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Wall Street Becomes Main Street: Is It 1929 Again?

Rules changes could have prevented financial crisis

By Fred Yager
ConsumerAffairs.com

September 24, 2008

Now, another change is taking place that will in essence turn Wall Street into Main Street as every major investment bank and securities firm comes under the ownership of a bank, which in turn will be regulated and controlled by the Federal Government via the Federal Reserve.

Think about it. The last remaining major investment banks, Goldman Sachs and Morgan Stanley, are becoming commercial banks. Bank of America is buying Merrill Lynch. Citigroup already owns Smith Barney. UBS, a Swiss bank, owns the former Paine-Webber. There used to be a law against commercial banks owning investment banks because the last time we had something similar, when the stock market crashed in 1929, it caused thousands of banks that held stocks in their portfolio to fail as well. This was one of the key factors that led to the Great Depression.

In 1933, Congress passed the Glass-Steagall Act separating investment and commercial banking activities to prevent commercial banks from taking too much risk with depositors' money. Over time, financial services companies argued that Glass-Steagall stymied competition and in 1999, the act was repealed. Banks began to open up investment units to compete once again with brokers. Brokers followed by creating their own banks and now we're back to square one. Only this time the problem involves investment banks over-leveraging themselves and taking too much credit risk.

So the government steps in with a $700 billion dollar bailout proposal to buy up all the toxic debt. That way the financial firms who created this mess can start over with a clean slate leaving taxpayers to pick up the tab two years from now.

But by that time, Main Street could turn into a ghost town, especially if some of that money isn't used to renegotiate all those bad sub-prime mortgages that got Wall Street into trouble in the first place. Fortunately, some congressional leaders are pushing to make renegotiating mortgages part of the financial bailout legislation in an attempt to turn off the foreclosure spigot. Ostensibly, some would also help the more than 7.5 million homeowners who are spending half of their income or more on housing costs, according to the U.S. Census Bureau.

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are urging Congress to pass the plan as soon as possible, hopefully by the end of this week.

As it stands now, the plan would give the government broad power to purchase devalued assets from troubled financial firms. That would, in turn, unlock the frozen flow of credit and stabilize the markets here and abroad. The Bush administration wants to expand the plan to buy up virtually any kind of bad asset -- including credit card debt or car loans.

So far, investor reaction to the plan has been mixed. Initially, there was an immediate flight due to some quick profit-taking and continued uncertainty that it would even work. Then the oil market shot up $30 dollars a barrel before dropping $24 all within one day's trading. As the week wore on, there was continued pressure in the financial sector while the rest of the market leveled out. Many investors are waiting to see what the eventual plan will look like before taking any actions.

Could it have been avoided?

Sadly, some economists say all this could have been avoided if the government simply changed its mark-to-market accounting rules. Remember those? We wrote about them a couple of months ago as playing a key role in the reason so many firms have had to write down billions of dollars in assets.

Normally, mark-to-market accounting makes sense for most financial instruments that are traded frequently and openly. But when they're not, other circumstances need to be taken into consideration. Not knowing how to price certain credit derivatives caused companies to write them down further than necessary. Then, when the market in these products became illiquid, their perceived values dropped even further. Or as Steve Forbes is often quoted as saying "you can't mark to market when there is no market."

But that's the law, and it is the mark-to-market accounting rule,not the reality of the economy or the actual credit markets, that contributed to the current financial crisis. It's what drove Merrill Lynch to sell $30.6 billion in illiquid mortgage securities to Lone Star Funds for 22 cents on the dollar. Economists will tell you that if Merrill was allowed to hold those securities, without marking them to an illiquid market, it wouldn't have to take a $24 billion loss and maybe it wouldn't have had to sell itself to Bank of America for $29 a share.

What they're saying is that all of this could have been avoided if the accounting rules were relaxed, changed, or even temporarily suspended to allow companies to sequester these distressed assets from the rest of its balance sheet. Some even suggest the government could make money by selling insurance to back these assets, which would carry less risk to the taxpayer than buying them, which is what the bailout plan proposes.

Still, the gnawing fear permeating everything is the specter of 1929, when a crash in the stock market sparked a run on commercial banks and the entire financial structure collapsed. Is this what we're setting ourselves up for again? We can only hope that wiser minds will prevail and that the unfettered greed of the recent past is replaced with a culture of living within one's means and not one's fantasies.

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