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Regulate the Regulators

|Includes: BAC, Citigroup Inc. (C), GS, JPM, T
One year after the largest banking crisis since the Great Depression; many blamed the economic woes on excess risk, greed, capitalism and lack of regulatory reform. While the media, politicians and Main Street point fingers, we continue to ignore a larger problem, the “revolving door” practice between Wall Street and policy makers. This “revolving door” practice involves working for a major financial institution then working for government preferably developing policy and then going back to work for financial institutions.  The systematic trading of favors between corporate and political elites has secured wealth and power in the most unimaginable places. Beyond regulatory reform, absent the regulation of the regulators another financial meltdown will likely happen again.
 
The next round of regulatory changes will define the financial landscape for the next decade; unfortunately, the policy makers leading this reform are the same individuals who helped deregulate the banking industry. Larry Summers, Obama's Chief Economic Advisor was previously a hedge fund manager and his resume includes advising the Clintons to reject warnings that banks be required to provide greater disclosure in derivatives trades and maintain reserves to cushion against losses. Current Treasury Secretary, Tim Geithner, is the third consecutive Goldman Sachs protégé to run the U.S. Treasury Department. His accomplishments include being President of New York Fed, which allowed institutions such as Lehman and Bear Sterns to operate at 30:1 leverage ratios without penalty and he also being pursued by the IRS for back taxes. Former Treasury Secretary, Hank Paulson, was chairman at Goldman before joining the Bush administration and asked congress for $700B to bailout the banks without any oversight in the first round of TARP. He oversaw the first distribution of billions that allowed financial institutions to either sit on the money, buy other companies or payout egregious bonuses rather than lend to businesses or consumers. He also allowed Goldman's main competitor Lehman Brothers go bankrupt while spending billions bailing out Bear Sterns, JP Morgan and Citigroup. Robert Rubin spent 26 years at Goldman before serving as Bill Clinton's Treasury Secretary. He then earned $126M from Citigroup over 8 years and resigned earlier this year. Is the government regulating the banking industry or is the banking industry running the government? The fact that systematic failure exists is testimonial failure of the Federal Reserve, SEC, Treasury and FDIC.
 
The last regulatory changes that allowed investment banks to operate without check begun under the same premise. A look at how regulatory changes occurs provides further insight into the revolving door and why the regulators need to be regulated:
 
The current regulatory landscape stem from changes in 1999 when Washington repealed the Glass-Steagell Act (“GSA”). This deregulation allowed banks to mix consumer cash deposits with other product offering such as commercial paper, stocks, bond, derivatives and investment banking. The banking industry had been seeking the repeal of Glass-Steagall since at least the 1960s and for nearly 40 years was unsuccessful. The impact of the changes was foreseeable; in 1987 Paul Volker, Fed Chairman stated if we repeal GSA:
 
“Lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.”
 
In August 1987, Alan Greenspan, former director of J.P. Morgan and a proponent of banking deregulation became chairman of the Federal Reserve Board. Ironically, in 1990, J.P. Morgan became the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed a 10 percent limit. The easiest way to change policy is to become the policy maker; the banks have executed this theory to perfection. In 1984, 1988, 1991 and 1995 attempts to repeal or adjust the act would fail, however, another large financial institution would change the rules yet again.
 
On April 6, 1998, the biggest corporate merger in history between Travelers (which owned Salomon Smith Barney) and Citicorp (the parent of Citibank) would create Citigroup Inc., the world's largest financial services company. The GSA and Bank Holding Company was implemented precisely to prevent a combination of insurance underwriting, securities underwriting, and commercial banking. The merger effectively gave regulators and lawmakers three options: repeal, end the deal, or force the merged company to divesting any business that fails to comply with the law. In the next election cycle, the finance, insurance, and real estate industries spent more than $200 million on lobbying and $150 million in political donations targeted to members of Congressional banking committees and financial services legislation.
 
In 1999, The House and Senate essentially repealed the GSA and Citigroup’s chairman issued a statement congratulating Congress, President Clinton, and 19 administration officials and lawmakers by name. Less than ten years later, Citigroup was among several institutions brought to their knees by the very actions they lobbied for.
 
The revolving door practice has resulted in a reckless and overexposed banking system yet no one has proposed addressing “to big to fail” or separating “systematic” needs such as deposits, consumer and business lending from the derivatives and other unregulated weapons of financial destruction. Where is the debate that Asset Back Securities, Credit Default Swaps and other exotic derivative exposure should be limited or even eliminated from "to big to fail" institutions? How does any sane regulator explain a situation where credit default swaps can ground the entire the airline industry? The derivatives market was apparently so lucrative and unregulated that AIG, the largest airline insurance provider got in the game. AIG was so overexposed, absent a government bailout, they could not have covered their policies and no airline company would fly without coverage. Instead of forcing a restructuring, our policy makers gave away billions in taxpayer money to wind down AIG positions resulting in billions in profit to Wall Street heavy hitters such as Goldman Sachs and Morgan Stanley. How will regulation better inform the public of these situations?  
 
In the end, Wall Street will always be smarter, faster and more innovative than any government agency. Wall Street will continue to create other vehicles to skirt regulation just like the last 50 years. Regulation alone is not the answer; today we have volumes of regulation and thousands of people “regulating” through various agencies today Madoff, Stanford, Enron, WorldCom and AIG situations still occur. In the last two weeks, investigations begun into whether the Fed improperly cut in front of other creditors in Lehman’s $613B bankruptcy after Fed was paid in full while other creditors are still waiting for pennies on the dollar. Citicorp potential bankruptcy will cost US taxpayers $2.5M after the Fed purchased preferred shares while Goldman Sachs stands to reap $1B; How will regulation address the the governments investment decisions?
 
In the 80’s when the AT&T was too big, the government broke it up. In banking, the government makes the biggest banks bigger. In automotive, the government guided automotive giants GM and Chrysler through bankruptcy while in banking; both the current and former administrations have established the largest transfer of taxpayer wealth to the private sector. The contrast is beyond double standard and unfortunately, no one is proposing the regulation required to our government in check, because the campaign donation pipeline will empty quickly. It appears the only tangible outcome will more rules and higher bank fees for taxpayers. I truly believe future historians may describe the past year as the Great Recession, a missed opportunity to fix our banking system and TARP as the largest monetary heist in history.
 
 Disclosure: I do not hold any positions in Citigroup, Bank of America, JP Morgan or AIG; Long positions in Goldman Sachs and AT&T.