Advice to Wall Street: Take a Deep Breath

The News & Advance
Published: September 18, 2008

TGIF. That’s the sigh of relief you’ll hear this afternoon from every nook and cranny on Wall Street, as those who still have jobs after this historic week, will be exclaiming, “Thank God it’s Friday!”

Lehman Bros., one of the oldest investment banks, is in Chapter 11 bankruptcy. The venerable Merrill Lynch has agreed to be bought by Bank of America. Washington Mutual, the nation’s largest savings and loan, reportedly is shopping itself to prospective buyers. AIG., one of the world’s largest insurers, went begging to the Federal Reserve for an emergency infusion of $85 billion to stay afloat. The Dow Jones, Nasdaq and S&P have gyrated wildly all week, swinging from the heights of optimism that the worst is over to the depths of despair that history as we know it is over.

While the proximate cause of Wall Street’s ills is the sub-prime mortgage crisis and the virtual collapse of the housing industry, the roots of the financial sector’s problems can be traced back to the 1999 repeal of the Glass-Steagall Act of 1933. (The “Glass” in the act’s name is none other than the late Carter Glass of Lynchburg, U.S. senator and former secretary of the Treasury.)

Passed soon after Franklin Roosevelt became president, the legislation essentially divided the nation’s banks into two classes: commercial banks and investment banks. Commercial banks, at their basic level, accept deposits for various types of checking and savings accounts from individual consumers; those accounts are protected by the Federal Deposit Insurance Corp. Investment banks, on the other hand, act as the middle man in large transactions, matching sellers of stocks, bonds and other financial vehicles with buyers. Many institutions also have pools of their own cash to invest in clients’ ventures.

The main difference between these two types of institutions was the amount of regulation and oversight put in place by the federal government. In 1999, former U.S. Sen. Phil Gramm of Texas and former Rep. Jim Leach of Iowa, both Republicans, shepherded the repeal of Glass-Steagall through the GOP-controlled Congress. President Bill Clinton signed it into law Nov. 12, 1999.

The most important change brought about by Gramm-Leach was the removal of the bar on commercial banks entering the brokerage business and other highly profitable lines of services, once the province of investment banks. This turf encroachment led to pressure on investment banks’ profits from traditional sources, forcing them to turn to riskier profit streams from highly financial vehicles based on complex, difficult-to-understand models.

And because investment banks faced less regulation and oversight to begin with, few people paid attention to mounting signs of concern over the years.

Now, the damage is done. Cleaning up the mess and preventing more near-term damage is the duty of the Bush administration. Figuring out a new model for Wall Street and the financial sector moving forward will be the primary duty of the next president.

Democrat Barack Obama has basically called for a return to the days of heavy regulation from Washington, with an emphasis on “heavy.” Republican John McCain is philosophically opposed to government getting entangled in the free market, however, he recognizes the landscape of the financial sector is fundamentally different than it was prior to the sub-prime crisis. He’s said he would empanel a presidential commission, along the lines of the Sept. 11 commission, to assess what exactly went wrong, determine where the relaxed regulatory system failed and plot a map for the future.

Though Obama and the Democrats have belittled McCain, his proposals are much more logical and forward-looking. Wall Street’s business model of the last nine years is basically obliterated; it’s impossible simply to turn the clock back to Nov. 11, 1999, as Obama and the Democrats want to do.

New thinking, new ideas are needed; this time, McCain’s got them.