I just had an interesting comment debate with my buddy Matt over at the Online Investing AI Blog. Matt’s a big fan of derivatives and a laissez-faire kind of guy. He views government regulation with a heavy dose of skepticism. I am not a big fan of cumbersome regulation myself. But, I have become firmly convinced the banking industry is out of control and they need to be more effectively governed.
Our economy, industry, currency, investments and the very future of our nation depend on the stability of our markets and financial systems. In the past decade, we have allowed banks to gamble with our future to increase their profits and this turned into a disaster. Banks have shown no remorse for the financial crisis they created and they remain defiant in the face of reform. If left unchecked, the potential for disaster will only increase.
The Seeds of Failure
The Glass-Steagall Act was created after the Great Depression to protect depositors from risky bank speculation. And, it worked very well for over sixty years. However, it was quietly dismantled in 1999 in a bi-partisan effort signed by President Clinton and lobbied for by the banking industry. Many economists now agree this key piece of legislation could have prevented the Sub-prime Crisis of 2008.
The reason Glass-Steagall was so crucial and the reason it should be restored, is because it mandated the separation of deposit and investment banks. The repeal means a number of scary things. Most important, deposit banks can now trade in risky derivatives with your money and if they go under, the FDIC must pay the depositors. This places the total risk of speculation on everyone but the bank. Also, bank holding companies can now be formed with the rights of both deposit and investment banks. Many investment banks quickly reformed as holding companies to grab a share of the TARP money, even though deposits and lending wasn’t their primary business.
The Bailout Mentality
Our government has set a dangerous precedent of bailing out banks, which in my opinion, encourages them to take unwarranted risks. This started with the Savings and Loan Crisis of the ’80s and continued with RTC crisis of the ’90s. During the Sub-prime Crisis of 2008, the financial industry received almost a trillion dollars of taxpayer money, in addition to an unknown amount received from the Fed for lending. And, the foreclosures are far from over.
Banks will continue to speculate wildly and then expect a bailout, as long as the government is willing to shift the burden onto taxpayers. It’s no different than if you visited a casino and you got to keep your winnings, but they refunded your losses. Of course, you would gamble as much as possible. Especially, if you received huge bonuses win or lose. That’s what has been happening in America and it has to stop.
There is a huge reason we need derivatives reform. As I have posted before, the notional amount of derivatives volume is approximately 11 times the combined GDP of all the nations in the world. This is an insane risk to let bankers, hedge funds and insurance companies gamble for profits with so much leverage. The potential for disaster is overwhelming and the next financial crisis is inevitable.
There are many forms of derivatives that should have never been legal in the first place. Securities with unlimited loss potential, such as naked shorts, should be banned. Securities without underlying assets, such as synthetic CDOs, should be banned. And, securities should be limited to a leverage multiple that is reasonable, such as 10-1. Purchasers should be required to prove they can cover their positions, so we don’t have any more defaults like AIG and LTCM. Finally, all derivatives should be traded on a regulated exchange, so they can be monitored by the SEC.
The Bottom Line
The bottom line is that I’m not opposed to bankers making a profit. And, they have plenty of opportunities, without gambling with our economy. Unless we limit their reckless activities, taxpayers will continue to pay the price in lost jobs and growing deficits.
“We need smart regulation. But we have a stupid government.”
Matt – Online Investing AI blog
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