How To Fix The US Financial System

The real culprits of the financial meltdown are the “too big to fail” banks, that leveraged the system to increase their profitability at the expense of the US …

The real culprits of the financial meltdown are the “too big to fail” banks, that leveraged the system to increase their profitability at the expense of the US taxpayers. By breaking up the large banks, ending proprietary bank trading and instilling greater transparency in the capital markets, the government can encourage increased competition and a true free market. See the following article from Money Morning for more on this.

America’s Founding Fathers were afraid of any concentration of power in the republic. They were particularly afraid that banking interests could hijack our fledgling democracy.

And yet today, 234 years later, our Founding Fathers’ worst fears have come true. Wall Street’s stranglehold on the economy threatens our very prosperity, and the future of a truly democratic republic.

It’s high time we address the truth about Wall Street’s tyranny and set a course for a more secure economic future – one that’s anchored by a safe banking system, not a system rigged by banks.

Banks Are the Gamblers … But You’re Taking the Risks

The credit crisis and Great Recession are the unintended consequences of Wall Street’s greed. I say “unintended consequences” because – let’s face it – Wall Street institutions tipped over their own money pot and bankrupted the public casino they had created to leverage bets with house money.

It all started with the Community Reinvestment Act of 1977 (CRA). This piece of legislation was designed to prohibit discrimination on the basis of race, sex, or other characteristics in the credit and housing markets. Of course, this eventually led to lax mortgage underwriting standards in later decades.

But it wasn’t just the Democrats or President Bill Clinton who pushed for an expansion of and greater reach for the CRA in 1999. It wasn’t just the Republicans or President George W. Bush who advocated easier documentation terms for homebuyers in a 2002 speech. It wasn’t just all the Democrats and Republicans who pushed for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to package and buy trillions of dollars of low-quality, mortgage-backed securities.

However misguided they might have been, these policies were all well intentioned. But each of these policies had unintended consequences. It was Wall Street that made sure these “consequences” could be shaped into a giant moneymaking scheme.

Consider, for example, the truth about the subprime mortgage mess.

Default rates on CRA-predicated mortgage loans were a lot lower than bankers had provisioned for. What the bankers realized was that even though they were pushed to make more of these types of loans than they wanted to, they actually made a good profit on them.

As long as housing markets were appreciating, CRA homeowners in distress could actually sell their properties and pay off their loans. Bankers sure weren’t complaining then.

After Wall Street pumped and dumped tech stocks on an unsuspecting American public – resulting in the “tech wreck” of 2000 … and after the horrific terrorist events of 9/11 … the U.S. Federal Reserve sliced interest rates to record lows and kept them there, much too long.

That’s when the subprime-mortgage and easy-credit games took off. Looking at the low default rates on CRA mortgages, bankers figured maybe loan standards were too high and there was room to lower them and still get paid in full. Standards were lowered across the board.

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No Intention of Holding onto “Garbage”

Behind the scenes, the big public casino had been readied and the dice were starting to roll. Because Wall Street and its lobbying armies had gutted existing regulations and stifled all efforts to safeguard the public from new exotic derivatives products, there was nothing to stop the juggernaut.

Banks had no intention of holding on to the garbage they were manufacturing. Wall Street securitized all the junk that it gathered together – and then sold it off to anyone who would buy it.

And because not everyone who would buy Wall Street’s junk was stupid, the institutions reformulated new products from that junk. The new “collateralized” products were just reconstituted, repackaged loans that redirected internal cash flows from mortgage payers so that some “tranches” of the new collateralized pools looked safe and could get the top “AAA” ratings from rating agencies.

It didn’t matter that rating agencies didn’t understand the new math; they were in on the game and got rich, too.

To add insult to injury, Wall Street employed another newfangled product. These “credit default swaps” were insurance-type contracts that anyone could offer on anything. But the real beauty of credit default swaps is that these contracts let Wall Street play on every side of every deal: Wall Street profited once when it sold the junk, again when it sold “insurance” on those subprime securities, and over and over again as it traded both the junk pools and credit default swaps.

