Below are President Obama’s remarks today on reforming the banking system, along with my interspersed comments and analysis of them.

THE PRESIDENT: Good morning, everybody. I just had a very productive meeting with two members of my Economic Recovery Advisory Board: Paul Volcker, who’s the former chair of the Federal Reserve Board; and Bill Donaldson, previously the head of the SEC. And I deeply appreciate the counsel of these two leaders and the board that they’ve offered as we have dealt with a broad array of very difficult economic challenges.

Over the past two years, more than seven million Americans have lost their jobs in the deepest recession our country has known in generations. Rarely does a day go by that I don’t hear from folks who are hurting. And every day, we are working to put our economy back on track and put America back to work. But even as we dig our way out of this deep hole, it’s important that we not lose sight of what led us into this mess in the first place.

Not losing site of what caused the mess in the first place is very important; already alternative versions of history that place primary blame on the Community Reinvestment Act (CRA) and on Fannie (FNM) and Freddie (FRE) are emerging.

The CRA had almost nothing to do with the crisis, and while FNM and FRE were far from blameless, they were actually reducing their market share significantly for most of the bubble period, and only really stepped up their activities when the rest of the mortgage finance system was starting to implode. Yes, they were over leveraged, but their main fault was that they were 100% exposed to the residential mortgage market.

It was the shadow banking system — one with wildly distorted economic incentives — that is at the root of the problem. Loans made by mortgage brokers, who were paid simply for making loans, with no provision for how collectable they were, were then packaged and sold by the investment banking houses, with big fees taken out all along the production chain.

The ratings agencies like Moody’s (MCO) also played a significant facilitating role by not doing their jobs and assigning AAA ratings to total garbage. They did so in the knowledge that the investment banks would be coming back with more business for them if the gave the “right” answer, and that they would go elsewhere if they came up with the “correct” answer about the quality of the paper.

This economic crisis began as a financial crisis, when banks and financial institutions took huge, reckless risks in pursuit of quick profits and massive bonuses. When the dust settled, and this binge of irresponsibility was over, several of the world’s oldest and largest financial institutions had collapsed, or were on the verge of doing so. Markets plummeted, credit dried up, and jobs were vanishing by the hundreds of thousands each month. We were on the precipice of a second Great Depression.
 
To avoid this calamity, the American people — who were already struggling in their own right — were forced to rescue financial firms facing crises largely of their own creation. And that rescue, undertaken by the previous administration, was deeply offensive but it was a necessary thing to do, and it succeeded in stabilizing the financial system and helping to avert that depression.

I agree that TARP was needed, but I seriously fault the previous administration for the incredibly generous terms the rescue financing was provided at. The program turned out to be successful, as credit markets are now pretty much back to normal, and most of the TARP funds have been paid back, with interest. If Hank Paulson had any interest in protecting the taxpayer, rather than his old buddies on the street, the program would have been much more profitable for the taxpayers, and might have helped hold down the national debt. 

The Fed, by dramatically easing monetary policy and engineering a very steep yield curve, also played a central role in getting the financial system back on its feet. However, the bailout caused the mother of all moral hazard situations: The big Wall Street banks can now count on being bailed out if they get into trouble.

The banks are too big to fail and know they have the U.S. and indeed the world economy by the short hairs. This is a very powerful incentive for them to act as irresponsibly as possible, knowing they are in a “heads they win, tails the taxpayers lose” situation. It is vital that we be able to regulate the risks that Wall Street is undertaking if they are going to be backstopped by the public.

Since that time, over the past year, my administration has recovered most of what the federal government provided to banks. And last week, I proposed a fee to be paid by the largest financial firms in order to recover every last dime. But that’s not all we have to do. We have to enact common-sense reforms that will protect American taxpayers -– and the American economy -– from future crises as well.

For while the financial system is far stronger today than it was one year ago, it’s still operating under the same rules that led to its near collapse. These are rules that allowed firms to act contrary to the interests of customers; to conceal their exposure to debt through complex financial dealings; to benefit from taxpayer-insured deposits while making speculative investments; and to take on risks so vast that they posed threats to the entire system.

That’s why we are seeking reforms to protect consumers; we intend to close loopholes that allowed big financial firms to trade risky financial products like credit defaults swaps and other derivatives without oversight; to identify system-wide risks that could cause a meltdown; to strengthen capital and liquidity requirements to make the system more stable; and to ensure that the failure of any large firm does not take the entire economy down with it. Never again will the American taxpayer be held hostage by a bank that is “too big to fail.”

Now, limits on the risks major financial firms can take are central to the reforms that I’ve proposed. They are central to the legislation that has passed the House under the leadership of Chairman Barney Frank, and that we’re working to pass in the Senate under the leadership of Chairman Chris Dodd. As part of these efforts, today I’m proposing two additional reforms that I believe will strengthen the financial system while preventing future crises.

