How Do We Prevent Another Great Recession?
Another Wall Street Meltdown
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 In 1999, the Glass-Steagall Act was repealed.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 helped to limit risks for depositors and investors.
Republican Senator Phil Gramm helped write and pass the Gramm-Leach-Bliley Act of 1999 that repealed the Glass-Steagall Act.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 were allowed broader latitude to combine the operations of commercial and investment banking once again. Between 1999 and 2008, the increased freedom cycled back to more precarious risk taking, this time contributing to a housing bubble that would cause millions in losses for banks, lending institutions and investors.
Regulation in the banking sector has gone through many cycles. What history has shown is that both highly regulated and highly deregulated policy in the financial sector can cause problems for the industry and the economy overall. A balance between the two could be the best anecdote but the competing agendas of banks and politicians make a balance hard to strike. The evolution of new products in the market also creates new challenges. Below we will take a look at what history has shown us and where we are headed.
The 2008 Financial Crisis
The subprime mortgage crisis began to surface in 2006 fully erupting in 2007 and reaching a peak in 2008. The housing market and mortgage lending saw some of the greatest reciprocities but at its core, the source of the problem was primarily a vast and rapidly expanding loan securitization and institutional credit derivatives market with little governmental oversight.
Before the 2008 Financial Crisis, the housing market was moving full steam ahead. Borrowers who couldn't really afford large home mortgages were being approved for borrowed money anyway, bankers were overly confident on asset backed lending, and lending stipulations were loose, allowing for the expanded approvals. Different than past historical cycles however was the emergence of derivative lending products. Big banks put mortgages together into packages of securities with varying levels of leverage and return, appealing to many conservative investors willing to take slightly more risk for what they thought were standard fixed income returns. Credit default swap trading among corporate institutions also increased, giving banks more power to swap loans on their balance sheets for different maturities and risk levels.
Enter Senator Phil Gramm once again. In 2000, Senator Gramm put a provision in the legislation that was passed, the Commodity Futures Modernization Act, exempting credit default swaps from regulation. Subsequently, a perfect storm ensued for the sub-prime mortgage loan market. Even those people who really didn't qualify for large mortgages were being approved. Countrywide Mortgage and its founder, Angelo Mozilo, was one of the biggest offenders. The traditional disclosure required from 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 huge amounts in 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 homebuilders got in on the act. They were selling houses as fast as they could build them to take advantage of the lower lending standards. Gradually, sub-prime borrowers began to default on mortgages they could not afford in the first place. It put the banks that held large amounts of these mortgages in a poor financial position. Problems also spread rapidly among the securitized and swap products that held subprime.
The Bailouts and Financial Reform
Unprecedented regulatory actions followed. 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 government also introduced the Dodd-Frank Reform Act, which would change the future and become America’s next leading regulatory act in the cycle to follow.
Dodd-Frank created capital and liquidity requirements for the large banks, requirements that had been formerly seen under the Glass-Steagall Act. It also specified that the large banks could not 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.
Dodd-Frank also stepped in where oversight had failed. It set standards through the Securities and Exchange Commission (SEC) for better disclosure of the securitization process. It increased the regulations for the institutional credit default swaps market. It increased the power of the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) for regulation of commercial and retail banks. Dodd-Frank also led to new stipulations for credit rating agencies who had given loan securitization products their highest credit ratings even though the toxic assets comprising the products were incredibly risky. Obviously one of the greatest targets was also the large Wall Street banks that did not practice diligent financial ethics.
Dodd-Frank financial reform also moved through many other channels. University curriculums evolved. Business schools increased their emphasis on regulatory processes and reporting. Additionally, regulatory jobs in the financial sector ultimately increased as well.
Dodd-Frank and President Trump
The financial reform bill put forth by the Obama Administration was about preventing another collapse of the Wall Street firms and re-regulating the financial industry. President Trump and the Trump Administration are fighting for a new regulatory cycle in the financial industry, one that seeks to give banks back more freedom in lending and reduce the exhaustive reporting that is a byproduct of Dodd-Frank’s financial reform.
Freedom and Limitations in Financial Regulation
Historical cycles and previous regulations have set a number of precedents for the financial industry. Regardless the industry proves to be one of the most cyclical in terms of regulatory rulings and operational governance. What history has shown is that both regulation and deregulation have their advantages but the two are hard to balance. Additionally, in situations such as the 2008 Financial Crisis it’s the emergence of new and overlooked elements that can also cause some of the greatest problems. Thus, if history can help to provide advice for the future it seems that both a regulated balance and a proactive approach to new market evolutions, such as cryptocurrency and its byproducts, are key.