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The Wall Street Crisis

Mark Vasina

How Deregulation Allowed the Stock Market to Run Amok

The shakeout in American financial institutions triggered by the subprime mortgage crisis is being tempered by a series of bailouts by that arch-nemesis of conservatives: Big Government. Fearful that the abrupt collapse of some of Wall Street’s financial titans would lead to widespread economic disruption, federal authorities have committed billions of taxpayer dollars to the task of maintaining stability (and protecting wealth).

The promise of trickle-down prosperity courtesy of unfettered markets appears to have evaporated with the fortunes of Wall Street executives. Investors — the really BIG ones, not just the humble citizens of the ‘ownership society’ — seemed determined over the last decade to shuffle much of their money from one financial bubble to the next, building increasingly unstable financial houses of cards.

When the ‘dot-com bubble’ burst in March 2000, massive amounts of money fled the stock markets for the bond markets, where they created and fed the ‘housing bubble’ via subprime mortgages. This bubble too burst in 2006, revealing a dangerously interlocked web of financial institutions helmed by some of the smartest people on the planet who staked billions (perhaps trillions) of dollars on the bet that homeowners who couldn’t afford their homes would be able to make their mortgage payments.

The ensuing cascade of failures — of mortgage companies, savings banks, hedge funds, investment banks and insurance companies — is only the beginning of the fallout which will certainly land in all sectors of the global economy. An attempt begun last year to kick-start a new ‘commodities bubble’ (oil and food primarily) with money salvaged from the subprime mortgage disaster has already fortunately lost much of its steam, although not without its own lingering economic damage.

The headline-grabbing stories of Wall Street gods brought down by greed, folly and groupthink cannot begin to reflect the harm to be visited on the less wealthy across the country who face the loss of home, job or savings. Although the recent market interventions by the federal authorities were certainly undertaken to protect the assets of the most wealthy in our country, the importance of the bailouts to the well-being of the rest of us is arguably very high.

As Washington implements plans to avert the feared market collapse (in truth, a massive government subsidy of the financial markets), the free market cheerleaders have an image problem. How to explain this acute failure of the ‘Invisible Hand’ to produce happiness and prosperity for even the rich? And how to rationalize this extraordinarily expensive market subsidy? The antiregulation spin machine is already at work to muzzle calls for stronger regulation of financial markets, and to stifle public awareness that this colossal market failure was enabled by the deregulation agenda steamrolling through the legislative and executive branches of our government at all levels.

One spin tactic being tested is denial: Our economy is basically sound. True or not, this argument sounds more like positive thinking than an intelligent observation. Presidential candidate and deregulation champion John McCain tried this tactic for a day after the announcement of the bailout of insurance giant AIG, but quickly dropped it when it met with public disapproval. Nevertheless, some conservative think tank pundits will continue to deplore the bailouts as failures of will to let the market work its eventual magic.

A more subtle tactic — soon to be ubiquitous — is to cloak a defense of the bailouts in the mantle of populism. Complain about expensive actions by Big Government while at the same time warning of the hazards of failing to stay the deregulatory course: We can’t really expect those Wall Street moguls to look out for our interests. But when their foolish greed jeopardizes our home mortgages and 401(k) plans… well, we can’t just sit here. Just let’s not fall for the sucker line that new regulations might help prevent these kinds of financial calamities in the future.

This tactic was employed by the Omaha World-Herald in its September 18 editorial. “Wall Street woes leave public fuming federal officials with challenges,” read the headline. The major challenge, according to the editors, is to avoid new regulations which will ‘overcorrect’ the problem, impairing the proper functioning of financial markets and distorting the lessons Wall Street will assuredly absorb from the current crisis.

The editorial warns that “increased regulation offers no magic solution,” since the “operations [of the big investment banks and AIG] were checked by outside auditors, credit analysts and rating agencies.” No kidding? After the dot-com bubble burst in 2000, newspapers (including the OW-H) were filled with stories of scandals involving rating agencies, ‘independent’ auditors, and leaky firewalls between ‘objective’ securities analysts and sales-driven investment bankers.