The best part about the whole scheme (which all the institutions were playing) was that the game was self-perpetuating. As long as finance companies, mortgage originators and banks were able to package and sell their pools of mortgages and other “leveraged loans,” the money from the sale of them went back to the folks who originated the individual loans in the first place.

The upshot: Those folks could make more loans and start the entire process all over again.

The more money that was available, the lower rates went. The lower interest rates went, the cheaper it was to finance and hold a portfolio of assets. But because rates were so low, and the return on quality loans was correspondingly low, bankers needed higher-yielding assets to maximize the spread on their “cost of carrying” pools of assets. So what happened?

It became necessary to offer mortgages to lower-quality borrowers in order to charge a higher (and more-profitable) interest rate.

That’s how the game snowballed. That’s how it became a feeding frenzy.

Where Greed Takes Control

The idea for Wall Street’s institutions was to “dance until the music stopped.” They all knew they had engineered a housing bubble and that the insane appreciation rates on anything with a roof would eventually fall back to earth. By then, the big players expected they would have found a seat, leaving them to watch the other, less-nimble players stumble and take their lumps.

There was one problem. Wall Street institutions were way too greedy and far too cocky. They believed that they were safe: In their view, they’d either be able to unload their holdings of the junk they’d created, or they had been clever enough to hedge away their risk with their own credit-default-swap-insurance schemes.

Because Wall Street believed it was safe, the institutions didn’t see what was really happening. They were all in the same boat … and that boat was sinking.

That boat happened to be the U.S. economy – and other top economies around the world. Because of their greed, banks actually made the boat and forced us into it. They sunk, along with us, but got bailed out while we were left to drown.

Here’s Where Things Get Good

At this point, you might find yourself asking: So what? Most of the banks have repaid the Troubled Asset Relief Program (TARP) money that they so desperately needed. Most are returning to profitability, and some are even reporting record profits and paying out record bonuses to executives.

Yes, some banks have gotten bigger, a lot bigger. Yes, there are more profits to be shared, because a couple of swaggering laggards of the old investment-banking mold – namely The Bear Stearns Cos. and Lehman Brothers Holdings (OTC: LEHMQ) – are gone. Is that so wrong? Isn’t that part of financial Darwinism in our capitalist democracy?

The truth is not what it appears to be. Bear and Lehman were ruthlessly crushed by their competition so there would be more business to be had by fewer players.

It wasn’t evolution. It was execution.

The bigger banks get, the more they rely on a de facto government guarantee. “Too big to fail” is a doctrine pushed by banks that want to be so big that they crush – or at least absorb – their smaller rivals.

Banks want to be a cartel and to be able to raise fees and the cost of money for their greater profitability, at will. Big banks are making money because the government is keeping interest rates low. Big banks are buying a huge portion of the U.S. Treasuries the government needs to sell to finance the deficit. And that deficit has reached its current size because the money was used to bail out the banks and to mitigate the collateral economic damage that Wall Street caused.

It’s a financing game, another bubble to re-inflate bank balance sheets by allowing them to generate a virtually risk-free, high-net-interest margin.

We need to be afraid of what our Founding Fathers were afraid of, too much power concentrated in too few hands – especially banking-interest hands.

We need to break up all the big banks. And then we need to spread their pieces around the country, placing credit closer to Main Street. We need to end all proprietary bank trading … to eliminate credit default swaps and collateralized debt obligations… and to instill transparency in all capital markets products, trading platforms, and risk-taking businesses that have any systemic impact.

We need a free market, not a free for all.

Competition and free enterprise are the hallmarks of our economic miracle. I’m for less government, less taxation and more power to the people. But this enormous concentration of power that Wall Street and the U.S. banking system have amassed is tantamount to an assault on our very freedom.

It’s time to end the tyranny of the banks. And to once again enjoy the financial freedoms that the end of this tyranny will bring.

This article has been republished from Money Morning. You can also view this article at
Money Morning, an investment news and analysis site.


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