Unfortunately, the bill that passed the House was watered down, and the Senate version is likely to be watered down even further. There is even talk that the Consumer Financial Products Safety Commission, which would be created to protect consumers from abusive financial products, might be killed in the Senate.

We need such an agency, just like we need the Consumer Protection Agency which helps prevent dangerous physical products (think defective toys that can kill kids) from reaching the marketplace. We need it just like we need the FDA to make sure a new blood pressure medication does not kill people by causing liver damage.

That job is currently done by the Fed, and it has proved itself to be hopelessly incompetent at it. At the Fed, consumer protection will always be a backwater area, while the best people are focused on other very important parts of the Fed’s mission, like monetary policy.

First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward. And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks.

Our government provides deposit insurance and other safeguards and guarantees to firms that operate banks. We do so because a stable and reliable banking system promotes sustained growth, and because we learned how dangerous the failure of that system can be during the Great Depression.

We went for a half a century without a major financial crisis in this country after the Depression-Era reforms were enacted. Those rules started to be relaxed significantly in the early 1980’s, and by the end of that decade we had the S&L crisis.

The rules continued to be eroded through out the 1990’s and the erosion accelerated meaningfully in the 2000’s. Surprise, surprise — we had a major financial meltdown.

But these privileges were not created to bestow banks operating hedge funds or private equity funds with an unfair advantage. When banks benefit from the safety net that taxpayers provide –- which includes lower-cost capital –- it is not appropriate for them to turn around and use that cheap money to trade for profit. And that is especially true when this kind of trading often puts banks in direct conflict with their customers’ interests.

The fact is, these kinds of trading operations can create enormous and costly risks, endangering the entire bank if things go wrong. We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest. And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses.

It’s for these reasons that I’m proposing a simple and common-sense reform, which we’re calling the “Volcker Rule” — after this tall guy behind me. Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers. If financial firms want to trade for profit, that’s something they’re free to do. Indeed, doing so –- responsibly –- is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.

This brings back the sprit of Glass-Stiegel. Essentially saying the bank cannot take insured deposits and run off to Vegas to try their luck. Risk-taking is vital to the economy, but it should not be done by insured banks.

Ideally we would go back to the days of 3-6-3 banking, where bankers borrow at 3% from depositors, lend it out at 6% on safe, well-collateralized loans, and can make it to the first tee by 3pm. The big-risk taking should be in separate financial institutions.

I suspect that if this proposal goes through, banks will have to make a choice, or possibly split themselves up. Firms like Goldman Sachs (GS) — which only became a bank holding company last year during the crisis — will go back to being investment banks, free to essentially be hedge funds. Others will decide to become safe stable commercial banks, ones with less risk, but also less profitable, and which would probably deliver utility-like returns.

The Goldmans of the world could earn very high returns, but if they messed up, their shareholders and even their unsecured creditors would take a big hit. Firms like JP Morgan (JPM) and Bank of America (BAC) would probably spin off their investment banks to shareholders as separate firms (basically undoing the acquisitions of Bear Stearns and Merrill Lynch).

In addition, as part of our efforts to protect against future crises, I’m also proposing that we prevent the further consolidation of our financial system. There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today’s economy. The American people will not be served by a financial system that comprises just a few massive firms. That’s not good for consumers; it’s not good for the economy. And through this policy, that is an outcome we will avoid.

My message to members of Congress of both parties is that we have to get this done. And my message to leaders of the financial industry is to work with us, and not against us, on needed reforms. I welcome constructive input from folks in the financial sector. But what we’ve seen so far, in recent weeks, is an army of industry lobbyists from Wall Street descending on Capitol Hill to try and block basic and common-sense rules of the road that would protect our economy and the American people.

In other words, “too big to fail” should be “too big to exist.” Essentially what he is talking about is actually enforcing the spirit of the anti-trust laws, which should foster more competition in the financial services industry and thus benefit consumers. Financial reform is one of those issues that is very important, but also very complex and, let’s face it, boring. 

So if these folks want a fight, it’s a fight I’m ready to have. And my resolve is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see soaring profits and obscene bonuses at some of the very firms claiming that they can’t lend more to small business, they can’t keep credit card rates low, they can’t pay a fee to refund taxpayers for the bailout without passing on the cost to shareholders or customers — that’s the claims they’re making. It’s exactly this kind of irresponsibility that makes clear reform is necessary.

We’ve come through a terrible crisis. The American people have paid a very high price. We simply cannot return to business as usual. That’s why we’re going to ensure that Wall Street pays back the American people for the bailout. That’s why we’re going to rein in the excess and abuse that nearly brought down our financial system. That’s why we’re going to pass these reforms into law.

Thank you very much, everybody.

Nice to see that Obama is finally ready to fight for Main Street and against the special interests. Up to this point he has been a disappointment to those who bought into the idea of “change we can believe in.” It is also nice to see that Paul Volcker has not simply been a potted plant decorating the West Wing, but is actually having some influence on policy.

I hope both of those things persist past a single news cycle.

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