Moving Forward from the Credit Crisis

On Monday, September 15, 2008, the country awoke to news that three of the nation’s largest financial institutions were unable to survive without help. Merrill Lynch found a buyout partner in Bank of America. AIG was able to secure funding from federal sources.¹ Lehman Brothers, however, was unable to secure a lifeline and the firm filed for bankruptcy, the largest in history and a major spark that set off the global financial crisis.²

In a matter of days, the nation’s financial structure had changed.

By now, this story is painfully familiar to most investors, who watched portfolios and retirement account balances shrink in the ensuing months. Now, more than a year after that fateful September day, the economy shows signs of stability. Yet many investors still wonder what has been done to correct the mistakes uncovered during the credit crisis and, more importantly, whether this situation could happen again.

Several proposals have come from the new administration, and the financial institutions have worked to “clean up” their balance sheets. However, it is still unclear exactly what form, if any, reform will take.

Reform Still to Come?

In March, Treasury Secretary Tim Geithner sought legislation that would empower the government to take over failing institutions like Lehman Brothers in order to prevent domino-like collateral damage from taking down other firms.³ This “resolution authority” would let the government step in, as it did with Fannie Mae and Freddie Mac just prior to Lehman’s collapse, to help firms avoid bankruptcy, which can freeze credit markets and lock up assets. Proponents say that the resolution authority, if executed properly, could be more efficient than ad hoc bailouts and could help avoid “too big to fail” dilemmas. However, the measure seems to be in legislative limbo and may not move forward.

A Presidential Proposal

In June, President Obama released an 88-page plan that detailed his proposal to overhaul the financial regulation system.⁴ In general, his plan would give the government greater power over Wall Street. It aims to increase government oversight and close regulatory gaps. The president’s proposal also seeks to create a new agency that would oversee consumer products, including mortgages and credit cards. The administration maintains that regulatory reform is a top priority, although no official legislation has yet been proposed.

Some observers question whether the proposed regulations will amount to safer and more efficient markets or lead to less efficiency and expensive bureaucratic overreach. Either way, the plan will likely see revision before anything is enacted.

In a bid to win support for his planned overhaul of the financial system, President Obama gave a speech to bankers on Wall Street on September 14, 2009, warning against the reckless behavior that led to the financial crisis.⁵ The president urged the big banks to put senior executive bonuses up for shareholder votes and to create pay structures that reward employees for long-term performance instead of short-term gains.

President Obama has also stressed the importance of bringing change to Fannie Mae and Freddie Mac. The administration’s proposal, however, is not expected until early 2010.

For their part, banks have been working to improve their balance sheets. The stress test that the 19 largest banks went through earlier in 2009 helped to diagnose the health of the institutions, revealing that while many of the firms needed to raise additional capital, the amount needed was lower than many people had predicted. Moreover, the largest banks have all made great strides to improve their capital ratios, considerably reducing leverage.

With the economy out of intensive care, the focus shifts from setting the break to preventing further injury. Although some steps have already been taken, additional government and private-sector action may be needed to reduce the risk of future problems.

1) The Wall Street Journal, September 15, 2008
2) The Motley Fool, September 11, 2009
3) The New York Times, September 8, 2009
4) MSN Money, June 18, 2009
5) The Wall Street Journal, September 15, 2009

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by StoneRiver–Emerald. © 2009 StoneRiver, Inc.