Back To The Future Financial System

For the past few months, the world’s financial system has been (literally) teetering on the brink of collapse.

This weekend the Fed took a final step in bringing this crisis off the cliff. The Fed allowed the two remaining investment banks (Morgan Stanley and Goldman Sachs) to become holding companies, effectively eliminating this separation, and returning us to the pre-1929 banking rules. This is being allowed so Morgan and Goldman will have better access to Fed bailout money. This will help keep them afloat, so that the crisis in the confidence continues its abatement.

The U.S. Congress passed the Glass-Steagall Act to create separation between commercial and investment banks. The 1929 Stock Market Crash, and the ensuing Great Depression, were largely attributed to banks that created stock pools, used excessive leverage, participated in “insider trading” and drove investor savings into their own shaky banking institution.

I find it curious that the issues that created our current financial crisis are virtually the same ones that this law was designed to guard against. Investment Banks moved in lock-step (along with commercial banks) to create a demand for certain financial products, they used leverage of 30-1 (the 1920s leverage was capped at 10-1), they traded algorithms like insiders and they allowed investors to keep on buying overvalued stock and securities until the very end.

The real culprit here was not under-regulation. It was politicians (so, what’s new?) who refused to heed the warning cries and allow regulators to do their jobs. It was politicians that created a law in 1993 that eliminated the tax deduction for corporate salaries in excess of $1 million. This forced companies to pay executives through such means as stock options, thereby changing business focus from long-term to short-term. It was also greedy financiers who cooked their books as long as they could, despite the risks, knowing that that the Fed would bail them out if they failed. Fannie Mae was ordered, by Congress, to buy mortgages from low-credit areas, where few mortgage bankers feared to tread.

This problem will continue until Congress acts vigorously to prevent it. This does not mean more regulations (except for hedge funds, who should have oversight with the rest of the financial system). It means consequences. There should be consequences for fraud.

Recently, Franklin Raines, former head of Fannie Mae, was ordered to pay more than $20 million in penalties and fines. This resulted from an investigation by the Office of Federal Housing Enterprise Oversight, known as OFHEO. OFHEO found that Raines and Fannie Mae had overstated company earnings by more than $9 billion from 2001-2004. (About 40%). This overstatement allowed Raines and others to earn more than $100 million in bonus money.

These fines are a start, but they will do little to discourage future financial atrocities. A fine of just 20% of illegal and immoral bonus money is nothing. It will take jail time to drive the point home.

It appears that Fannie Mae and Freddie Mac relaxed their lending standards far more than the public was led to believe. This “public” includes the financial institutions that hold this (now worthless) paper, the hedge funds, the money market funds, the pension managers and the mutual fund managers. All of these groups were led to believe that these mortgages were solid, adhering to long-held safety standards. Financial institutions were gorging on a feast of tainted food. Now they are all kneeling by the toilet.

In their haste to point fingers and punish culprits, I do hope that Congress looks to the root of the problem before issuing a new spate of government regulations that will do little to solve the problem.

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