Wall Street's New Reality
President Obama believes the new financial reform legislation, nearing completion in Congress, will protect us from a repeat of the 2008 banking meltdown.
Don’t bet on it.
For all the rules, regulations, and new “risk” commissions the legislation will be creating, what appears to be missing is a clear, definitive statement that ends the notion that banks like Citigroup—which mindlessly engaged in risk and jeopardized $800 billion in customer deposits before it was bailed out along with the rest—are no longer “too big to fail.” Without a clear statement that the government won’t step in to bailout mindless risk taking, watch for it to return, maybe not tomorrow or next year, but someday, when the Wall Street profit machine kicks in and memories fade about the events of 2007 and 2008.
Why should anyone expect some paper-pushers in Washington to prevent something as complicated as the next great financial meltdown when they couldn’t stop Bernie Madoff's Ponzi scheme?
All of which is one reason why banking stocks, which have gotten hammered in recent months, staged a rally on Friday. To be sure, there’s a lot in the proposed legislation that the banks hate. One banking executive said he expected the legislation to carve at least $3 billion in profits from his firm each year. The Volcker Rule, proposed by President Obama’s senior economic adviser Paul Volcker, appeared to make it through the final cut, meaning, we are told, that firms can’t make risky market bets, which means lower profits. Banks will have to raise capital, which also depresses earnings. There will be limits on the firm’s business of selling derivatives to large clients; they will have to create a special unit with its own capital to sell the most complex of these products. Banks like JP Morgan will get hit because the bill will force them to cap, and thus lower, so-called interchange fees, or the fees they charge for credit card transactions.
And there will be a new consumer agency watching over the banks dealing with individual investors, banking customers, and people looking to take out loans, presumably monitoring whether average folks are getting screwed on interest rates and fees. So look for higher litigation costs as the agency hands cases to state attorneys general and other regulators.
On top of all that, a “Financial Stability Oversight Council” will make sure the banks don’t take the kinds of excessive risks that led to the 2008 meltdown.
Sounds great, right? Well, keep in mind that before there was such a council, there was the SEC, the Federal Reserve, and a bunch of other bureaucratic entities making sure Wall Street risk-taking wasn’t unusual. And guess what? They all failed miserably. And by the way, why should anyone expect some paper-pushers in Washington to prevent something as complicated as the next great financial meltdown when they couldn’t stop Bernie Madoff's Ponzi scheme, the details of which were handed to the Securities and Exchange Commission numerous times on a silver platter before his fraud was exposed?
And that’s my larger point. I’m sure there are some well-intentioned remedies in the proposed law, which still needs final approval and must be signed by the president. The Volcker Rule seems appropriate. Limiting so-called proprietary trading at banks where they come up with their own trading strategies and use their own capital to make market bets seems like a prudent thing given what happened—until, of course, you scratch the surface of the proposal.
From what I understand, the rule doesn’t cover risk-taking trades that begin with a customer order. And guess what caused the great financial crisis of 2007 and 2008? Wall Street trades that began with the big firms packaging mortgage debt and other complex bonds for customers, and then holding the bonds they couldn’t sell on their balance sheet while they earned interest, until they began to crater, taking the banking system down with them.
And here’s something else to chew on: the vast majority of the trades at firms like Goldman Sachs, the most aggressive trader in the market, still begin with a customer order to buy and sell something (a stock or a bond.) That’s when Goldman works its magic and takes a position in the market to make money, often screwing its clients in the process, as Congressional hearings recently showed.
But the biggest hole in the bill is the continued notion that banks and government are really one big, happy family. The banks will take risks as long as it’s approved by the bureaucrats in Washington who don’t understand risk-taking, and the government stands ready to help the system survive a 2008 meltdown scenario by being able to swoop in and “wind down” troubled firms that present grand “systemic risk” to the markets and the economy when they get into trouble.
Sheila Bair, the head of the Federal Deposit Insurance Corporation, was quoted today in The Wall Street Journal saying that such powers will act as a deterrent because firms know that if they screw up, the government will come in and take them over.
“This is a kind of a nuclear bomb that you hope you never have to use,” she said. “The fact that it's there, I think, is going to be important. And if we have to use it, we will.”
Bair is a fine regulator, maybe the best one we have, but her logic seems to be a bit off on this one. The notion that the government is a backstop to “unwind” the Lehmans of the world before they cause massive losses in the market as they implode is the very thing that led to their implosion. Knowing that the government was ready to act to fix the financial system in times of trouble gave the Wall Street traders all the confidence they needed to take as much risk as they chose, without the consequences of losing everything.
Maybe before the president again assures us that the legislation he can’t wait to sign will prevent financial Armageddon, he should call for a little sit-down with Connecticut Senator Chris Dodd, the main architect of the reform. Dodd himself recently commented that “no one will know until this is actually in place how it works.”
During their talk he should ask Dodd why he would say something so stupid. And while he’s at it, he should lean on Dodd to add the following amendment to his comment: “Let all the banks be advised that the next time they gamble and lose no one will be there to bail them out.”
And if you think any of this will happen, I have a wonderful mortgage bond to sell you.
Charlie Gasparino is a senior correspondent for Fox Business Network. He is a columnist for The Daily Beast and a frequent contributor to the New York Post, Forbes, and other publications. His new book about the financial crisis, The Sellout, was published by HarperBusiness.