Friday, April 16, 2010

Wall Street Regulation Then and Now

by Richard Crews
There are two fundamental functions of financial institutions such as banks. The first is allocation of capital. An example of this is a bank's receiving deposits from many customers, and making loans of batches of this money to businesses that want to buy inventory or equipment, or to new homeowners purchasing a property. Other examples are financial institutions that create stocks and bonds thereby, in effect, pooling the money of investors who buy those stocks and bonds so that businesses have working capital.

The second fundamental function of financial institutions is to safeguard wealth. Depositing ones savings in a bank or buying stocks and bonds is a lot safer than buying extra chickens, storing up grain from a good harvest in sacks in the basement, stuffing dollar bills under a mattress, or burying gold coins in the back yard. Someone who uses such traditional safeguards can become the victim of fire, theft, or bad weather.

For several decades prior to 2008 financial institutions, large and small, operated more and more without substantial government supervision. This was called "deregulation." The belief was that financial managers would act responsibly and ethically.

But financial managers are human beings. Some gave in to the greed, short-sightedness, laziness, and deceitfulness that often afflicts our species. And the ones who took such self-serving shortcuts artfully, made more money than the others, so more and more followed suit. They used excessive leverage (essentially claiming they had more money than they did--much more--as much as 30 or 35 times more); they made loans to people they knew could not pay them back; they bribed bond-rating companies which were supposed to assess and assure the true value of bonds; but most of all they invented derivatives so that they could sell stocks back and forth to one another at ever increasing prices.

The result was, for example, millions of bad home loans, bundled to hide their weakness and sold to distant investors, and a vast network of complex, back-scratching insurance deals (totaling several tens of trillions of dollars) supposedly guaranteeing these, but in reality far in excess of any company's ability to pay.

When the housing bubble burst--that is, when a homeowner could no longer sell or refinance a home for several percent more every year--the whole phony stack of cards came tumbling down.

The obvious remedy to prevent this happening again is new, stronger laws and watchdogs (regulators).

The trouble is that financial institutions used the rebound from the financial debacle they had caused to get rich and powerful again--to start paying themselves multi-million dollar bonuses again; to start pouring multi-millions of dollars into lobbying and political campaigns again.

A year ago financial managers stood amidst the wreckage of their industry humbly pleading for help. Now they stand atop a mountain of profits again, arrogantly and artfully demanding that Congress do nothing to impede their games.