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Glass-Steagall? Be Careful What You Wish For

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What will the effects be if new legislation is enacted?

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After a Massachusetts wake-up call, Obama has decided to pay more attention to Paul Volcker. Is it too little, too late to quell public anger? What will the effects be if new Glass-Steagall legislation is enacted?

Let's explore those questions starting with Obama to Propose New Rules on Proprietary Trading.

President Barack Obama tomorrow will offer proposals to limit the size and complexity of financial institutions' proprietary trading as a way to reduce risk- taking, an administration official said.

"We've got a financial regulatory system that is completely inadequate to control the excessive risks and irresponsible behavior of financial players all around the world," Obama said in an interview with ABC News broadcast tonight.

"People are angry and they're frustrated," Obama said in the ABC interview. "From their perspective, the only thing that happens is that we bail out the banks."

The proposed rules could limit activities of banks like Goldman Sachs Group Inc. (GS), the most profitable investment bank in Wall Street history. Goldman reaped more than 90 percent of its pretax earnings last year from trading and so-called principal investments, which include market bets on securities and stakes in companies.


Obama to Propose Limits on Risks

The New York Times also weighs in on the issue in Obama to Propose Limits on Risks Taken by Banks.

President Obama on Thursday will publicly propose giving bank regulators the power to limit the size of the nation's largest banks and the scope of their risk-taking activities, an administration official said late Wednesday.

He also would prohibit proprietary trading of financial securities by commercial banks, including mortgage-backed securities. Big losses in the trading of those securities precipitated the credit crisis in 2008 and the federal bailout.

Last week he proposed a new tax on some 50 of the largest banks to raise enough money to recover the losses from the financial bailout, which ultimately could cost up $117 billion.

Now, in perhaps his most daring move, he is calling for a modern-day version of the Glass-Steagall Act, which in 1933 separated commercial and investment banking. The new separation would prohibit standard commercial banks from engaging in proprietary trading using funds from their commercial division.

Only a handful of large banks would be the targets of this legislation, among them Citigroup (C), Bank of America (BAC), JPMorgan Chase (JPM) and Wells Fargo (WFC). Goldman Sachs, the Wall Street trading house, became a commercial bank during this latest crisis, and it would presumably have to up that status.

Mr. Volcker has been trying for weeks to drum up support -- on Wall Street and in Washington -- for restrictions similar to those passed in the Glass-Steagall Act in 1933. That law separated commercial banking and investment banking, so that the investment arm could no longer use a depositor's money to purchase stocks, sometimes drawing money from a savings account, for example, without the depositor's knowledge.

Mr. Volcker has gradually lined up big-name support for restrictions on such trading, but the Obama administration until now had focused on regulating the activities of the existing financial institutions, not breaking them up or limiting their activities.

"When I was running Citi," Mr. Reed said of his tenure in the 1980s and 1990s, "we simply did not trade for our own account."


Targeting Big Banks

Either an idea is a good one or it isn't. And if it's a good one, then it should be uniform. I see no sense in targeting "a handful of large banks."

Glass-Steagall Scapegoat

Moreover, I think Glass-Steagall is a scapegoat for this crisis. I'm not the only one. Please consider Volcker's Quest to Reinstate Glass-Steagall.

The loudest argument to bring back Glass-Steagall usually goes something like this: Depository institutions (commercial banks) need to be very safe and stable. If you allow investment banks to take big risks with those deposits, bad things can happen.

Now let's take a step back. What are these risky securities we're talking about? They're bonds backed by real estate -- originated by commercial banks. So really, it was the commercial banks that took the crazy risks that almost broke the economy. If there was never securitization, and the same subprime loans were made, then we'd have very, very sick depository institutions, but investment banks would have been largely unscathed.

Of course, there was securitization, and that was done by the investment banks. Where might Glass-Steagall have helped here? Well, it wouldn't have. Securitization existed before the Act was repealed, and it would exist if it's brought back. Commercial banks can still sell mortgages into giant pools for investment banks to make securities out of, with or without the mortgage originators and bankers living under the same umbrella. Commercial banks also still would have retained lots of their mortgage exposure, and still been quite sick. Just ask Countrywide.

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