Demonizing Wall Street

Pandering to populist sentiments distorts economic realities

In their zeal to enact financial regulatory reforms (many of which are needed), Democratic leaders in the Senate have chosen to heap most of the blame on Wall Street for the near collapse of the financial system in 2008 that led to a deep recession and 10 percent unemployment.

Pejorative characterizations of Wall Street as a casino and a gambling den have abounded. To quote Senate Majority Leader Harry Reid, the practices "were worse than any illegal gambling game that was ever constructed in America." And the legislation itself has been labeled as the "Wall Street Reform Bill."

While all of this pandering to populist sentiments may be good politics, it totally distorts the economic realities of the investment banking business. Worse yet, in their efforts to rein in what were admittedly excesses and abuses, numerous Democrat senators have been pushing remedies that risk undermining what has been one of this nation's greatest economic strengths—namely, its global leadership in capital formation and financial innovation.

Among these pernicious amendments to the bill that the chairman of the Senate Banking Committee, Chris Dodd, has more circumspectly authored are: one that would require the break-up or downsizing of the nation's big five investment banks; one that prohibits all banks from proprietary trading (i.e., trading for their own account); and one that would require banks to spin off dealing in those little-appreciated and much-maligned instruments known as derivatives. I'll speak to each of these in turn.

The big five (J.P. Morgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, and Bank of America) are the only U.S.-based institutions with truly global reach and the only ones capable of competing on equal terms with their European counterparts (a number of whom are even larger) in what's become a truly global market.

The Dodd bill precludes the "bailout" at taxpayer expense of financial institutions that are deemed "too big to fail" because of the "systemic" risk that the failure of one could bring down all the others. This came close to happening in the fall of 2008 when a sixth member of the fraternity, Lehman Brothers, went bankrupt and the government came to the rescue of the others with its Troubled Asset Relief Program that pumped upwards of $100 billion into the big five along with lesser sums to hundreds of other banks. Loans to the big five have all been repaid with interest, so the taxpayers aren't on the hook. Prospectively, the Dodd bill provides for the orderly dissolution of any failed banks by having the Federal Deposit Insurance Corp. seize control and wind them down without any resort to taxpayer funds (save for bank assessments). So the too-big-to-fail rationale for downsizing the big five goes away, and the global competitiveness imperative for keeping them intact remains.

Banning banks from proprietary trading, as Sen. Jeff Merkley of Oregon and his co-sponsors would do, is ill-conceived for much the same reason. Global competitiveness compels that U.S. institutions be able to offer a full array of financial services as do their European counterparts. Once having underwritten new securities offerings, they've got to be able to act as dealers to provide liquid markets for them on an ongoing basis and be able to hedge their positions and engage in trading that diversifies their risks.

When it comes to the occult subject of derivatives, I happen to be something of an authority, having been the founding president of the Chicago Board Options Exchange in the early 1970s. The CBOE remains the world's largest exchange-traded market for derivatives, which get their names from the fact that their value is derived from that of an underlying instrument—a stock in the case of stock options.

But in recent years, the exchange-traded options markets have been dwarfed in size by over-the-counter activity in derivatives on everything from interest rates, currencies and commodities to—especially of late—defaults on bonds and other debt instruments. Bloomberg places the overall size of the OTC derivatives market at $600 trillion, but that's a vast overstatement because it measures gross positions, many of which actually offset one another.

A key to the success of the CBOE was standardization of option terms and their clearance through a clearing house where offsetting trades of all parties could be netted against each other and margin (i.e. collateral) maintained on every firm's net position.

OTC derivatives, on the other hand, have been largely customized, meaning that every trade stays on the books of both parties with resultant huge accumulations. A primary thrust of the Dodd bill, guided by Treasury Secretary Tim Geithner, is to bring transparency and central clearing to derivatives on exchanges regulated by either the Securities and Exchange Commission or the Commodity Futures Trading Commission. But if well capitalized U.S. banks are precluded from participating, it will knock the financial props out from under any such entity or at the very least put the U.S. at another huge competitive disadvantage in a sphere that Geithner recognizes serves many useful purposes. So it came as a bolt out of the blue when Sen. Blanche Lincoln of Arkansas managed to get a provision inserted in the Dodd bill that would prevent banks from dealing in derivatives.

If Wall Street had been the perpetrator of the 2008 crisis and all that ensued from it, then perhaps the vilification that the Senate Democrats are heaping on it would be more justified. But such is not the case. The prime cause of the crisis was the subprime mortgage lending binge that begat the housing bubble that burst with calamitous effects. Of the 10 largest subprime lenders, seven were based in California and only one (Citigroup) on Wall Street.

It's true that Wall Street aided and abetted them by bundling their toxic loans into what became known as collateralized debt obligations and selling them to institutional investors around the globe. As the market for these CDOs began to crash, the dealers couldn't move enough of them off their books to escape huge liabilities. It was these liabilities that tanked Lehman Brothers and threatened all the others.

What's most needed now, as the astute Geithner and Federal Reserve Chairman Ben Bernanke have stressed, is higher capital requirements and—the flip side of that—lower ceilings on the leverage that financial institutions can incur. These safeguards, along with collateralization of their obligations, will prevent a recurrence of the 2008 breakdown without unduly shackling or flogging Wall Street.