Why there’s no quick fix – and no easy fix at all – to Wall Street’s problems

From the archives: This article originally appeared in the October 08 edition of The Cape Town Globalist

A lot can change in a year. A toddler can learn to walk. Pink can become the new black. And a financial system can lose $5-trillion like blood from a wound. This has been one such year. To some, it’s a vision that borders on the apocalyptic.

Until recently, the current situation seemed unthinkable on Wall Street. The US housing crisis had been severe (see Volume 3, Issue 1 of THE CAPE TOWN GLOBALIST), but bankers and investors were confident the market was stable and could take the losses in its stride. Only the keenest-eyed economists, and the gloomiest, saw the punishing that was to come. But come it did.

See our brief rundown of the financial crisis if you’re still a bit confused…

There’s been much talk – at election podiums, around dinner-tables, and in many newspapers – about the need to control “recklessness” and “greed” on Wall Street. Certainly, there’s something slightly disturbing about a system so prone to volatility; where a bank can vanish on little more than a whispered rumour; where bankers pursue profit with regular folks’ money, and lose it in what turns out to be reckless practice.

Hysterical as these thoughts may be, these are hysterical days. (At least, you probably feel that way if you have money invested in the markets right now.) But once we get past the populist rhetoric,and past the pseudo-economics, is serious reform a serious possibility.

“Cowboys or traders?”

Clearly, the current financial system can have disastrous consequences, however periodic they may be. A system built on faith can send century-old banking institutions crumbling as soon as investor confidence evaporates. The whole system is at risk from self-fulfilling prophecies, where investors withdraw their money from a bank that is thought to be failing, thereby causing it to fail.

The fundamental issue is responsibility. In a system where bankers can lose billions of dollars which aren’t really theirs, there are no safety nets for common citizens who have their savings invested through pension funds. Those who lose the money aren’t the ones who pick up the tab. In a rational world, how can the reckless behaviour of a few determine the fate of so many?

Only one other institution carries so much individual power: government. But there’s usually a structured, democratic process that invests this power in a government, as well as some system of check and balance. So why do bankers have near total freedom to pursue profit?

Wall Street’s $$$hit-list

Bear Stearns was one of the world’s biggest independent investment banks. It collapsed in March and was acquired by JP Morgan Chase in May 2008.

Lehman Brothers filed for bankruptcy in September 2008. It was one of the five largest independent investment banks.

The Federal Reserve, like any other central banking system, is responsible for developing monetary policy. It also has regulatory and supervisory responsibilities.

Fannie Mae (Federal National Mortgage Association) was created in 1938 to provide easier housing loans in the post-Depression years. A publically traded company, it backed loans in the secondary mortgage industry. Together with Freddie Mac, Fannie Mae was taken into Federal hands after increasing liquidity troubles in 2008.

Freddie Mac (Federal Home Loan Mortgage Corporation) was created in the 1970s as a competitor for Fannie Mae in the secondary mortgage industry.

American International Group (AIG), one of the world’s largest insurance firms, was bailed out by the Federal Bank of New York in September 2008 after suffering a liquidity crisis.

Bank of America is the United States’ largest commercial bank and, after the acquisition of Merrill Lynch, the largest financial services company in the world.

Merrill Lynch was another large independent investment bank that was sold to Bank of America in September 2008.

JP Morgan Chase is one of the oldest traditional bank holding companies in the world. It purchased Bear Sterns in May 2008.

Goldman Sachs & Morgan Stanley are the two largest investment banks in the world. In light of recent financial market developments they changed their status to bank holding companies in order to be eligible for emergency government funding.

To save, but not spoil or smother

There is no clear solution to the question of what to do about this inherent instability. All the parties affected have their own views on what should be done. For many regular people, the answer appears to be a no-brainer: increased regulation of the financial sector, and greater intervention form governments and central banks.

The problem is that regulation needs to prevent immense failures like the ones seen recently but also allow for immense profits in the good times. Even if one accepts that modern economics is cyclical, it’s always tempting to intervene to try to moderate the economic slumps. Though central banks and the IMF are drafting new policy in this regard, it is mostly focused short-term solutions: trying to promote transparency, improve rating techniques for the debt packages, and restore investor confidence. Nevertheless, there’s a lingering question about hard policy: Can we restrict banks’ financial activity to stop them from hurting themselves and the rest of us?

For mainstream economists and financiers, increased regulation is not a comfortable solution. “Regulation is dangerous because you do not want to discourage innovation,” argues Brian Kantor, an Investec strategist in Cape Town. “Any regulation may inhibit innovation.” With the capitalist economy built on entrepreneurship and innovation, anything that might stifle this is a no-no.

Greater government involvement also brings complications. Kantor feels that when government bails out a struggling bank with taxpayers’ money, it creates “a serious moral hazard”. He elaborates: “Once you bail out a big bank, then it sets a dangerous precedent because others may begin to think that they are infallible, and enter into even greater risk.” Because of the huge growth in the industry over the last ten years, some institutions have simply become too large to be allowed to fail. An entity becomes “too big to fail” when their collapse would cause intolerable consequences in the eyes of the government. This is the case with the two mortgage giants Fannie Mae and Freddie Mac. If these institutions were to collapse, “the American real estate market would suffer a terrible short term shock,” says UCT Economics Professor Don Ross.

Fannie Mae and Freddie Mac’s histories make them, in part, the responsibility of the US government. “Fannie Mae was created during the Great Depression by Roosevelt in order to provide affordable housing to the people,” explains UCT’s Dr Tchana Tchana. Freddie Mac was established in a similar vein in 1970. They were quasi-private companies with their shares publicly tradable. Thus, they were responsible to their shareholders although they remained under congressional oversight. With Freddie Mac and Fannie Mae having lent or underwritten $5.3 trillion of the United States’ $12 trillion mortgage debt, it is quite clear that the fallout of their bankruptcy would have been disastrous. This does not apply to private banks, as the US government made clear in the case of Lehman Brothers.

Economic orthodoxy says the answer lies in a competitive, almost Darwinian, environment. Some banks need to fall to teach others a lesson. Intervention only allows inefficiency and malpractice to thrive. Yet this must be the bitterest pill for the millions of people whose only part in this was their pension fund.

There is no denying that the financial system as it stands regularly hurts a lot of people, but neither can we ignore that it makes them and others a great deal of money the rest of the time. It would be narrow-minded to suggest that the status quo is the best or only viable way to run a global economy, but there is as yet no alternative with real traction beyond the few members of the group that conceived it. While the economists and bankers work on it, though, the rest of us will be stuck with the up-and-down, boom-and-bust cycle that makes modern economic life so interesting.

***

Bernhard Schlenther is research editor at The Cape Town Globalist.

Wayne Idas is a third-year PPE student.

Jonathan Bertscher is a second-year business science student

Murray Hunter is editor-in-chief at The Cape Town Globalist.