Financial reform on Wall Street after the bailouts: the wrong focus

A push in Congress to prevent another financial meltdown is itself at risk of a political meltdown.

Democrats and Republicans are at odds over how much to rein in Wall Street’s unregulated practices and avoid more federal bailouts of “too big to fail” financial firms. And President Obama, the self-proclaimed bridge-builder, is trying to intervene.

But this debate would be less polarized – as during the health-care debate – if lawmakers didn’t simply try to pit “Main Street” against “Wall Street.” This distinction ignores just how much those two realms of commerce depend on each other to bring security and wealth to America. And by setting up such simplistic stereotypes, lawmakers ignore how much each “street” is in need of similar and overlapping reforms.

In an election year, of course, it is easier to target big financial institutions. And in Washington’s strange logic, the more lawmakers threaten big firms, the more those firms throw money into the campaign coffers of political parties and powerful members of Congress in an attempt to water down proposed regulations. In addition, left-wing activists also can whip up donations from angry Americans – many of whom, in a twist of politics, include the anti-Wall Street members of the conservative Tea Party Movement.

The other problem in focusing almost exclusively on big firms is that the effort diverts attention from the root causes of the crisis: federal support for the buying of homes – a huge subsidy that for decades created the impression that a house is a nearly risk-free investment.

That support only grew as the powerful housing industry, from real estate agents to home builders, threw more money at lawmakers. And it also led to an explosion of overly risky mortgages and easy government credit – often at the urging or directive of Congress. As former central bank chairman Alan Greenspan testified last week: “I sat through meeting after meeting in which the pressures on the Federal Reserve – and on, I might add, all of the other regulatory agencies – to enhance lending were remarkable.”

To bolster growth in the riskier mortgages, they were packaged and resold by Wall Street (as well as by government entities Fannie Mae and Freddie Mac), further magnifying the risk on a global scale. The big firms also betted on whether those mortgage securities would fail, employing an arcane financial method call derivatives, often designed by so-called hedge funds.

Rather than rein in federal support of home buying, Congress is now divided over how to regulate the largely unregulated derivatives industry. Should such deals, now done in private, be forced to become public? What types of derivatives deserve regulation? Is it even possible for a government regulator to foresee risk in derivatives? Should all hedge funds pay a fee to government to be used in case one of them goes belly up?

Big banks, too, will likely be asked to set aside more cash as a capital reserve in case they get into trouble.

All these proposals – keeping more cash on hand, fees for emergency bailouts, more transparency of private contracts – could also be applied to the “Main Street” side of this financial crisis – or potential home buyers.

Should home buyers be required to pay high down payments on a mortgage? Or pay high fees into a bailout fund if they go into foreclosure? Or be required to reveal more financial background to government?

Making it harder to own a home, however, is not politically popular on Capital Hill. And yet lawmakers know that their past pressure on government agencies to ease credit to home buyers was the starting point for the 2007-08 financial crisis.

Finger-pointing at Wall Street is fine, even needed, but first the finger of Congress should be curved back at the originating culprit.

If Congress wants to be a physician to financial firms, the first rule is “heal thyself.”