Wall Street Reform

Americans paid an enormous price for the financial meltdown: eight million jobs lost, $17 trillion in savings gone, and faith in the system obliterated. While the sickening freefall of two years ago has stopped, the financial system still operates under the creaky regulatory system that allowed the crash. That will soon change.    

This past month, Congress passed the final version of the Wall Street Reform and Consumer Protection Act, an essential component of our multifaceted effort to turn the economy around. Along with the stimulus, programs to stem the tide of foreclosures, and legislation to improve small business lending, reforming the rules that govern our financial system is absolutely essential to returning us to prosperity and preventing another economic collapse.

The reform is sweeping in scope because the causes of the crisis were many and varied. Partisan finger-pointers love to blame one convenient target. Democrats blame Wall Street. Republicans blame Fannie Mae and Freddie Mac.

The reality is that irresponsibility and incompetence existed in every link in a chain of money madness. Consumers were sold mortgages they could never afford, and gorged on cheap debt. Banks bundled those mortgages into complicated securities of mind-bending complexity. Credit rating agencies stamped AAA ratings on the most toxic of them, and all sorts of moneyed players used derivatives to place huge and hidden bets on how they would trade.

Meanwhile, Congress and the regulatory agencies were asleep.

The reform will change behavior at every link in the chain: fewer distressed consumers, less risk on Wall Street, more transparency in the markets and more competence at the regulators.

At the consumer end, a new and independent Consumer Finance Protection Bureau will consolidate the fragmented consumer protection duties now scattered among several regulators.  Anyone who remembers the aggressive marketing of no documentation "liar loans," watched their credit card rates rocket without warning, or wonders about an overdraft fee of $35 charged on a $3 cup of coffee understands the need.

The problem lies in the importance of fees to banking profitability. Not long ago, banks and other lenders made their money by lending at a rate a few percentage points higher than that at which they borrowed. Today, they make billions in profit on a cornucopia of fees: late fees, overdraft fees, ATM fees, etc.  This new business model, like the cell phone business model, works best when those fees are more complicated and less transparent than they might be. To understand this, just go read your credit card agreement.

There is nothing wrong with a fee-based business model, so long as consumers understand the deal. But often they don't, and often they fall prey to the American temptation to consume at all costs. This combination is a recipe for indebtedness that would have shamed our grandparents. Bottom line: we've long prevented companies from selling you a toaster that will burn down your house. The new consumer regulator will prevent someone from selling you a mortgage that will put your house into foreclosure.

The reform makes common-sense changes to the ways banks bundle, trade and bet on the mortgages, credit card and other debt they sell to consumers. Most importantly, they will be required to retain a meaningful slice of whatever whizz-bang security they create. No more assembling some Frankenstein monster and selling it to the confused-looking guy next door. From now on, the wizards of Wall Street eat their own cooking. The incentives of seller and buyer will now be a little more aligned.

Even more important, the reform finally drags into the light of day the unregulated derivatives market. Derivatives are complex securities that vary in value based on something else: soybeans, interest rates, or the price of the aforementioned Frankenstein monsters of bundled subprime mortgages. They are used by farmers and industrialists to get rid of risk and by others to take risk.

The markets for these complex products, which brought down AIG and were central players in the collapse, dwarfed the stock market by a factor of ten. And they were unregulated and shadowy. No more. Derivatives will now largely trade on open exchanges and be subject to close supervision by regulators.

Little about this crisis stands out as so awful as the bailout of the "too big to fail" institutions.  In late 2008, as millions of Americans were everything, their government used billions of their dollars to rescue the industry at the core of the problem. Though probably necessary to avoid economic Armageddon, the bailout led to an explosion of white hot rage. It is testament to the strength of our democracy that our system survived. But it must never happen again.

To that end, large and interconnected financial companies will be subject to close oversight by a new council. They will be required to retain more capital, act more prudently and not take risks that could bring them and the system down. If all else fails, the council will have clear powers to step in and undertake an orderly "resolution" of a failing institution, just as the Federal Deposit Insurance Corporation has been doing with banks for generations.

No more confusion. No more bailouts. The funeral is pre-planned. Management is gone, stockholders are wiped out, and any assets are delivered to a failed firm's creditors.
The political debate that accompanied reform too often pitted Wall Street against Main Street, corporations against consumers, Democrats against Republicans.

The reality is that everyone has a powerful shared interest in a financial sector that innovates, extends credit, employs people and pays taxes, but which does so safely. The new reform strikes that balance, and will go a long way to restoring the faith of the American consumer in the financial system.