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Will the Senate Clear the Financial Market Minefield?

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Jennifer Taub

As early as next week, we will learn whether the United States Senate has the courage to clear the financial market minefield. If so, one day, we will look back and praise these leaders for returning the economy to the type of safety and stability we experienced for fifty years following the New Deal reforms.

What are these landmines? The economic blowup of 2008 was caused by excessive borrowing by the banks and shadow banks to finance long-term illiquid assets, speculation in credit derivatives, and predatory mortgage lending practices. The fallout included 7 million lost jobs, double digit unemployment, one in 25 homes in foreclosure, and huge cuts in state and local services.
Without any devices to prevent catastrophe, two years ago, giant, interconnected investment banks began to collapse under the weight of their own toxic balance sheets. Then, the absence of governmental authority to swiftly dismantle them created further instability. This brought us the memorable taxpayer funded, $30 billion Bear Stearns backstop, the $700 billion bailout (that turned into a more than $4 trillion expenditure), and the 2009 taxpayer subsidized, $140 billion Wall Street, pay-for-failure compensation.

This disaster could have been prevented had we heeded the warning signs of the S&L Crisis, Long-Term Capital Management implosion, and Enron off-balance-sheet scandal. These meltdowns signaled the need for leverage limits for all big or systemically important financial players, including, as Alan Greenspan recommended during his testimony before the Financial Crisis Inquiry Commission, all banks, hedge funds, insurance firms and other non-bank financial institutions. They reminded us that all borrowing and other forms of leverage should be disclosed on balance sheet and not hidden in a special purpose vehicle, or engineered to vanish through a layering of worthless credit insurance.

Yet, the landmines of excessive leverage, speculation and predation lay buried still in our regulatory landscape. As we approach the Senate debates, I hope that ensuring a steady stream of campaign contributions from the banking lobby (which has spent an estimated $1.4 million a day to block reform) proves less important than protecting and defending the citizens of this country from the instruments that Warren Buffett once deemed "financial weapons of mass destruction." And, I hope that the Democratic majority is not forced by the prospect of filibuster, to compromise away our future safety, one hidden explosive at a time.

A close review of the Senate bill reveals numerous steps in the right direction. For example, the time-proven, bank-funded process used by the FDIC for resolving failing depository institutions would now be applied to behemoth banks and some of the shadow banks. In addition, the bill would require regulators to heighten prudential standards. It would impose limits on banks lending to other banks. As a preemptive measure, it also permits government action against financial firms that pose a grave threat to the system. The Senate bill also contains tremendous advances in the areas of consumer protection, investor protection, and corporate governance.

Yet, some significant danger zones remain. The bill contains no absolute leverage limits. It leaves tremendous discretion in setting leverage, liquidity and other prudential standards, in the hands of the new oversight commission, which is made up of regulators, some of whom may be subject to "capture" and ideologically-based reluctance to rein in risky behavior. Regarding derivatives, while the bill would put some small portion on exchanges, as SEC Chair Mary Schapiro noted in a recent op-ed, there are too many loopholes.

Additionally, in the Senate bill, the much-heralded Consumer Financial Protection Agency would not stand alone, but would be housed in the Federal Reserve. This is the same institution, that when faced with overwhelming evidence of fraud and abuse in the mortgage markets failed to use its legal authority to stop "stated income" loans and exploding ARMs. Additionally, the bill would do nothing to prevent speculation in credit derivatives which brought down AIG and continue to embed hidden leverage.

Furthermore, voices from across the political spectrum, including Arnold Kling, the Wall Street Journal editorial board, Dean Baker, James Kwak and Simon Johnson, make a compelling case that we need to break up the TBTF banks. And, there are advocates in the Senate for an amendment to the Dodd bill that would reduce banks to a smaller percentage of the GDP, back to the size they were in the early 1990s. However, the bill presently, preserves the giant banks and sets no limits on their organic growth.

Fortunately, there is still time -- and possibly, the will-- to make our markets safe again. Removing any of the incendiary devices will surely help. However, only a systemic, comprehensive approach can deliver another half century of safety for investors, savers, and taxpayers. Only if Congress thoroughly removes all known landmines and swiftly and vigilantly responds with new laws to clear the field when more risky practices become apparent, can we hope to end this "boom cycle."

Jennifer S. Taub is a Lecturer at the Isenberg School of Management, University of Massachusetts, Amherst and a member of the Economists' Committee for Stable, Accountable, Fair and Efficient Financial Reform ( S.A.F.E.R.). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.