The lure of leverage

During the past 10 years, lenders engaged in many reckless activities, including profligate mortgage origination by Fannie Mae and Freddie Mac and the insurance giant AIG's issuance of huge dollar numbers of credit default swaps. But the glut of leveraged mortgage debt that has given rise to the crisis gripping the U.S. financial system was enabled by three government actions that could be reversed.

First, major investment banks were relieved of the federal net capital rule limiting the amount of debt they could contract.

Secondly, the Glass-Steagall Act, separating investment and commercial banking, was repealed. And, third, regulation of derivative securities was abolished. Let's take these one at a time.

Net Capital Rule

Capitalists have always used equity ownership of assets as leverage, or security, to borrow sums to finance acquisition of additional assets. In 20th-century America this circular process came into increasing use until the market crash of 1929, in the aftermath of which were enacted the basic laws and regulations governing securities distribution and trading. One regulation enacted by the Securities and Exchange Commission was the net capital rule, which restrained the risk-taking of securities firms to protect their financial safety and that of their customers by limiting their permissible ratio of indebtedness to equity to generally no more than 15-to-1.

In the 1980s and 1990s, two developments occurred. There arose hedge funds and other nonbank financiers that successfully resisted government regulation. Second, investment banks enlarged their business from fee-based representation of their clients to acquiring participating interests in those clients' transactions. In doing so, the firms were constrained by their ethical duty to avoid conflicts of interest by acting solely for their clients' benefit, and by the net capital rule.

Conflicts of interest were readily waived by investment banking clients because of the ability of those firms to raise capital that could not be easily financed otherwise. But the net capital rule was a more stubborn barrier to participation in clients' transactions. So the investment industry used significant resources to lobby for its modification. In 2004 the SEC exempted the five biggest U.S. investment banks, an action that allowed leverage ratios at those firms of up to 40-to-1, contributing heavily to the insolvency and demise of three of them: Bear Stearns, Merrill Lynch and Lehman Brothers.

Glass-Steagall Act of 1933

This act separated the investment business from the risks of commercial banking, which had debased the securities markets during the Great Depression. But, by 1980, when investment banks started to consolidate into large and profitable institutions, the much more highly capitalized commercial banking industry once again sought to enter the securities business by seeking congressional action watering down Glass-Steagall.

In the 1980s, the Federal Reserve Board acted to expand the authority of commercial banks to allow them to engage in municipal bond and commercial paper trading, then to permit them to expand trading into the whole range of debt and equity securities. In 1990, the board authorized J.P. Morgan, of which Alan Greenspan had been a director until his ascension to the Federal Reserve Board chairmanship, to not only trade in but to underwrite investment securities.

Those decisions paved the way to what would become a wholesale assault on Glass-Steagall. In 1994, the Fed acted to allow banks to operate investment affiliates. In 1998, the Fed authorized acquisition of the Alex Brown investment company by Bankers Trust and the merger of Citicorp and Travelers Insurance, further scrambling the once orderly and sensibly regulated financial services sector.

Finally, in 1999, after fierce lobbying from the commercial banking industry, and under the leadership of Sen. Phil Gramm, R-Texas, Congress passed and President Bill Clinton signed a bill repealing Glass-Steagall. Its demise completed the admixture of commercial banking and investing activities, giving life to the creation of enormous loan pools collateralized by mortgage and other assets and sold as securities.

Deregulation of derivative securities

Securitized pools of mortgage debt are difficult to value because the mortgages that constitute the pools are undifferentiated as to borrower and therefore incapable of the scrutiny required to know which are adequately secured or even whether the underlying loans are in default. When the federal regulator of derivative securities -- the Commodity Futures Trading Commission -- grew restive and began to publicly discuss dealing with the burgeoning mortgage mess, mortgage originators and securitizing investment houses lobbied Congress to block reform.

On Christmas Eve 2000, Gramm inserted into a 13,000-page annual appropriations bill the ill-titled Commodity Futures Modernization Act, which provided that derivative securities were no longer subject to any regulation. After that, offerings of securitized debt exploded as means to create large profits for mortgage pool accumulators and for banks selling the securitized debt. Significant profits were made as well by issuers, counterparties and traders of credit-default swaps, derivative instruments issued to insure payment of mortgages. But the swaps were in fact chips in a giant shadow market of bets for and against repayment of the debt, a market now estimated at trillions of dollars.

In the hour of our country's greatest financial peril we are reaping the product of leverage sown by the irresponsible acts described above. To prevent complete collapse of our financial system Congress must, among other steps, move to rebuild the wall between investment and commercial banking, to regulate derivative securities and to reinstitute net capital requirements for all investment entities.