Economy

As Wall Street Collapses, Will Washington Get a Clue?

The speculative nature of the financial industry is a threat to national economic security. It requires a serious exit strategy.
As the Dow hemorrhages, Wall Street firms are betting on which one will bite the dust next, and Federal Reserve Chairman Ben Bernanke probably wishes he could leave as the next administration sets up shop, no one is proposing the long-term solution to the banking crisis: regulating the industry.

The Fed was right to turn Lehman Brothers away from its window during those final moments of doom on Sunday night. As such, the resulting $613 billion Chapter 11 filing, the largest bankruptcy in U.S. history (WorldCom dropped to second with a mere $104 billion in assets) was secured.

It was wrong to back the $30 billion bailout of Bear Stearns in March, which facilitated JPM Chase's acquisition of Bear. It should not be the Fed's responsibility, or the government's, to back investment bank speculation. Instead, regulators should have been more vigilant as speculation outpaced available capital, and transparent quantification of risk went out the window.

However, it should be the government's job to stabilize the financial system; the question is how. Unfortunately, neither the Federal Reserve, nor the government, nor the presidential candidates have the slightest clue. Neither a blame game nor desperate piecemeal fixes will work. This is not about Republican or Democratic policies, but systemic bipartisan deregulation. Only a quick bout of sweeping and decisive regulation can fix what's broken.

In 1932, three years after the 1929 stock market crash, the banking system last stood at a brink of implosion. Franklin Delano Roosevelt zoomed past Herbert Hoover into the White House. The country was struggling through a Great Depression unleashed by the forces of unregulated economic greed. FDR stood up to the unrestrained power of Wall Street and contained it. The resultant New Deal included a stoplight at the heavy intersection of financial capital and unregulated greed, called the Glass-Steagall Act of 1933.

Decisively, the Glass-Steagall Act forced institutions within the banking community to pick a side. If you want to deal with the population at large, take their deposits, give them a safe place for their savings and make reasonable loans for which you are as responsible as the borrowers -- terrific. As a commercial bank, you will have the newly established Federal Deposit Insurance Corporation (FDIC) backing your depositors. We, the federal government, will regulate you.

If you want to raise capital through speculative investors at home or overseas -- fine. But as an investment bank, you don't get our backing and you don't get to mix it up with citizens' lives or use their capital to fund your trading activities.

That simple premise, the pristine logic of the Glass-Steagall Act, not only kept consumer and speculative capital from intertwining within the same institution; it simplified the ability to understand the activities of all financial organizations. Transparency was not perfect, but it was more easily accomplished.

Lehman Brothers got a taste of the intent of Glass-Steagall. Its demise is ugly, not just because of its 156-year history, the 25,000 employees who are suddenly without jobs, or the long list of institutions to which Lehman owed money that will be slugging it out in bankruptcy court.

It is ugly because it underscores the supreme gutlessness of the executive and congressional branches of government. Bernanke is desperately trying to figure out how to save the banking industry from itself. Treasury Secretary Hank Paulson can't wait until the election saves him from himself. And the presidential candidates are giving Wall Street, and each other, a barrage of verbal shellacking.

None of this changes the playing field.

The catalyst for this current crisis may be the housing market -- not because individual borrowers slightly overleveraged, but because the entire banking industry massively overleveraged. The larger culprit is the killing of Glass-Steagall, which paved the way for this recklessness.

Yet, rather than considering the massive risks of merging commercial and speculative banking interests, given the overwhelming evidence, federal officials actually pushed for Bank of America's $50 billion all-stock takeover of Merrill Lynch, rather than questioned it.

I worked on Wall Street, at Lehman and Bear and Goldman Sachs. Take my word for it: You cannot merge risk management systems more quickly than this economic crisis can continue to unfold. It is technologically impossible.

This knee-jerk move follows the same dangerous green-lighting of mega-mergers that began when Citigroup took over Salomon Brothers after Congress killed Glass-Steagall in November 1999, and continued with Chase taking over JPM and recently Bear Stearns.

The Fed wants to avoid another huge failure in Merrill Lynch by pushing it under the rug of Bank of America. That is bad policy. Bank of America cannot possibly have a clue about the extent of Merrill's potential losses. This commercial bank taking over a speculative giant is much more dangerous than Lehman Brothers tanking. The Fed was within all of its rights and sanity to say no to Lehman's plea for a bailout. But it won't be able to do the same thing with Bank of America, which, unlike Lehman or Bear, is responsible for the accounts of millions of customers -- real people with real money on the line.

The speculative nature of the industry, in which commercial and investment banks can borrow beyond their abilities to repay, is a threat to national economic security. It requires a serious exit strategy.

There is no easy answer, but there is only one solution -- and it lies polar opposite to the Bank of America-Merrill Lynch merger logic. The only real way to stabilize the financial industry is to take it apart, quantify and separate its risks, and begin again. We can do this. FDR did it. The market is larger now, and more global. That is not an excuse for inaction; it belies a screaming need for useful action and meaningful regulation. Period.