In the grip of our Great Recession, with more job losses to come, we have yet to fix the broken financial system that is an underlying cause of this whole mess. How can we do it? Some of the ideas being talked about in the halls of Congress are as dangerous as the reckless congressional activity that helped to precipitate the disaster in the first place.
The public no longer sees Wall Street as the catchphrase for the American financial sector but as a symbol of greed and excess. That's not an unsophisticated stereotype. The wreckage is manifest. Most of the traditional banks and investment firms, along with the so-called shadow banking system in the United States—and indeed in Europe—have been seriously damaged and in some cases destroyed. Five major investment banks, all in New York, have either disappeared (Lehman Brothers, Bear Stearns, Merrill Lynch) or been transformed into bank holding companies (Morgan Stanley, Goldman Sachs). Hundreds of small banks and nonbank lenders have totally disappeared. The financial system buckled because it had too much debt, not nearly enough equity capital, and too much irrational exuberance.
It wasn't supposed to happen like this. The long history of financial panics wrecking American lives had produced what we thought was a tight regulatory system. Why did the system fail? Because regulations didn't keep pace with fast-moving changes in the industry. It was like having a cop on a bicycle trying to catch a rogue in a Ferrari. Money market funds undermined deposit accounts in banks; commercial paper undermined the business of short-term lending to big corporations; high-yield bonds had the same effect on lending to smaller companies; and the securitization of mortgages on homes and office buildings, along with other debts such as auto loans and student loans, transferred scrutiny of this method of finance from the original lending officers—who understood the quality of these loans and their risk—to the capital markets, which hadn't a clue about the risks of the paper they were buying and sold it to people who were, if possible, even more clueless. They were all relying on rating agencies whose assessments have proved misleading at best. The original lenders did not suffer the consequences of bad loans. They had an incentive to take on still more risky loans. This is why the securitization market, making up more than a third of all U.S. finance, virtually collapsed.
Fannie Mae and Freddie Mac, which dominated the housing market with an implicit government guarantee, were supposed to be rock solid. But they were building on sand, pressured mainly by Democrats in Congress and tempted by their own greed to lend to home buyers who couldn't afford what they promised to pay. Mix in (well-paid) financial mismanagement and the hundred million or more dollars contributed to congressional election funds that helped discourage regulation, and you end up with the catastrophe that forced us to nationalize Freddie and Fannie. Now we face losses thought to be many multiples of the original government estimates of $25 billion.
The financial system remains vulnerable to a second shock. In return for access to government liquidity, we've imposed greater regulation on the two remaining investment banks that became bank holding companies, along with constraints on other recipients of federal financial assistance. The commercial banking system is today receiving funding at very low interest rates from the government. One would think it would be easy for commercial banks to start lending again and get the economic engine restarted. But when they lend, they do it only at huge—and highly profitable—interest rate spreads. They need to accrue the new profits to absorb some of the staggering actual and potential loan losses remaining on their books.
Shouldn't the Federal Reserve Board, perched at the top of the financial system, have seen what was going on? The Fed is blamed for creating the orgy of debt by failing to see the dangers in the rapid growth of securitization and derivatives and for maintaining the federal funds rate at 1 percent in 2003-2004. Critically, while the regulators looked to their conventional issues of the safety and soundness of individual institutions, no one was responsible for protecting the entire system from the ricochets of interconnected risks. In the Great Depression, wise heads created the Glass-Steagall Act to mandate the separation of commercial banks from investment banking. In 1999, President Bill Clinton and Congress revoked the act, thereby accelerating financial consolidation through mergers and acquisitions. So we got huge firms whose failure could bring down the whole pack of cards. The too-big-to-fail phenomenon led to bailouts with taxpayer money, provoking a deep-seated public anger that has been further aggravated by the recent pile of executive bonuses.