Written by: Nick Caleb
Researched by: Casey E. Sanders
Edited by: Stefanie Herrington, Daniel Kwak, and Eric Blaine
Managing Editor: Amy E. Seely

ATTENTION:  The final buzzer may have just sounded on the Wall Street Era.

The global marketplace is in the midst of a serious financial crisis of which the effects are in no way limited to American International Group (AIG). Alan Greenspan, former chairman of the federal reserve, says that the economy is the worst he’s ever seen. In addition, economic experts agree that a quick fix is needed to stave off complete economic collapse. In the next few days and weeks, there will be an intense policy debate that could shape the face of the market for decades to come. To reconstruct the mechanisms that led to this crisis, one need only revisit a bit of recent regulatory history.

One of the changes in the law that contributed to the current crisis was the 1999 repeal of the Glass-Steagall Act, which was enacted after the 1929 stock market crash. In short, the Act banned banks, insurance companies, and brokerage firms from teaming up. This legal barrier protected bank depositors from the higher risks associated with security transactions (those involving stocks, bonds, and derivatives), instead of making traditional, safer investments with the best interests of depositors in mind. As Slate Magazine explains, “in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble burst in 1929, exposure to Wall Street helped drag down the commercial banks.” After twenty-five years of unsuccessful attempts to repeal the law, the 1998 Citicorp and Travelers merger (resulting in Citigroup) finally persuaded the U.S. government to remove Glass-Steagall from the books.
When Glass-Steagall was repealed, commercial and investment banks became intimately reacquainted, bringing back the conflict of interest that existed before the Great Crash. In fact, today many banks own brokerage firms and provide investment services. The repeal was a green light for commercial banks to re-enter the high-risk securities markets. On the advice of financial advisors, government regulation was reduced mainly to “private counterparty surveillance” and “oversight of process,” while commercial banks were re-exposed to Wall Street in a big way.

As Wall St. looked to best exploit the situation, securitization of debt became a major trend. Essentially, any leased property, residential mortgages, home equity loans, student loans, credit card debts, and other debts can be “bundled” into asset-backed bonds which can be traded like any other stock or bond. Banks began to issue mortgage loans and then sell the promise of repayment to another larger institution (like an international investment bank, hedge fund, private equity fund, etc.). The larger institution would combine many of these mortgages (or other forms of debt) into a “bundle” and then use the promise of its future repayment as collateral for a loan–from yet another institution–that would finance a merger or corporate restructuring effort.

Widespread securitization, combined with risky lending and borrowing, an inability of homeowners to make mortgage payments, and extremely low interest rates from the Federal Reserve gave rise to the subprime mortgage crisis.

Too big to fail

Another concept that plays into the crisis is that an institution can become ‘too big to fail’; the premise being that its failure would cripple the marketplace. In such cases, the government has repeatedly stepped in and bailed out the troubled institutions. Some argue that such government action creates a moral hazard and creates incentives for high-risk loans that will eventually lead to another bailout situation. Such action, without preventative measures, is the equivalent of rewarding bad behavior and not expecting it to happen again. Despite the criticism, the U.S. government is authorized to intervene in a crisis, and has done so recently.

For example, one financial power that the government can use is a structured loan, which the Federal Reserve negotiated last week with failing AIG.  The loan, which amounted to $85 billion, must be paid back within two years.  Consequently, AIG has a huge incentive to sell off its subsidiaries and pay back the loan quickly. Despite the power, the Federal Reserve does not normally issue massive structured loans (or oversee the dismantling of giant insurance companies), so there are many procedural details to be worked out.

Beyond loaning money, the Federal Reserve has far-reaching and significant powers over the financial and banking markets, including: the power to raise and lower the discount rate; targeting the federal funds rate; and manipulating the money supply by setting the percentage of a bank’s deposits that have to be held in the vault and by buying and selling treasury bills. When the supply of money is high, interest rates go down and the dollar loses value versus foreign currencies (and vice versa). The goal of the Federal Reserve is to keep the value and supply of money stable.

Soon after the structured loan, the Securities and Exchange Commission (SEC) used its administrative power to stop the short-selling of securities of 799 financial companies.  Section 12(k)(2) of the 1934 Securities and Exchange Act authorizes such emergency action when “the Commission determines [that it] is necessary in the public interest and for the protection of investors.”  The SEC believed that short-selling was “contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation” and that the ban will help return the market to equilibrium.

As this crisis is relatively unheard of in modern times, the Federal Reserve, SEC, and Treasury Department have been improvising to find short-term solutions to keep the market afloat as Congress and the Executive Branch negotiate a bill to hopefully solve the crisis and prevent a reoccurrence.

The Race for the Cure

The most interesting piece of this whole debacle is the race to fix it. Political parties, government agencies, and economists are all putting forth proposals at record paces.

The Department of the Treasury proposed a bill to Congress asking for certain authority in the financial bailout. The first draft contains several substantive provisions that will carry weight in the attempt to fix the crisis. Section 6 limits the authority to purchase assets to $700 billion while Section 10 compensates by raising the legal limit of the national debt to $11.315 trillion. Section 8 would give ultimate authority to the Secretary of the Treasury, as his decisions would be “non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” Over the summer, Congress authorized a similar action with the bailouts of Fannie Mae and Freddie Mac. This time around, the Senate has questioned the constitutionality of granting such widespread authority to the Department of Treasury, without oversight.

In addition, Treasury Secretary Paulson confirmed that foreign banks will also benefit from the bailout, but that it is a distinction without a difference because U.S. taxpayers “don’t care who owns the financial institution.” However, it is very likely that the inclusion of foreign banks in the bailout will significantly increase the price of the bailout past the original $700 billion proposal.

Democratic members of Congress propose any bailout should require company executives to accept restrictions on the amount of compensation they can receive. The Treasury has apparently conceded on this issue.  Allowing bankruptcy judges to modify the terms of certain debts is a major Democratic goal.  Also, Democratic lawmakers insist that any bill would have to include relief for homeowners and not just Wall Street.

Yet another camp insists that there should be no bailout at all. Their argument is that a bailout is tantamount to financial socialism and that it would increase the risk of such bad behavior happening again.  Their solution would require short-term adjustments, but ultimately rely on free-market forces to fix the crisis.

Into the Great Unknown

Only the future will reveal whether the government actions taken in the next few weeks will prevent further crises in the long term.  The world within the market works on a quarterly basis and long-term stability is not of primary importance in that sort of arrangement.  However, crises have a way of rapidly changing people’s perceptions on things, and this crisis seems to have revealed a fundamental flaw in the financial markets.

It is refreshing to see an open debate about financial policies finally reach the public’s eye and, if anything, the crisis will hopefully persuade major market players to stop treating the financial markets like glorified casinos.