The Changing Face of Wall Street
“The only thing constant is change.”
It’s an old saying dating back thousands of years to ancient Greece, but it’s just as true today as it was back then. And for the millions of investors who are living through the biggest Wall Street shake-up since the Great Depression, the changes brought about by this latest crisis will leave lasting marks on our investing landscape for years to come.
Back in the “good old days”
To understand exactly what all the financial fuss is about, we need to take a step back and look at how we got to where we are today. At a very basic level, the recent Wall Street crisis was the end result of nearly three decades of deregulation and increased risk-taking in the markets.
After the stock market crash of 1929, which wiped out the fortunes of countless individuals, the government began to take active measures to protect investors from another such disaster. In 1933, The Glass-Steagall Act was signed into law. This piece of legislation established the Federal Deposit Insurance Corporation (FDIC) in an attempt to restore investor confidence in the country’s banking system. Glass-Steagall also included several reform measures which were designed to keep banks from taking too many risks with depositors’ money. One main provision of the law mandated that commercial and investment banking activities be kept separate to reduce overall risk to the system. For many decades, our financial system operated within these tightly regulated guidelines. However, as in any epic story, this peace was not to last.
Starting in the early 1980s, the political winds began to shift and the idea of trusting in the free market, rather than in government regulation, started to gain favor. Slowly, a push began to free Wall Street from the heavy hand of regulation. In 1999, President Clinton signed the Financial Services Modernization Act, which essentially repealed the reforms of the Glass-Steagall Act. Commercial banks were now free to engage in investment banking activities and securities trading, which offered fat profits. Like ants at a picnic, soon banks (and even insurance companies) all over the country were swarming into Wall Street to get a piece of the action, expanding their operations and using leverage to take on more risk.
At the same time, a push to expand home ownership soon resulted in a loosening of lending standards. Borrowers who previously hadn’t been able to qualify for a mortgage were now able to get loans, although at much higher interest rates. Banks were eager to lend in this “subprime” market, anticipating the higher profits they could earn from these customers.
The overall result of these actions was a tremendous increase in financial activity and employment in this sector. It’s hard to believe, but prior to the current recession, roughly 40% of all U.S. corporate profits came from the financial sector! It was like waving a freshly-baked pie in front of a starving person — no one could resist the lure of “easy” money. And so the profits multiplied, courtesy of the increased risk that our financial institutions were taking.
A crack in the foundation
Unfortunately, the bad thing about taking on extra risk is that it is, well, risky. And if things go wrong, that can translate into a serious problem. In this case, the house of cards began to tumble in the housing markets. Many people who held subprime mortgages began to have trouble paying, which caused problems for the banks that had lent them money. Banks that had loaded up on these mortgage securities were suddenly left with less money than they owed to their depositors and other institutions, thanks to all the leverage and excess risk in the system.
As this solvency crisis rippled throughout our financial system, many banks failed and either went out of business, were gobbled up by more healthy competitors, or were basically taken over by the government. Lehman Brothers, Bear Stearns, AIG, Fannie Mae, and Freddie Mac were just a few examples of big-name institutions that were brought to their knees by these events. Banks became afraid to lend to anyone, and credit, one of the main engines of economic growth, seized up. The stock market plummeted, right along with housing values across much of the nation. Few people could have imagined just how bad things could get and how close our financial system came to collapsing.
So what is being done to ensure that this doesn’t happen again? And what’s to keep another “too big to fail” financial institution from falling into the same trap? Well, the scary answer is that, in many cases, there really are no safeguards in place to keep the same disaster from happening all over again.
To get some straight answers from someone in the know, Money Track recently spoke with Simon Johnson, the Ronald A. Kurtz Professor of Entrepreneurship at MIT’s Sloan School of Management. Professor Johnson is also a senior fellow at the Peterson Institute for International Economics in Washington D.C. and a former chief economist at the International Monetary Fund (IMF). He feels that right now, the problems that led to this crisis haven’t been properly addressed and that many banks are simply resorting to business as usual. “Nothing much has changed in substance as well as in form,” Johnson feels. “We seem to have learned nothing and changed nothing as a result of this crisis.”
To prevent another financial disaster from taking hold, reform is sorely needed. “The financial sector has become very risky,” Johnson says. “It needs to be reformed top to bottom to bring those risks under control to make sure these powerful players…can’t take on the same kinds of risk in the future…. The people who were running Lehman and Bear Stearns are not savvy investors. They didn’t understand risk. They completely messed up, they destroyed their firms and wiped out an enormous amount of value.”
What reforms are needed? First, keep any one bank from becoming too big to fail. “Anything that is too big to fail is too big to exist,” Professor Johnson notes. Secondly, he feels consumers need greater protection in the marketplace and the administration’s proposal to create a consumer protection agency is a step in the right direction.
From Wall Street to Main Street
Ultimately, reform is still an ongoing process and specific regulations are being worked out at the highest levels of our government. But while we all wait to see what new laws will be enacted, what can everyday investors do to protect themselves in the future?
Well for one, investors should buckle their seatbelts – we could still be in for a bumpy ride. While much of the panic in the market has dissipated, there could still be a lot of volatility ahead as our economy works through these problems. So make sure you’re prepared for further surprises. One of the few bright spots in this whole debacle is that investors have suddenly rediscovered the lost art of saving money. The national savings rate actually hit a 15-year high of 6.9% earlier this summer, so it seems many people have gotten the message and are taking steps to shore up their personal balance sheets.
Secondly, the events of the past few years have provided investors with an opportunity to reassess their risk tolerance. It’s easy to think you can stomach the large losses that more risky stocks may incur, but it’s another thing to actually live through watching more than half of your hard-earned money disappear! If you’ve lost sleep watching the stock market take its dizzying ride in the past few years, you may not be quite as risk-tolerant as you thought and it might make sense to cut back on your overall equity exposure a bit.
Ultimately, proper reform and regulation could make for a more stable financial system and a better Wall Street, but only if we can identify and learn from our collective mistakes. Change may be an inevitable part of life, but if we do not learn from history, we are doomed to repeat it. Let’s hope this is a lesson we take to heart.