Where The Crisis Came From

Over the past three decades, there has been a sea change in the way that credit is extended in America, creating the problems and the need for reforms that we face today.

At the heart of the financial crisis lie the complex, opaque derivative securities created not by traditional Main Street banks but by Wall Street, and with the passive complicity of regulators.

Wall Street created, originated and sold an alphabet soup of derivative securities, and it was such synthetic instruments not traditional mortgage loans, small-business loans or other standard lending originated by banks that unleashed a flood of credit, created a vast excess of housing, weakened the capital structure of the banking industry and undermined popular confidence in banks.

In previous generations, home buyers obtained mortgages and other loans from local, or Main Street, banks, which typically held those loans until they were fully repaid and therefore had an interest in making loans that borrowers could afford.

But then Wall Street started slicing, dicing and packaging mortgages into bundles that served as the basis for bonds sold in the securities markets. Traditional bank deposits were no longer the primary funding source for credit. Instead, loans were being financed by the capital markets and packaged and sold by Wall Street.

Mortgages were originated by one firm, packaged by another, sold by a third and serviced by yet another but none of them worried about whether the mortgages would be repaid, because they didn't hold the loans on their books.

Securitized debt grew nearly 50-fold from 1980 to 2000 compared with a mere 3.7-fold increase for bank loans. In 1998, traditional bank lending was surpassed by securitized debt for the first time.

By the end of 2007, Wall Street accounted for two-thirds of all private U.S. debt. This growing market for synthetic mortgage-backed securities inundated the country with credit that, combined with historically low interest rates and exotic new mortgage products, fueled the housing bubble and turned our financial markets into a virtual casino. In the collapse that followed, billions of dollars' worth of mortgage-backed securities were written off.

But the public continues to think of banks as the primary source of credit and to blame banks for the credit crunch. Public officials contribute to the confusion by criticizing banks while allowing Wall Street to operate this "shadow banking industry," which exists outside the standards for safety and soundness that apply to banks and without obligation to make clear the extent of such firms' debt, leverage, capital or reserves.

Many Wall Street firms played significant and contributory roles in the evolution of this crisis. Wall Street's most prominent investment bank, Goldman Sachs, historically the industry leader, was at the forefront of the creation, origination and sales of derivative securities and also spent $40.6 million on lobbying and campaign contributions from 1998 to 2008. In 2008 alone, Goldman spent $8.97 million in this way almost 11 percent more than the Financial Services Roundtable, a trade organization that represents 150 top financial institutions.

The conversion of this investment bank into a giant hedge fund went unchecked by legislators and regulators, despite constituting a radical change to our financial system. And it has received billions upon billions in taxpayer bailout funding to keep it alive.

By contrast, consider how regulators treat Main Street banks compared with the way they deal with this highly connected investment bank: When M&T Bank applied for regulatory approval to acquire a modest-size bank in Utica, N.Y., it took 10 weeks and a promise to divest three branches before permission was granted. When this Wall Street investment house decided to seek a commercial bank charter in the midst of the financial storm, permission was granted in less than a week.

By obtaining this charter, Goldman Sachs received access to the Federal Reserve Discount Window and the Federal Deposit Insurance Corp., which has long been funded by dues from thousands of community-based banks across the United States and which has since guaranteed $28 billion of the investment bank's debt securities. That's equal to 10 percent of all funds guaranteed under the government's Temporary Liquidity Guarantee Program.

The same could be said of many other large financial firms that are also big spenders in Washington. The 10 largest recipients of federal Troubled Assets Relief Program funds including two Wall Street investment banks and three other, non-bank institutions that participated spent $82.4 million on lobbying and campaign contributions in 2008 and $523.6 million over the past 10 years.

This sort of behavior is simply wrong. Corporate leaders have an obligation to set the right tone a moral tone lest public confidence in our private enterprise system erode.

Also, we must restore the balance of regulatory oversight between commercial banks and other parts of the financial services industry. We should do so not only to be fair to banks but because the nation's ailments won't be cured unless solutions are directed at the entire financial system, not just one-third of it.

Like it or not, or believe it or not this is how it happen......