Goldman Suit Makes Case for Radical Change

by Laurence J. Kotlikoff

Barack Obama's administration and Congress continue to ignore the primary cause of our financial debacle and to propose reforms that badly miss the mark.

The cause was first and foremost financial fraud, of which the Securities and Exchange Commission's lawsuit against Goldman Sachs Group Inc. is just the latest scandal. The financial industry, aided and abetted by rating companies on the take, politicians on the make, and regulators on a break, systematically manufactured trillions of dollars of securities that we now call toxic. And we call them toxic, not because they were risky, but because they were phony.

Whether or not Goldman is innocent, fraud in the industry didn't arise because banks were too large, too leveraged or too interconnected, although this greatly exacerbated the financial fallout and this needs to be fixed.

The fraud arose because large parts of the finance business decided to make money the old fashioned way: by stealing it. When you issue liar mortgages, rate CCC assets as AAA, insure the uninsurable, pay yourself massive and fully undeserved bonuses, shop for compliant regulators, and bribe politicians to change rules -- that's theft, plain and simple.

Proprietary information, not proprietary trading, was the key to the crime: ``We'll make you a mint. But no questions. If we disclose, others will learn, and we'll no longer beat the market.''

Snake Oil

If only everyone could beat the market. And if only Wall Street's wizards, as a group, actually had proprietary information of social value. But the main information they were keeping private was their sale of snake oil.

When the fraud surfaced, so did the questions. Was every asset toxic? Was every loan overvalued? Were any financial statements to be trusted? These questions were asked about every bank, no matter its pedigree, the tenure of its ``top'' management, or its regulator.

And this new information, that there was no information, laid waste to one financial company after another. Today, two-plus years into the crisis, full non-disclosure prevails. No one can drill down on the Internet to the individual holdings and liabilities of any major financial institution, least of all our central bank -- the Federal Reserve, which has printed more than $1.2 trillion to buy up who knows precisely what.

Financial Plague

No one will swap something real for bank paper, which they suddenly suspect is worthless and aren't permitted to inspect. Hence, financial plague, whether spread by truth or rumor, can strike any part of our financial system at any time. And if the plague hits our central bank, its paper, the almighty buck, will find few takers. The Fed has already laid the basis for such hyperinflation, having printed more money in two years than in the entire history of the republic.

If consumer prices were to skyrocket, we would see a run on the banks, with people desperate to buy something real before their money becomes worthless. Federal Deposit Insurance Corp. guarantees that our dollars, as opposed to our purchasing power, are safe, would be of no help. And such a run would force the U.S. government to douse the fire with a gas tanker. It would be forced to cover explicit and implicit FDIC, money-market, commercial-paper, insurance-industry and other financial guarantees. This means printing at least $10 trillion more.

Limited-Purpose Cure

There's a simple cure for an ever-virulent financial plague. It's called limited-purpose banking. This implements what Bank of England Governor Mervyn King strongly advocates, namely transforming financial companies into utilities that stick to their legitimate purpose: intermediation, rather than gambling with the taxpayers' money. Former U.S. Treasury Secretary and Secretary of State George Shultz, as well as many other top policy makers, economists and five Nobel laureates, have endorsed a consideration of limited-purpose banking.

Unlike the Volcker Rule, which draws a line in the sand between commercial (good-boy) and investment (bad-boy) banks, limited-purpose banking erects a concrete barrier between financial intermediaries with and without limited liability.

All financial institutions, such as banks, insurance companies and hedge funds, would operate strictly as pass-through mutual-fund companies. Investment banking would become a pure consulting service, and trading operations would simply match buyers and sellers, with no exposure.

Mutual funds are, effectively, small banks with zero leverage. Their investments can lose value, but the funds, themselves, can never fail. Hence, limited-purpose banking puts an end to financial collapse.

New Regulator

Limited-purpose banking also replaces some 115 federal and state financial regulatory bodies with a Federal Financial Authority, effectively the equivalent of the Food and Drug Administration for securities held by the limited-purpose-banking mutual funds.

The FFA would use federal tax returns to verify income and employment statements on mortgage and commercial-loan applications as well as on new tenders of stock. It would hire multiple, non-conflicted private firms to appraise collateral and provide ratings. And it would oversee third-party custody of all mutual-fund securities.

Most importantly, it would disclose all details about individual mutual-fund securities in real time. Markets don't work when people can't tell what they are buying. The FFA would make financial products transparent, but it wouldn't say which products can or can't be sold. Once a new security is processed by the FFA, and fully disclosed, it would be put up for auction to the mutual funds. This would ensure that households and firms receive financing at the lowest cost available.

`Break the Buck'

In addition to the 8,000 or so mutual funds now being marketed, limited-purpose banking would feature cash and insurance mutual funds. Cash mutual funds hold only cash and, consequently, never break the buck (apart from the service fee). All other mutual funds would proclaim: ``This fund is risky and can break the buck.'' Cash mutual funds would replace today's checking accounts. We would write checks against them and draw on our balances with debit cards and via automated teller machines.

Insurance mutual funds would pool risk and accommodate all forms of modern finance -- including derivatives and securitization -- without pretending to insure the uninsurable.

Let's Get Real

It's time to really fix our financial system. If we don't, we should stop planning the flowers for the next Wall Street funeral and start digging a massive grave -- one large enough to hold Uncle Sam.