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On September 14, President Barack Obama gave a speech in NewYork to mark the anniversary of the Lehman Brothers failure. It was ayear ago when -- during the course of a single jaw-dropping week -- theinvestment bank declared bankruptcy; Bank of America took over MerrillLynch; and the U.S. federal government bailed outAmerican International Group. How has Wall Street changed during thepast year, and what will these changes mean for investors? What newfinancial regulations have been discussed, and what remains to be done?How much longer will it take the U.S. economy to emerge from the woods?Knowledge@Wharton spoke with finance professors Jeremy Siegel and Richard Herring to get their take on these questions and more.
An edited transcript of the conversation follows.
Knowledge@Wharton: Let's start by talking about President Obama's speech. What did you think of it?
Richard J. Herring: Like many of his speeches, itwas strong on aspiration but short on detail. It was highly symbolic,to rattle the saber at Wall Street, the den of the problem. But at thispoint, it really depends on what Congress does with what he's proposed.He's proposed reform that is both timid and bold. It's timid in that itreally doesn't do much to the regulatory structure. It's bold inproposing some fairly radical attempts to control the non-bankfinancial institutions that have proved very troublesome in the currentcrisis.
Jeremy Siegel: It was fairly good. He's restatinghis proposals that the Treasury put out quite a few months ago, some ofwhich I support. There are some good points in those proposals,[although] a few trouble me. I am pleased that he said, "I've alwaysbeen a strong believer in the power of the free market." For someonewho is accused of being a socialist or a communist, those are welcomewords. He is not anti-Wall Street. There needs to be some reform andsome of the proposals are good ones.
Knowledge@Wharton: We'll come back to the reforms.But since you mentioned Wall Street -- in the year since the collapseof Lehman Brothers, how has it changed? What will the changes mean forthe stock markets and investors?
Siegel: We saw the whole concept of the investmentbank totally changed. It killed itself as a standalone institution. Ithad to be absorbed by a commercial bank, as was the case with BearStearns, or in the case of Lehman, liquidated or take on acommercial-bank holding company status to get federal [funding] access.We saw institutions that got so big and when capital dried up, theypanicked and said, "I have to have access to the Fed," and becameholding companies. Even Goldman Sachs, the most successful of theinvestment banks, [did that].
We can speculate on what's going to happen. Maybe the hedge fundswill be the new investment banks. The power of the Fed is enhanced as aresult of the crisis and the ability to snap your fingers and getcapital from the market is something that many firms are going to haveto think two or three times about. It's not going to be as easy in thefuture.
Herring: It's changed surprisingly little, giventhe gravity of the situation and our near-death experience. Some verywell-known and respected institutions have disappeared, but they havemore or less morphed into larger institutions. While we had severalinstitutions that were too big to fail, we now have fewer institutionsthat are emphatically too big to fail.
The approach started to go wrong with Bear Stearns. But it becamemost obvious with Lehman Brothers and American International Group(AIG), because we demonstrated in the space of two days that we hadabsolutely no capacity to resolve [problems at] large, insolventnon-bank institutions. We just didn't have the right tools to do it.Now the Obama administration, without being very specific, has at leastrecognized that's a problem. Unfortunately, the delays in implementingchange may endanger the whole reform project because the financialinstitutions are lobbying very hard to not change anything.
Some institutions will be paying record bonuses again. In fact, theU.S. government has set up a situation where [bonus systems] can bevery easily arbitraged by institutions getting essentially federalmoney [while] taking risky positions and making easy profits. In onesense, we've made the situation worse. There are green shoots ofrecovery all over the economy, but many of them are what [The New York Timescolumnist] Roger Cohen calls parachutes. You can say that with regardsto the Cash for Clunkers program, because that's why retail salesmainly went up. That's not sustainable. You can see it in terms of thefirms whose profits have increased because they are being supported incertain markets by the Fed's intervention, which is now taking a viewon not just the level but also the structure of interest rates. Thecredit structure of interest rates has always been something that we'velet the market decide. You can no longer depend on that.
Knowledge@Wharton: A lot has been said in the past12 months about financial reform. In his speech, President Obama calledit, "The most ambitious overhaul of the financial regulatory systemsince the Great Depression." What has been accomplished so far?
Herring: Almost literally, nothing except toencourage everyone to believe there are at least 19 institutions thatare too big to fail. All that has been accomplished is to make themoral hazard problem even worse. That's not fair to his reforms because[Obama's] proposal recognizes those problems and tries to pull back onthem. It's just not clear how he's going to get them through Congress.It's not like a parliamentary system; even though he's a very popularpresident who controls strong majorities in both the House and theSenate, it's still a very much a trilateral separation of powers.Congress has enormous power, to both move and obstruct in this case.And lobbyists have enormous power in Congress.
Some obvious combinations he didn't even suggest because they werepolitically impossible. For example, the Commodity Futures TradingCommission (CFTC) and the Securities and Exchange Commission (SEC) bothregulate derivatives, but the CFTC regulates them "on exchange"; the SEC "offexchange." It makes no sense to have both of them. But historically,the CFTC has regulated commodities so it's controlled by the SenateAgriculture Committee and the SEC is controlled by the Senate FinanceCommittee. [Members of] both committees depend heavily on contributionsfrom lobbyists from those industries to be reelected. So they're not atall eager to consider consolidation, even though it would make a lot ofsense. That leads to a situation with a lot of regulatory arbitrage.And the only regulatory arbitrage Obama is dealing with directly is theOffice of Thrift Supervision (OTS), which has thoroughly disgraceditself in the round, [being] responsible for the largest loss theFederal Deposit Insurance Corporation (FDIC) has ever sustained andeven condoning back-dating of capital.
Finally, it looks like there's a proposal to merge them with theOffice of the Comptroller of the Currency (OCC), which is also acreature of the Treasury. It's an independent creature presumably, buthoused in the Treasury just like the OTS. They would be replaced with aconsolidated office of bank supervision. But [Obama] hasn't talkedabout an even more sweeping reform, which would put the other banksupervisory bodies in that same place because the Fed feels that, as amatter of theology, it has to have a hand in bank supervision. The FDIC-- because it pays the bill when things go wrong -- also feels it needsto be involved. So it's not clear what's going to come out of Congress.But it's pretty clear it's not going to come out quickly.
Siegel: Very little of the reform package has beenput in place. The most important issues and actions that have beentaken have been those of the Federal Reserve in terms of providingliquidity to the system and extending deposit insurance to more classesof deposits. The most important aspect of the Treasury's reform packageand is part of Obama's proposals basically is that we're going toidentify a group a financial institutions that are "too big to fail."They're going to be called Class 1 financial institutions and have tohave a lot of capital so the government doesn't end up holding the bag.And it won't only just apply to banks -- we've had that for a long time-- but to all financial institutions.
When we look back to before the crisis, we had a way to unwind banksin trouble. We had no way to unwind large non-bank financialinstitutions, especially AIG.... We need procedures to unwind those aswell as what we already have for the banking system.
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