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How do we Prevent Another Financial Crisis?

The Debate on how to Prevent Another Wall Street Meltdown

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Updated January 14, 2011

As of today, Congress has opened a debate on President Obama's proposed financial reform bill.

There are issues that the Republicans don't agree with in the bill. Here is a list of some of the issues and people involved in the financial reform bill and their status.

Prevent Another Collapse of the Wall Street Firms

In the fall of 2008, the U.S. economy stood on the brink of collapse. Part of the reason is that the financial system, particularly the commercial and investment banks, had been deregulated starting in 1980 and culminating in 1999. In 1999, the Glass-Steagall Act was repealed. The Glass-Steagall Act separated the powers of commercial and investment banking, which insured that banks would not take too much risk with depositors' money.

Republican Senator Phil Gramm helped write and pass the Gramm-Leach-Bliley Act of 1999 that repealed the Glass-Steagall Act. Another key player was long-time Federal Reserve Chairman Alan Greenspan, who was also a champion of bank deregulation.

After the repeal of Glass-Steagall, greed won out over prudence and banks did indeed take too much risk with their depositors' money. Between 1999 and 2008, Wall Street became less like the fabled financial district and more like the Las Vegas Strip. Even the regulation that still existed didn't seem to be working.

The financial reform bill put forth by the Obama Administration is, first, about preventing another collapse of the Wall Street firms and re-regulating the financial industry to some degree.

Derivatives, Securitization, and the Housing Bubble

The housing market, before the Great Recession, was moving full steam ahead and borrowers who couldn't really afford large home mortgages borrowed money anyway for mortgages. Big banks put these mortgages together into packages of securities of derivatives, called credit default swaps, which became the toxic assets that we would later hear so much about. The derivatives market is not regulated so banks could slice and dice these home mortgages into packages of derivatives just about any way they wanted.

Enter Senator Phil Gramm once again. In 2000, Senator Gramm put a provision in legislation that was passed, the Commodity Futures Modernization Act, exempting credit default swaps from regulation.

A perfect storm ensued with a phenomenon called sub-prime mortgages. Even those people who really didn't qualify for large mortgages started being approved for those mortgages. Countrywide Mortgage and its founder, Angelo Mozilo, was one of the biggest offenders. The traditional disclosure required of borrowers was not required and Countrywide was making mortgages to just about anyone who walked in the door. Dick Fuld, who was at the helm of Lehman Brothers when it failed, invested in huge amounts of subprime mortgages as did the government agencies, Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were later bailed out because of this decision. Lehman Brothers was one of the largest failures of a financial firm in history.

Even home builders got in on the act. They were selling houses as fast as they could build them and some helped potential homeowners get mortgages by lying about their qualifications.

Gradually, sub-prime borrowers began to default on their mortgages that they could not afford in the first place. This put the banks that held large amounts of these mortgages in a poor financial position as they suffered steep losses in their loan portfolios.

The Bailouts

In order to stabilize the biggest of the Wall Street firms, for fear of their failure, a bailout fund of $700 billion was established, the infamous TARP fund. The reason for TARP was that letting some of the bigger firms, like Citigroup and AIG fail would further destabilize the economy. The current financial reform bill essentially assesses a tax on the large firms creating a fund to use if any of them become unstable. This is one of the key points of disagreement in the financial reform bill.

The proposed financial reform bill also sets capital and liquidity requirements for the large banks, requirements that were formerly set under the repealed Glass-Steagall Act. It also specifies that the large banks cannot have a debt to equity ratio of more than 15 to 1. When the Wall Street meltdown happened, the debt to equity ratio of many of the large banks was much higher than that.

Credit Rating Agencies and Existing Regulations

There is some regulation left regarding banks and other financial institutions even though the Glass-Steagall Act was repealed. We have to ask where those regulatory agencies were during this meltdown, however. For example, the Securities and Exchange Commission (SEC) had the power to ask for better disclosure of the securitization process of the credit default swaps. Under former Director Chris Cox, it did not.

The Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) both regulate commercial or retail banks. Where were they when these banks were making questionable mortgage loans to sub-prime borrowers?

Other regulatory players are the bond credit rating agencies that rate bonds issued by the large banks. There are three primary bond rating agencies -- Moody's, Standard and Poor's, and Fitch Ratings. They gave the large banks who were putting these loan packages together their highest credit ratings even though the toxic assets comprising the loan packages were incredibly risky. Of course, the credit rating agencies are paid by the banks who employ them which seems to scream conflict of interest. There has since been some talk of nationalizing the credit rating agencies.

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