What is the problem that needs to be corrected by financial reform?
For the recent status in Congress, click Congress fails to accomplish financial reform
(See also So much for ending Too Big to Fail
The way to find the correct solution to a problem is to know as much as possible about the problem. You can't fix what you can't explain.
To achieve financial reform, we need:
First, to understand the causes of the economic collapse of 2008-2009,
Second, to review the actions taken by the government, particularly since the Lehman collapse in September 2008 to deal with the crisis,
Third, to ask whether this massive response was necessary,
Fourth, to look at the results of these actions,
Fifth, perhaps then we'll see what would be a solution.
First, the causes of the housing boom and bust were many and included the following:
(1) social policies to increase home ownership;
(2) government mandates to Fannie Mae and Freddie Mac to provide liquidity in the subprime secondary mortgage market;
(3) relaxation of lending standards;
(4) Federal Reserve actions to reduce the federal funds rate from 6.5% in 2000 to 1.0% in 2003 to 3.0% in 2005 when housing prices were 77% higher than in 2000;
(5) invention of mortgage-backed securities, collateralized debt obligations, credit default swaps, synthetic CDOs, etc. by the financial services industry to profit from these conditions;
(6) banks played rating agencies against each other to get AAA ratings on their products;
(7) lobbying success by major banks in avoiding regulation;
(8) In April 2009, Senator Richard Durbin said, "the banks ... are still the most powerful lobby on Capitol Hill. And they frankly own the place."
(8) the revolving door of senior executives moving between positions in banking, Treasury and the Federal Reserve;
Second, we need to review certain actions taken by the government after Lehman Brothers collapsed in September 2008 to deal with the financial crisis.
(1) The Federal Reserve gave an $85 billion credit line to AIG to keep it from defaulting on credit default swaps it had guaranteed.
(2) On October 3, 2008 Congress passed the Troubled Asset Relief Program (TARP), which delegated to the Treasury Department the authority to buy $700 billion of toxic assets from financial institutions.
(3) On October 13, 2008 the heads of nine major banks were called to the Treasury Department. Each was given a term sheet to sell preferred shares to the government and told by Treasury Secretary Henry Paulson (former CEO of Goldman Sachs) to sign it. The CEO of Citigroup said, "This is very cheap capital!" Warren Buffett had recently invested in Goldman Sachs at 10% interest with options and the government was investing at 5% with fewer options. The government also said it would begin guaranteeing the debt issued by the banks! These were two very large gifts by taxpayers to the nine largest banks.
(4) Banks were able "to book huge revenues from trading and bookkeeping gains" because "the Federal Reserve purchased $1.5 trillion of longer-dated Treasury bonds and housing agency securities in less than a year." This also "gave a sharp boost to the price of bonds and other securities held by banks". (David Stockman, New York Times, January 20, 2010)
Third, was this massive response necessary?
The accepted wisdom from Republican and Democratic officials and most of the media is that we were on the verge of a massive breakdown in the economy in October 2008 after Lehman collapsed. More research is needed, but below are two views that agree and two that disagree on this question:
(1) President Obama simplified the cause and magnified the possible effect, saying "like when a lack of accountability on Wall Street nearly leads to a collapse of our entire economy." (University of Michigan commencement address, May 1, 2010)
(2) Mitt Romney writes that, "A cascade of bank collapses was on its way", because "Commercial paper ... one of the instruments in which many money market funds had invested" was affected. (Mitt Romney, page 127, "No Apology", St. Martin's Press, 2010) The Reserve Primary Fund, a major money market fund, had "broken the buck", causing a loss of confidence in other money market funds.
(3) Peter Wallison testified to Congress that, "[t]he Lehman example seems to demonstrate that even when a major institution fails at a time of profound market panic the actual systemic risks are minimal."
(4) John B. Taylor believes, "the problem was ... the failure of the government to articulate a clear, predictable strategy for lending and intervening into a financial sector". ("Ending Government Bailouts As We Know Them", Hoover Press, 2010, p 48) Taylor "conclude[s] that there is no clear operational definition and measure of systemic risk at this time." (p. 49)
Fourth, We need to look at the current results of our past actions,
The book "13 Bankers" by Simon Johnson and James Kwak has the best analysis I've seen of the causes of the breakdown, actions taken in response to the crisis, alternatives that could have been considered, some of the results of actions taken, and what should be done now. Here are some excerpts:
(1) There are now fewer banks and they are larger.
(2) "The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion." (p. 211, Mervyn King, head of the Bank of England)
(3) "The critical problem ... we've got to resolve is the too-big-to-fail-issue." (p. 210, Alan Greenspan, October 2009 speech)
(4) Large banks get a hidden subsidy from the government because bond investors lend money to the banks with government guarantees at 0.78 percent less than small banks, leading to "consolidation and concentration in the financial sector." (p. 205)
(5) Banks should "compete on the basis of products, price, and service rather than implicit government subsidies." (p. 219)
(6) Above $10 billion in assets, there are very few economies of scale in banking. (p. 212)
(7) "Corporations rely on syndicates of banks for major offerings of equity or debt." (p. 211)
(8) David Stockman wrote, by "fixing short term interest rates at near zero" the Fed is shrinking "the banks' cost of production -- their interest expense on depositor funds -- to the vanishing point." As a depositor, you are getting only a few cents of interest on your checking and savings accounts. Stockman said, "by supplying the banks with free deposit money (effectively, zero interest loans), the savers of America are taking a $250 billion annual haircut in lost interest income." (New York Times, January 20, 2010)
Fifth, What would be a solution to these issues?
Answer, Break up the banks by separating commercial banking from capital market activity.
This solution is described in the Discussion Forum below.