. Goldman Sachs allegedly permitted clients to take secret positions against the very financial products that it had created.  
 
The picture being revealed by the jigsaw puzzle of multiple investigations is now emerging clearly in my eyes. These financial institutions are too big and conflicted to manage, too big and conflicted to regulate, and too big to fail.  Even Alan Greenspan has said about our current predicament:  “If they’re too big to fail, they’re too big.”
 
Our country took a giant step backwards during the last financial crisis, upending the dream of home ownership for millions of Americans, and throwing millions of people out of work as well. The credibility of our markets, one of the pillars of our economic success, was badly damaged. It must be restored. There must be structural and substantive change to Wall Street, where bankers must resume their central role of efficiently allocating capital, not taking bets in opaque markets that no one can understand.  
 
The solution is clear.  We must split up our largest financial institutions into more manageable entities; we must separate their component parts so they are no longer inherently conflicted and so they can be properly regulated. Only then, if necessary, can they be allowed to fail without sending our entire economy to the precipice of disaster.”

CNBC’s Maria Bartiromo had a very interesting interview lineup yesterday including Treasury Secretary Timothy Geithner, SEC Chairwoman Mary Schapiro, FDIC Chairwoman Sheila Bair, and Elizabeth Warren, Chair of the Congressional Oversight Panel for the federal TARP program (troubled asset relief program).

The top two takeaways:  The administration isn’t going to break up the bank holding companies, and the administration is working on plans to overhaul Fannie Mae, Freddie Mac and even the Federal Home Administration. 

There’s been a lot of pressure, both from the left and the right, to break up the too big to fail (TBTF) banks.  But Secy. Geithner made it clear that the administration is going to stick to its proposals of stricter capital standards, stronger oversight and developing an estimated $50 billion bailout warchest (paid for by the banks themselves) that will be used to fund a bankruptcy type wind down of any part of the largest banks that fails.

Geithner said the regulations are aimed at making the largest banks financially stronger while allowing the government to set up what he described as “a firewall” around any part of these banks that fails.

What comes after that may have best been described by Bair, head of  the FDIC and probably the person with the most experience in shutting down failed banks.  Bair essentially described the process used by FDIC.  You separate the good assets from the bad, bundle the good ones and sell them off–usually to another bank.  The bad assets are also worked off, over time, and sold for what they can fetch.

Both Bair and Geithner made it clear that bank investors in the failed banks, or portions of a holding company containing bank units, will no longer be protected as was done in the recent bailouts.  The same will be true for large financial but non bank institutions such as credit units within large manufacturing companies.  An example of these would be GMAC, or GE Credit–or an insurance company such as AIG that  decide to form financial product units.

As for credit default swaps, both Geithner and Schapiro said reform will put sunlight on who holds what swaps, and in what amounts, so that regulators won’t be caught off guard not knowing how much leverage is being used.

In terms of the recommendation for a Consumer Financial Products Agency, Warren said one problem now is that there are seven different regulatory agencies that have responsibility for consumer protection, in one form or another, and they haven’t been able to protect consumers from abusive sales practices and unfair contracts.  Putting these employees at one agency, Warren said,  will “concentrate them on one clear mission.”  Such an agency will be “strong, viable and can get the job done,” Warren said.

Warren, a Harvard Law professor who has long championed stronger consumer protection regulation, has been publicly mentioned as a possible chairman for this yet to be formed agency, but she declined to respond when asked if she’d take the job.  What she wasn’t asked by Bartiromo, unfortunately, was whether such an agency could be effective while housed with the Federal Reserve, one of the seven regulators that is supposed to protect consumers now.  Early betting is that the agency will be under the Federal Reserve, an organization whose membership is made up of banks.  And banks don’t like the idea of even having such an agency.

The Freddie, Fannie and FHA reform was not described in any real detail.  But Geithner made it clear there would be major changes proposed by the administration.  The Secretary repeated his assurance that current investors will be protected, but the implication is that reform may change that in some way.

Right now Fannie and Freddie are the biggest recipients of government support–more than $1.5 trillion–in one way or another.  Called GSE’s or government sponsored enterprises, they are hybrids that are investor owned, but charged with a public mission.  In this case a mission to make home mortgages as affordable as possible.

They are two of the least popular organizations in Washington DC because they’ve garnered almost as much taxpayer support between them as all the too big to fail banks combined.   At this point, no one has proposed how the government can safely extricate itself from the relationship.

Warren was the clearest in her opinion of the two.  “I don’t like the public/private” concept, she said, adding that “It’s time to pull the plug.”

So it’s pretty much “middle of the road,” for the Obama administration right now.  They want more effective regulation that will prohibit a repeat of the 2008-09 financial collapse, but they are apparently willing to maintain the concentrated TBTF business model many believe is the root cause of the collapse.

Politically, this will be very interesting.  Will financial regulatory reform turn out to be a bi-partisan effort in contrast to the partisan, and often ugly health care debate?

Probably, if for no other reason that big banks are the bad boys in the minds of most Americans.  Neither party wants to be seen as a lackey for TBTF banks.  But there will be disagreements.  A likely one is that Republicans seem to be positioning themselves as supporters of eliminating the TBTF business model entirely and returning to some form of Glass Steagall where Investment Banks and Commercial Banks were kept separate. 

If this turns out to be a popular position, and it could be considering that both the Democact left wing (Obama’s base support) and the Republican right wing want the banks dismembered, then the administration may have to re-design their proposal radically.  Or at least convince the public that their proposals essentially do effectively separate investment banks and commercial banks, even if they are under the same corporate holding company structure.  That might be a very tough sell, if for no other reason that doing so is a complicated process that most people may not at all understand.

TBTF banks may be the only group more unpopular than Congress.  Kicking this group is an almost no lose position.

The second issue may involve the consumer protection idea.  Here, the Democrats may have the upper hand because it is strongly favored by them.  The progressive wing will want a separate, independent agency, not beholden to anyone who actually produces and sells financial products.  Republicans on the other hand aren’t likely to take on the entire banking industry.  They’ll smack TBTF banks forever, but banks of all sizes depend upon mortgage and credit products–the very core of what this new agency will investigate–and that is probably simply a too populist message for even a Tea Bagger Republican party.

And it is probably a too populist one for Obama too.  He’ll do the agency, but probably cave in on it being truly independent.   Which, from Beezer’s perspective, is too bad.  Obama needs to show his foundation that he too, is progressive.