How to Prevent a Repeat of 2008

By Steven Goldberg, Contributing Columnist,

As Winston Churchill might have put it, capitalism is surely the worst economic system,except for all the others that have been tried. It's capitalism's risk takers -- often using borrowed money -- who produce many of the innovations that spur economic growth.

But now, a year to the day since the collapse of Lehman Brothers, it's clearer than ever that capitalism without effective regulation is a disaster waiting to happen. Until the government takes steps to better regulate our financial system, we're sitting on a time bomb.

The financial crisis that we appear to have survived by a whisker was, by far, the worst since the Great Depression. But it's only the most recent case over the past few decades in which the financial world has nearly exploded.

A few other lowlights:


On October 19, 1987, the Dow Jones industrial average plunged 23% in a single day. A chief cause was a bizarre financial product, called portfolio insurance, that promised institutional investors that they could avoid major losses if they sold stock-index futures when share prices declined. But selling of futures only triggered more waves of stock selling.

A couple of years later, about 750 U.S. savings-and-loan associations went belly up because of bad real estate loans, costing taxpayers $125 billion and sparking the 1990-91 recession.

Long-Term Capital Management, a hedge fund whose founders included two Nobel-prize winners, leveraged its assets 30 to 1, then made thousands of supposedly low-risk investments. When many of those bets suddenly soured in 1998, the Federal Reserve, fearing that LTCM's collapse threatened the entire financial system, organized a bailout by major Wall Street firms.

Do these sound familiar? They should. All have echoes, some not so faint, from the recent financial panic, which was touched off by the peddling around the world of Wall Street-concocted derivatives that were tied to lousy loans made to home buyers in the U.S.

What's needed to prevent -- or at least lessen the likelihood -- of repeat disasters? Smart re-regulation. Unfortunately, that is much easier said than done. Do it too harshly and you'll restrict the growth of the economy. Do it too lightly and you'll court another financial doomsday.

You can hardly expect special interests -- those in danger of regulation -- to favor change. So they are spending millions of dollars to prevent effective regulation, stuffing the campaign coffers of both Democratic and Republican lawmakers.

What should the government do? To start, no firm of substantial size should be allowed to leverage up its assets by more than is prudent. Leverage (borrowed money) is the mother's milk of free markets. It enables companies to grow rapidly. But when investment banks with tentacles all over globe leverage up by 30 to 1, as several did before the current crisis, your money and my money is at risk.

We've known the dangers of too much leverage for years. After the Long-Term Capital Management crisis, an interagency government report to the Federal Reserve concluded, "The central public policy issue raised by the LTCM episode is how to constrain excessive leverage more effectively." That report, as we all know, led to no significant changes.

Derivatives massively increase leverage-and make it hard to understand the balance sheets of financial companies. Derivatives need to be regulated, and they need to trade openly. And companies must be required to reveal exactly what their derivative holdings obligate them to do. Warren Buffett warned prophetically in 2003 that derivatives were "financial weapons of mass destruction" that posed a "mega-catastrophic risk" to the economy. They need to be reined in.

The same goes in spades for one special breed of derivatives, credit-default swaps. In essence, these allow institutions to insure against the collapse of another institution. That offers a great hedging tool if, for instance, the first institution owns millions of dollars of bonds issued by the second institution. But too often, CDSs were bought by investors who had nothing at risk-and sometimes much to gain should the second institution collapse.

I'm convinced that the combination of bearish investors selling short the stocks of financial institutions and buying CDSs on them helped lead to the collapse of several major institutions, including Lehman Brothers.

What's more, American International Group sold so many credit-default swaps that went sour that only the government has been able to save the insurance giant from collapse. The remarkable thing is that the cure for the CDS problem is relatively simple: Just require that they be traded openly on exchanges-with ordinary regulation, capital and margin requirements. The exchanges and market participants would do most of the policing themselves.

Hedge funds were big players in this game (see Ban Hedge Funds?). These lightly regulated pools of money often take huge risks because their managers get a large chunk of a hedge fund's profits but lose nothing if their fund sinks. Hedge funds add little of value to the capital markets that can't be accomplished with lower risk by ordinary mutual funds and other market participants.

Hedge funds are just one of the big players in commodity markets. A 1999 law permitted private trading in derivative commodity contracts-those that aren't traded on the commodity exchanges. Outside investors are needed to make commodity markets function effectively, but the massive volatility in the oil market, for instance, has brought economic dislocations.

The 1999 repeal of the Glass-Steagall Act was a huge mistake. This Depression-era legislation forbade commercial banks (those that lend to consumers and businesses) from combining with insurance companies or investment banks. It would have prohibited the creation of behemoths such as Citicorp, which at one point provided commercial banking, investment banking and brokerage, as well as insurance.

When these financial conglomerates were created, their executives argued that their very heft would enable them to shrug off problems in any one part of the firm. We all saw how well that worked out.

I'd like to see financial companies stick to doing one or two things well. Investment banks should advise corporations on public offerings, mergers, acquisitions and other corporate actions. Brokerages should execute trades and provide research. Neither should trade for their own gain, which brings them into direct conflict of interest with their customers. Nor should banks or brokerages run mutual funds, which creates its own set of conflicts.

The big banks aren't doing much lending to companies or helping companies access the capital markets these days. The bulk of their profits are coming from trading for their own accounts-the same dangerous activity that helped bring them to the brink just one year ago.

A simple fix in another area: home mortgages. Someone who approves a borrower for a home mortgage-or any other simple loan-ought to be on the hook for a substantial percentage of the loss if the loan sours. Otherwise, we're sure to get a rerun of the insane "liar loan" fiasco that contributed to the real estate crash.

Ironically, a lot of the complex new products that caused problems during the past two decades would have been impossible without the huge advances in computers. Wall Street's financial wizards-with their ever more complex and riskier inventions-have repeatedly brought the financial system near collapse. More than half of current stock-market volume consists of "high-frequency trading" executed entirely by computers.

Regulators haven't kept up. The Securities and Exchange Commission couldn't even catch Bernie Madoff, much less enact regulations and deploy experts to keep these new inventions from turning on us all. That needs to change.

Reforms have to be global in scope, or nearly so. Many firms opposed to regulation are already threatening to take their business to a country that's more lax. Like it or not, the economy is global.

In the late 1970s, the U.S. embarked on a much-needed era of deregulation that helped make the country more competitive. As tends to happen with any trend, deregulation was carried to extremes. In 2008, the world received a wake-up call about the excesses of unfettered deregulation. If we fail to heed it, we face a bitter reckoning.

Steven T. Goldberg (bio) is an investment adviser.