Justin Kistner

Dear Obama, here is the financial reform we need

I just finished reading The Big Short. It’s a story by Micheal Lewis chronicling the lesser known events that lead to the subprime mortgage meltdown, aka the second worst financial disaster in American history. Learning about the fraud that allowed Wall Street banks to go bankrupt was scary. Then learning that $360 billion in tax payer money was given to those same banks to pay off the debts they incurred as a direct result of their irresponsible behavior was infuriating. And then to learn that they used a good amount of that money to also pay themselves an average bonuses of half a million dollars per employee for mismanaging the firm while still getting paid by the US government really set me off.

However, none of it motivated me into action like learning that nothing has been put in place to prevent it from happening again.

Are we chumps?

The whole meltdown occurred is because middle-class and poor Americans were played like suckers. Predatory lending gave average Americans all of the rope they needed to hang themselves. Once droves of people defaulted on loans that banks knew they could never repay, then $700 billion was set aside to bail them out. But, that money was then diverted into the hands of the very criminals that bait and switched us out of our homes.

Why? Because we were too dumb to see it coming. Then we were powerless to direct the money into the hands of the people. And, in the wake of the events, few even realize today just how badly we got played.

We’re a bunch of chumps. Unless we wake up to what happened and apply the necessary pressure to make things right, we deserve our fate.

Quick recap of the subprime mortgage meltdown

If you haven’t had the chance to catch up on what happened, allow me to take a moment to explain things at a high level and in layman’s terms.

At the turn of the millennium, banks began lending money to people who couldn’t afford the loans. Wall Street did this because they were making a lot of money off of packaging a bunch of loans into a bond, which is a pool of loans. To fuel their greed for mortgage bonds, they needed more loans. To increase the amount of loans, they simply lowered their standards for approving loans. The only problem is that investors wouldn’t want to invest in bonds made out of crappy loans, so Wall Street pulled a fast one.

Bonds are made up of tiers of loans that are rated from best to worst. Wall Street took the crappiest loans from bonds and repackaged them into new bonds that would again be rated from best to worst. That means that loans originally rated as shit, now got rated as gold. And they did this over and over, which drove billions of dollars of investment in low quality loans because they tricked people into thinking they were high quality. To fuel the machine, they simply needed more crappy loans so they did things like give a $750,000 loan to a migrant farm worker with a $14,000 annual salary. The ticking time bomb eventually went off and resulted in a meltdown.

So what can we do about it?

There are some very simple measures we can put in place to prevent this kind of disaster from happening again. Here are four:

1. Strengthen predatory lending laws
Since the fuel for the doomsday machine was loaning money to people who couldn’t afford, we simply need to prevent that. Fixed.

2. Improve access to information for ratings firms
Moody’s and S&P are the two largest players that rate the quality of bonds. These ratings are what investors use to determine where to invest their money. The higher bonds are rated, the less risky they are considered and that increases people’s desire to invest in them. However, the meltdown happened because the ratings companies got the ratings wrong. That happened because they didn’t have enough access to information about the originating loans. In fact, the only data they had was “pool level” data. For example, instead of having the FICO scores for each loan in the pool, they only had the average for all loans in the pool. So, if the only data available to Moody’s and S&P is pool level data, then how are they supposed to rate things correctly?

The fix here is simple. Require trails back to the originating loans so ratings can be made off of data for each loan in the pool.

3. Establish the SEC equivalent for the bond market
After the stock market crash that lead to the Great Depression, the Securities Exchange Commission was established to provide oversight. Today, the bond market dwarfs the size of the stock market, but there is no supervision! Let’s learn from history and use a market crash as the impetus to establish oversight in the bond market. Honestly, I don’t care if we simply extend the authority of the SEC or create a new administrative body to focus only on bonds. Either way, this group would enforce that bonds are packaged in compliance with the law and they would audit the ratings companies to ensure they are rating bonds correctly. This is a no-brainer.

4. Consider outlawing banks as public companies
Long before the market melted down in 2008, a shift in liability occurred in the 1980s that paved the way. In the 80s, Wall Street banks began to go public. Before that, banks were partnerships. As a partnership, the risk the banks took was on the partners. As a public corporation, the risk is shifted to the share holders. Share holders can’t possibly be involved enough to prevent executives from screwing up the bank. That means banks can mismanage their company, get paid tens of millions in salary and bonuses, and not care if the company goes under. Keeping the risk on the shoulders of partners would remove incentives to not care about risky investing.

Yes we can

There are probably more loopholes that would have to be plugged to protect our economy from another bond market failure, but these four simple measures would be a great start. Obama was elected into office on the premise of change and hope. But, that was our message. We can’t expect him or anyone else in the government to take care of our responsibilities for us. We have to hold them accountable and demand the reform we need to protect us. That said, I’m not sure what the next steps are for implementing these four measures. Clearly we need to organize. What are you thoughts about the best way to do that? Do we need a petition? Or what?

06/05/2010 economics