The Real Story Behind Wall Street’s Collapse

The ill conceived and poorly executed regulations imposed upon the financial services industry over the past eight decades are the direct and proximate cause of the current turmoil taking place on Wall Street.  Although certain narrowly tailored regulations are beneficial to the economy at large, the “shot-gun” approach favored by legislators over the years has cause far more harm to Wall Street and to the global economy than good.

Although regulations that are specifically tailored to curtail the misconduct of a small number of companies is beneficial to the economy at large, the “shot-gun” approach favored by legislators over the years has cause far more harm to Wall Street and to the global economy than good.

In the wake of the Great Depression, in 1933, Congress passed the Glass-Steagall Act, which in substance prohibited Investment banks and commercial banks from operating under one roof. As a result, U.S. banks were required split their operations into completely separate companies. The House of Morgan, for example, was required to split into three distinct and separate entities including “J.P. Morgan” (a Commercial Bank) and “Morgan Stanley” (an Investment Bank). Glass-Steagall had the effect of weakening the entire U.S. banking sector by putting it at a substantial competitive disadvantage when compared to banks in the rest of the world, which were still able to offer “Universal Banking” services to their customers. U.S. Banks suffered under the heavy weight of this overly burdensome legislation, which even Senator Glass (one of the proponents of the act) later in life conceded was a poor idea. The Glass-Steagall Act was finally repealed in 1999, once Congress was no longer able to deny the several decades worth of evidence which demonstrated that it had caused, and was continuing to cause, significant harm to the U.S. financial services industry.

More recently in the late 1970’s regulators, in an attempt to provide opportunities for individuals classified as “lower income” or “minorities”, applied considerable pressure on commercial banks to actually to lower their lending standards. Although it is popular in some circles to assert that “Wall Street greed” caused the relaxation of lending standards, in actuality it was the imposition of Federal guidelines which influenced banks away from applying their time tested, historical model of analyzing an applicant’s credit history when determining whether the potential borrower would be more or less likely to repay a loan, and therefore qualify for a mortgage.

In 1977, the Community Reinvestment Act was passed, the explicit intent of which was spelled out clearly in the preamble to the act:

“The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods”.

This economically unsound piece of legislation actually encouraged commercial banks, and in some instances required them, to provide mortgages to those individuals who were unlikely to be able to repay them. During the1980’s and 1990’s while home prices continued to rise, the effects of these bad loans were never felt, as a bank could simply foreclose on a mortgage and recoup its losses. Now however, with real estate prices falling, banks are unable to recover their losses through foreclosures as the amounts of the outstanding loans are in excess of the current market price of the properties. In addition, individuals are finding that they owe more on their mortgages than their homes are worth, precipitating the dramatic increase in mortgage defaults, which lead to the current crisis.

More recently, the Sarbanes-Oxley Act of 2002, (commonly known as “Sarbox” or “SOX”) the onerous legislative response to the accounting scandals of a few years ago, has caused yet additional significant damaged to the U.S. financial services industry. Sarbox, together with the Community Reinvestment Act, are the two largest contributing factors to the turmoil currently taking place on Wall Street. As discussed earlier, although narrowly tailored regulations are necessary to curtail misconduct engaged in by a small number of companies, the “shot-gun” approach favored by Sarbox does far more harm to honest companies, who make up the vast majority of Wall Street, than good.

Sarbox has made listing in the U.S. far less attractive to both domestic and foreign issuers and has driven initial public offerings, and their investment banking fees, overseas. Although various studies have been put forth to demonstrate that Sarbox has had little or no negative effect on the U.S. economy, those studies fail to take into account various subtle and complex latent factors, such as the Act’s impact on the U.S. investment banking sector. Although opponents of big business have focused extensively on the securitization process, they seem to be missing the broader picture. Certainly bad loans are a large part of the meltdown currently taking place on Wall Street, however they are not the main factor behind the collapse and sell-offs of Lehman, Merrill Lynch and other venerable banking institutions. During the 1980’s and 1990’s, the vast majority of the world’s 25 largest IPO’s were listed in the U.S. In 2006 however, of the top 25 global IPOs, only two were registered in the U.S. and every one of the top ten were registered abroad. For the first 11 months of 2007, approximately US$255 billion was raised from 1,739 IPOs globally, however of those deals, only 178 IPOs were listed in the US, generating a mere US$39 billion in proceeds. As the larger investment banks, which usually act as underwriters on these IPOs charge fees in the range of 7% of proceeds, billions of dollars in underwriting fees have been lost each year since Sarbox came into effect in 2002, precipitating the investment banking failures we see today. Although a few of the investment banks attempted to follow the IPO’s overseas, they were largely unsuccessful in recouping the investment banking fees they lost from the U.S. IPO’s. Most recently, newly released data indicates that only 29 companies went public in the U.S. during the year 2008, generating a mere $931 million in revenue. 

This is not the first time in Wall Street’s history that the investment banking sector has made bad investment decisions, no industry or individual is infallible, and Wall Street is no exception to this general rule. This is the first time however that Wall Street has been unable to offset losses from bad decisions.

In any free market economy, the private sector must be left to its own devices to operate efficiently, with as little government intervention as reasonable. It is the overregulation of the past several decades which has caused the current economic crisis. Politicians need to understand that it is only by reducing regulations that the global economy will be able to avoid a full scale economic meltdown, rather than by adding new draconian prohibitions to an already overregulated industry.