Holding On to the Perks

The details of the long-awaited Wall Street reform bill seem to have been finalized. The banking industry, which strongly opposed much of the legislation, will likely see this as a partial defeat. Yes, a portion of the post-crisis policy response can be construed as punishment for the crisis that the banking industry inflicted on itself, on the economy, and on taxpayers.

As Brady Dennis reports in The Washington Post: "While it would not fundamentally alter the shape of Wall Street or break up the nation's largest firms, the legislation would establish broad new oversight of the financial system. A new consumer protection bureau housed in the Federal Reserve would have independent funding, an independent leader and near-total autonomy to write and enforce rules. The government would have broad new powers to seize and wind down large, failing financial firms and to oversee the $600 trillion derivatives market. In addition, a council of regulators, headed by the Treasury secretary, would monitor the financial landscape for potential systemic risks." Other key measures would force banks to spin off portions of their derivatives trading businesses and limit the amount of capital they could invest in private equity or hedge funds.

As we plow through the legislation to figure out the winners and the losers, it’s worth pondering what Wall Street got out of the crisis. Most of the reaction, in fact, nods to it being a boon to the banks. And some of those benefits will remain intact even after the legislation passages. Here’s a look at the handouts given to Wall Street.

First, Wall Street has received—and continues to receive—free money from the Fed as a result of the crisis. To kick-start the financial system, the Fed in December 2008 lowered the Federal Funds rate target to between 0.00 and 0.25 percent and has left it there ever since. Translation: banks can borrow money from the Fed for next to nothing. The Fed last week reaffirmed its policy and noted that conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Second, the Federal Reserve, the Treasury Department, and the FDIC (and the taxpayers who stand behind all three institutions) offered the banking system an extraordinary set of asset and market guarantees. The Fed and Treasury bailed out AIG and Bear, Stearns—and all their counterparties. Treasury guaranteed the assets of Citi and Bank of America. The Federal Reserve and Treasury guaranteed several trillion dollars in money-market funds, and several hundred billion dollars in commercial paper. In many instances, these guarantees were lifted without being used. But they provided a crucial source of stability for a crippled financial sector. And many of these guarantees are still intact, such as the FDIC’s expansion of deposit insurance from $100,000 to $250,000 per account and the FDIC’s guaranteeing of $305 billion in debt issued by financial institutions.

Third, investment banks were welcomed into the Fed’s system. At the height of the crisis, Morgan Stanley and Goldman Sachs, the two remaining independent investment banks, were allowed to become bank holding companies. That meant they could pivot instantly from relying on fickle credit markets to relying on near-free money from the Federal Reserve. For the past 21 months, Morgan Stanley and Goldman have used the Fed’s cheap money to finance trading, investment banking, and lending activities.

Fourth, banks received lots of cheap capital courtesy of the government through the TARP.  In the fall of 2008 and early 2009, investors were demanding tough terms to invest in banks. To entice Warren Buffett to invest, Goldman Sachs had to pay 10 percent interest on preferred shares. Through the TARP’s capital purchase program (CPP), the government bought preferred stock in banks that bears a 5 percent interest rate (plus warrants). About two thirds of the $204 billion invested through the CPP has been paid back. But as this list of transactions shows, several hundred banks are still sitting on a combined $65 billion in cheap capital.

Fifth, and most important, the government essentially guaranteed the mortgage market. In the fall of 2008, the U.S. nationalized failed mortgage giants Fannie Mae and Freddie Mac, and formally assumed their debts. This helped banks in two very significant ways. Banks were huge holders of Fannie Mae and Freddie Mac bonds. When the taxpayers assumed responsibility for those debts, it preserved the value of the bonds and spared banks from damaging write-downs. Next, as the private mortgage markets collapsed, the nationalized institutions continually stepped up their activities, boosting the size of mortgage they would buy. The upshot: banks can make conforming mortgages without risk. Inside Mortgage Finance has reported (here’s the relevant article from The Wall Street Journal) that in the 2010 first quarter, “government-related entities backed 96.5% of all home loans.”

So if you see a bank executive, lobbyist, or apologist complaining about the unjust punishment inflicted on the industry by this legislation, keep in mind the many ways in which banks enjoyed—and continue to enjoy—preferential treatment from the government.

Daniel Gross is NEWSWEEK’s economics editor and the author of Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation and Pop!: Why Bubbles Are Great For The Economy.