President Obama Unveils the Most Significant Wall Street Banking Reform Since the 1930s. What does it actually do?

Yesterday, President Obama took the offensive and unveiled the most significant Wall Street banking reform since the Great Depression. Investors were blind-sided by the announcement, and Wall Street bank stocks took it on the chin; JPMorgan dropped 6.5%, Citigroup was down 5.5%, Bank of America was down 6%, and Goldman Sachs dropped 4%. There is a good reason for the selloff -- if Obama's proposals make it intact through the gauntlet of the legislative process, profits from Wall Street banking firms will not be as robust as they have been in years past. And, the economy should finally be free of certain highly risky Wall Street investments.

Before I get into what exactly President Obama's banking proposals will achieve, let's discuss how the proposals came about. Up until yesterday, it was the general consensus that the two people that had Obama's ear on financial activity was Treasury Secretary Timothy Geithner and Lawrence Summers, his chief economic advisor. Under their influence, Obama was slow to act on Wall Street banks, and what action he had taken, was largely of little effect. Unbenownst to many, Obama was also privately meeting with Paul Volcker, at least a dozen times over the past year. What Obama unveiled yesterday, was largely influenced by Paul Volcker. Who is Paul Volcker? He was the Chairman of the Federal Reserve under Presidents Jimmy Carter and Ronald Reagan. After his years of public service, he headed a prominent Wall Street banking firm. His background is important because he is widely respected by those in both public and private finance.

Now, let's take a quick glance at the historical context. For a few years now, I have been advocating that the Glass Steagall Act (also known as the Banking Act of 1933) be reinstated; recall, it had been largely repealed in 1999 by a Republican-led Congress under the Gramm-Leach-Bliley Act. In 1933, a Senate Dem and House Dem sponsored the Glass-Steagall Act, that was a reaction to the major commercial banking failures that largely contributed to the Great Depression. Prior to the Act, it was lawful for commercial and investment activity to be conducted under a single banking firm. This model was problematic, however, because risky investment activity on Wall Street put at risk commercial deposits. So, this Act separated investment banks from commercial banks and established the FDIC that insures banking deposits.

Fast forward to 2007 and 2008, Wall Street banking firms were investing in yet another of a long line of so-called "innovative" securities, this one called an MBS (mortgage backed security -- which basically turns a traditional mortgage into an investment that can be traded on Wall Street; it is a form of derivative). Had investment firms simply invested in MBS' with actual capital they had on hand, everything would have been fine. Because of greed, however, bankers were investing in MBS' with enormous amounts of leverage (debt). Lehman Brothers (which was one of many to collapse in the crisis, collapsed after 158 years in business), for example, was leveraged at a ratio of 31:1, which means that for every real dollar or real asset or real collateral it had on hand, it was using 31 times as much debt. Think about that one for a second; and Wall Street investors have the reputation of being the 'best and brightest' of America... uhh, yeah, something like that. Other investment firms were similarly over-leveraged. [Some day I will recount a story of another over-leveraging catastrophe that took place in 1998 when Long Term Capital Management nearly collapsed our financial system]. The effect of Wall Street's over-leveraging, was that it ballooned the MBS market into a monster amounting to roughly $16 trillion at the height of the financial crisis. That amount put enormous risk on our economy because if their bet was wrong, all of the banks combined could not come up with the collateral needed to pay the bill. And wrong they were. As housing prices fell sharply, banks started seeing huge losses from their MBS investments. And you know the rest of the story, the American public had to foot the bill to bail them out.

Volcker's Wall Street bank reform proposals are important as it removes this kind of illogical risk taking out of our economic system and goes a long way toward preventing future market bubbles. The Glass-Steagall Act is thought to be a contributing factor for why we had a relatively stable market for 50+ years (historically, markets were experiencing major bubbles at least once every 20 years); "in the spirit" of Glass-Steagall, the new "Volcker Rule" which prohibits Wall Street banking firms from doing highly-leveraged "proprietary trading" and putting at risk commercial deposits, should have a similar effect as the 1933 Banking Act. This is one part of Obama's proposal.

The other part of Obama's proposal is that banks will see further limitations on the amount of liabilities any one bank can hold. The effect of this rule is to stop any one bank from becoming too large and having too significant an impact on the economy should it fail. Used in conjunction with other banking reforms currently working through the system, it should effectively put an end of "too big to fail" firms. Thankfully.

We learned another important revelation yesterday. Not only was Obama working with Volcker behind the scenes, Obama has also been working very closely with financial regulators overseas. Yesterday, we learned that not only will American banks have to operate under these new rules, so too will such foreign banking powers as Barclays and UBS. The BBC is reporting that London, Switzerland, and other financial centers will be enacting similar banking rules so that all major banks are playing on a level field.

Brilliant work, President Obama. Brilliant.

Peace

Jeremy