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The Financial Crisis: Lingering Problems

It’s been a year since the collapse of Lehman Brothers sent shock waves through the financial markets and, despite all the noise in Washington, lawmakers remain unsure how best to proceed with regulatory reform.

One thing, however, seems plain: Failure to address the underlying weaknesses in the banking system – some of which are not on the reform docket – could result in a crisis relapse in the next few years.

“Washington is great at doing things that are useless,” says Mark Calabria, director of financial regulation for the Cato Institute, a libertarian think tank. “It’s not just a matter of doing something, but doing something that will specifically help us to avoid the next crisis and I don’t really see Washington moving in that direction – of really addressing the fundamental flaws in the system.”

A number of factors, of course, contributed to the financial meltdown that came to a boil in 2007 and overflowed in 2008: record-low interest encouraged rampant consumer and corporate borrowing and easy lending standards triggered a boom in shaky mortgages and securitized debt.

As default rates started to soar, banks and other investors that purchased that so-called “toxic debt” began to report massive losses.

Bear Stearns, AIG, Freddie Mac , Fannie Mae, Lehman Brothers, Merrill Lynch and Wachovia succumbed in one way or another.

The federal government extended trillions of dollars and the Obama administration has proposed a number of steps to address the vulnerabilities in the financial system—and prevent a repeat performance—emphasizing greater transparency, accountability and risk control.

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A new Consumer Financial Protection Agency, for example, would safeguard consumer interests against credit card, mortgage and other types of fraud, while the Federal Reserve would be granted to new powers to monitor the system and neutralize too-big-to fail firms.

This Day 1 Year Ago - A CNBC Special Report - See Complete Coverage
This Day 1 Year Ago - A CNBC Special Report - See Complete Coverage

Other proposals would increase capital requirements for financial institutions to insulate against losses and strengthen oversight of the gigantic over-the-counter derivatives market, which has long flown under regulatory radar.

The financial industry, of course, including the Securities Industry and Financial Markets Association (SIFMA), is lobbying hard to help shape reform, fearing overregulation will stifle innovation.

“As legislation advances, SIFMA will be a constructive voice in the debate, working to ensure that this new regulatory structure fills the gaps exposed by the current crisis, without reducing this industry’s role in providing for our nation’s overall economic growth,” says SIFMA
President Tim Ryan.

Some, though, including Calabria, suggest Obama’s proposals do not go far enough. (Latest on reform prospects,)

Still Blowing Bubbles?

“If we adopt the administration’s plan to make the Federal Reserve the be-all-end [to regulate systemic risk], we’ll definitely be back in this position in ten years,” he says. “Once this list of companies that are deemed ‘too big to fail’ gets out, and it will, market participants will infer that debt holders will always be made whole.”

Those institutions will also be able to borrow at significantly lower costs than their rivals, he adds, which will make them grow larger and further concentrate the industry, which will only reinforce the problems.

While the administration claims tougher oversight will prevent that, critics say the Fed’s track record of being asleep at the wheel during the dot-com bubble and the housing bubble makes that hard to believe.

To truly stabilize the fragile financial markets, Calabria believes the Federal Reserve should begin raising interest rates—albeit slowly—today.

“We seem to have learned nothing about monetary policy,” says Calabria. “We have a habit of boom and bust and we’re going down that trail now.”

For example, if the Fed holds the federal funds rate (the interest rate banks charge each other for loans) excessively low (the target is now zero to 0.25 percent) for the next two or three years, as it did following the dot com crash, “that’s a recipe for another bubble,” he says.

“We need to start pulling back on all the monetary stimulus well ahead of the labor market bottoming out,” says Calabria.

Dean Baker, co-director of the Center for Economic and Policy Research, agrees that changes at the Fed are a key component to long-term stability.

“[Former Fed Chairman Alan] Greenspan’s take was that we let it run its course and we picked up the pieces,” says Baker. “But I would say bubbles are very serious and they have to have it as their responsibility front and center to combat bubbles, using public warnings, regulation enforcement and interest rates [to slow an overheated economy.]”

The current crisis, he notes, is the result of mismanagement and “incredibly poor regulation,” not the lack of the right laws.

“There was a housing bubble that should have been easy for the Fed to see and that alone guaranteed we were going to have a very serious downturn when it collapsed,” he says, adding Greenspan should have issued frequent, public warnings.

“He needed to pound home the message that there were extreme imbalances in the system," says Baker, "and use data to show that this was not his personal opinion. Very few [banking] executives would have been able to disagree with him. It’s hard to tell your board, ‘Oh, well, I don’t care what Greenspan says.’”

Fannie & Freddie: A New Look

The extent to which regulators can prevent round two of the financial market meltdown also hinges on a makeover for Freddie Mac and Fannie Mae, say some analysts.

“If we put Freddie and Fannie back out in the market place as they were, without any changes to their structure, they’ll clearly blow up again,” he says. “There needs to be a real solution and it needs to be done in a way that’s credible.”

His suggestion: Either split them up into a dozen or so smaller entities that compete with each other, so one can fail without bringing down the housing market, or nationalize them outright so there’s no ambiguity for shareholders.

“This hybrid structure of private gain, public loss where they get to keep the profits and taxpayers take the loss is an utterly unsustainable model,” says Calabria.

Credit Ratings: Diminished Role

Though the White House is urging the Securities and Exchange Commission to strengthen its oversight of credit-rating agencies, Calabria says the real key to restoring balance is to reduce the reliance on credit ratings by bank regulators, pension fund managers and investors.

“A lot of SEC regulators go in and if they see a AAA rating they never actually look at the loan,” says Calabria. “Regulators and investors need to stop outsourcing their job to these entities and perform much greater, independent due diligence.”

As it currently stands, Obama’s plan emphasizes greater disclosure, but Calabria says it’s unclear how that will effect change.

Tax Code: Key Changes

Lastly, Calabria says he believes the tax code should be modified to reduce some of the incentives of borrowing – both consumer and corporate.

“There seems to be universal acceptance that leverage played an important role in making our financial system so fragile, but there doesn’t seem to be any effort to change that,” he says.

Indeed, the tax code provides countless incentives to encourage borrowing, from home mortgage interest deductions to corporate write-offs, while at the same time discouraging equity investments through the double taxation of dividends and capital gains tax.

“There are a number of things that drive a massive wedge between the cost of debt and equity,” says Calabria. “We massively subsidize the use of debt and we tax equity and then we act surprised that everyone is highly leveraged, but there’s no discussion of actually changing any of that.”

Considering Congress can scarcely agree on the details of banking industry reform, however, a complete revision of the US tax code is a lofty goal indeed.

For now, it remains unclear what shape the regulatory safety net will take.

It’s sure to be a long and painful road, though, for private industry, investors and consumers alike—all the more so if regulators fail to confront the continuum of challenges head on.