Although some concerns were addressed by modest reforms, can we naïvely expect that these private sector watchdogs will now carry out their duties with such everpresent wisdom, skill and integrity that no amount of additional government oversight could improve the situation? And the existence of well-intentioned laws clearly offers no magic solution if government watchdogs strive to provide only politically correct (for the deregulation crowd, that is) lax enforcement.

Policymakers must address critical problems exposed in our financial markets by retooling and redirecting our federal regulators.

• This means tougher interpretation and enforcement of existing regulations and stronger oversight by bank regulators, the Securities and Exchange Commission (which has been conspicuously uninvolved in the recent federal rescue operations) and our other market watchdogs. John McCain has called for the resignation of the head of the SEC. However, without a presidential or congressional commitment to push the SEC in the right direction, replacing the SEC head is merely a shell game.

• This means a careful look at the impact on the current crisis of the 1999 repeal of “Glass-Steagall” firewall provisions which prevented corporate interlocking of commercial banking and investment banking interests. Beginning in 2000, commercial banks were themselves able for the first time to create the securities (including the now worthless subprime mortgage bonds) which removed billions of dollars of mortgages from their balance sheets and reduced the amount of capital reserves they were required to hold as a backstop for the risk of these loans.

• This means re-regulation of mortgage markets to contain imprudent excesses and fraudulent practices by mortgage lenders. Fannie Mae was created by New Deal legislation in 1938 to channel private investment into home mortgages. Originally a federal agency which encouraged the mortgage industry to focus on safe conventional lending practices, Fannie Mae was privatized in 1968 and, in recent years, led the profit-driven charge into the uncharted territories of risky subprime lending.

• This means legislation to enable regulators to identify and control risks in portfolios of esoteric financial derivatives such as credit enhancement swaps, and to require adequate capital reserves against these portfolios. Credit enhancement derivatives were widely used to lay off risk in subprime mortgage bonds and to improve bond ratings. AIG was an exuberant provider of this unregulated form of financial insurance, and this played a major role in the insurer’s demise. Such derivatives were excluded from regulation by the “Commodity Futures Modernization Act of 2000.”

• This means above all that we must elect policymakers who truly recognize that markets do not exist in a vacuum, but require resilient and transparent institutions — private and public — with proactive legal and regulatory underpinnings. The current disaster is strong evidence that the costs of regulation are potentially far less expensive and disruptive than crisis management.

Both major presidential candidates are now calling for regulatory reform. McCain, confirmed foe of government regulation, has adopted the populist tactic in defense of the deregulation agenda. His call for largely unspecified reforms hinges on a consolidation of regulatory agencies, akin to that which created the Department of Homeland Security. Without substantive new regulatory powers and market redirection, however, his reforms would amount to little more than a classic rearranging of the deck chairs on the Titanic.

Barack Obama, who can draw credibly on a suspicion of unregulated markets as a traditional Democratic Party value, is easily the more credible change agent. His attacks on the Bush/Cheney Administration’s antiregulatory actions over the last eight years are certainly on target — much as the deregulatory zeal of the Reagan Administration gave birth to the savings and loan crisis of the late 1980s.

But Democrats have not always been staunch defenders of strong regulation of financial markets. Robert Rubin, former cochair of Goldman Sachs and Clinton’s Treasury Secretary, supported the repeal of the Glass-Steagall firewalls in 1999, as well as the federal legislation which excluded esoteric financial derivatives from regulation in 2000. Rubin, an advisor to Obama, reportedly now recognizes the need for oversight of these financial instruments by federal regulators.

The voting public must choose leaders who have the courage to support — not vilify — government’s unique and essential role of market oversight, over the objections of business lobbies. Effective government oversight is necessary not only for the safe and sensible operation of our financial markets, but also for the protection of the health and well-being of the American people in our homes, workplaces and public commons.

Mark Vasina worked as a risk manager in New York for Bear Stearns in the early 1990s, after several years with the FDIC and the Office of Thrift Supervision.