“Obama Takes a Baby Step in the Right Direction”

Today, President Obama finally took meaningful action toward financial reform, apparently prodded by his disaster in Massachusetts. Heck, if the Democrats cannot retain Teddy’s seat, there is no safe refuge. The Republicans and Tea Partiers will take the next election in a landslide unless Obama changes course, and fast.

Briefly, here is what he announced. Government spent a huge bundle trying to rescue Wall Street, and while that was distasteful, it was necessary, for otherwise the economy would have slipped into a second great depression. The financial system is now stronger than it was when he took office, but Wall Street continues to engage in its antisocial practices, Hoovering all the nation’s profits, paying huge bonuses, and trading rather than lending.

According to Obama, the root of the problem is that these institutions take advantage of their government guarantees (deposit insurance and bail-outs when things go bad) to gamble with house money. He says the root of the crisis was that these government-protected institutions engaged in proprietary trading and created their own hedge funds and private equity firms. The access to insured deposits gave them low cost funds with which they took huge risks at taxpayer expense. Further, they have sent an army of lobbyists to Washington to prevent financial reform. Hence, he proposes a new “Volcker Rule” that would prohibit these regulated financial institutions from operating hedge funds, private equity funds, or proprietary trading. And the government will prevent further consolidation of the financial sector.

The reforms sound good. It is always too easy to criticize reform for not going far enough. However, the nature of this proposal seems to indicate that Obama still does not understand the scope of the problem. Let me provide what I believe to be more than mere quibbles:

1. The financial bail-out was not needed and would do nothing to prevent another great depression. We had a liquidity crisis that could have been resolved in the normal way, through lending by the Fed without limit, to all financial institutions, and without collateral. That is how you end a liquidity crisis. But that has nothing to do with the Paulson/Rubin/Geithner plans that variously bought bad assets, injected capital, and provided guarantees — in an amount estimated above $20 trillion. None of that was necessary and none of it prevented collapse of the economic system. Banks are still massively insolvent. If we wanted to leave insolvent institutions open, all we had to do was to use forbearance. And, in truth, that is the only reason they are still open for business.

2. And of course, none of that had any benefit at all for Main Street. Indeed, we could have closed down the top 20 banks (responsible for almost all of the mess) with no impact on the economy. The only thing that has helped was the fiscal stimulus package. That will soon run out, and although it helped it was far too small. Obama has zero chance of getting more money for Main Street unless he can convince Congress and the public that he has changed his ways. The reforms he has announced fall short.

3. The financial system is not healthier today. Indeed, it is much more dangerous. The Bush and Obama administrations reacted to the crisis by encouraging and subsidizing consolidation of the sector in the hands of gargantuan and dangerously insolvent institutions. The sector is essentially run by a handful of rapacious institutions that have made out like bandits because of the crisis: Goldman, JP Morgan, Citi, Chase and Bank of America. All of these are systemically dangerous. All should be closed. Today.

4. Yes, the lobbyists are a problem. What do you expect when you operate a revolving door between Wall Street and the administration? Goldman essentially runs the Treasury. The lobbyists are in Washington to meet with their former colleagues, and to oil that revolving door. There is only one solution: ban all former employees of the financial sector from government employment (including roles as advisors), and prohibit all government employees from ever working for a Wall Street firm.

5. It is not enough to subject banks to the requirements of the Volcker Rule. Any institution that has access to the Fed and to the FDIC should be prohibited from making ANY KINDS OF TRADES. They should make loans, and purchase securities, and then hold them. (An exception can be made for government debt.) They should perform underwriting and due diligence to ensure that the assets they hold meet appropriate standards of risk. And then they should bear all the risk through maturity of the assets. They should not be allowed to offload assets, much less to short assets that they sell, while knowing they are trash (Goldman’s favorite strategy). They should not be able to hedge risks through derivatives. They should not be allowed to purchase credit default “insurance” to protect themselves. They should not be allowed to move risk off balance sheet. They should not be involved in equities markets. Any behemoth that does not like these conditions can hand back its bank charter and become an unprotected financial institution. Those that retain their charters will be treated as public-private partnerships, which is what banks are. They put up $5 of their own money, then gamble with $95 of government (guaranteed) money. The only public purpose they serve is underwriting-and that only works if they hold all the risks.

6. Obama ignores fraud. It is rampant in the financial sector. Indeed, it has no doubt increased since the crisis. Where do you think all of those record profits come from? It is a massive control fraud, based on Ponzi (or Bernie Madoff) schemes. This must be investigated. Fraudulent institutions must be shut down. Management must be prosecuted and jailed. Only if Obama is willing to take on fraud will we know that he really is about hope and change. He has got to start with the Rubin, Geithner and Summers team. Fire them, then investigate them. That is change I can believe in-and an end to “business as usual”, as Obama put it.

*This post was first published on New Deal 2.0