Clinton did it (and others helped)

Commentary: How would effective financial services reform look? Like 1999

By David Weidner, MarketWatch

NEW YORK (MarketWatch) -- On Wall and Main streets they call William Jefferson Clinton the "comeback kid," but it's not because of some election-day surprise.

It's because most everything he did regarding financial services regulation has come back to haunt us.

If it wasn't apparent before, the former president's handiwork became clear last week when President Obama announced sweeping financial services reform. The plan's efforts to bring fair dealing to the mortgage markets, rules to the derivative marketplace and restraint to big financial firms underscored the missteps of the second Clinton term.

Reuters
President Bill Clinton

That's because we had weakly regulated markets when Clinton took office. When he left, they were an invitation to lawless dealing where, for the ease of it, Willie Sutton would have traded his gun and mask for a briefcase and necktie.

During his final three years in office, Clinton created a fertile environment for home-lending charlatans, hiding places for Wall Street swindlers and a regulatory structure that had served the financial marketplace so well for more than six decades.

Clinton bashing -- like Bush bashing -- is often a cop out, but he made some critical mistakes when it came to dealing with the financial industry. Three poor decisions stand out.

The first was a change in 1997 to the amount of taxes a homeowner had to pay on the sale of his or her home on up to $500,000. This change effectively made buying and selling a home for profit the most compelling investment in America by tax standards. It changed our housing market from one of supply and demand to one of rampant speculation.

The second mistake was one of inaction. In 1998, Long-Term Capital Management's use of derivatives and leverage required a massive $3.6 billion hedge fund bailout organized by the New York Federal Reserve Bank. After the fiasco rocked the markets, the administration was on the spot. Would it require tighter regulation of this new form of investment vehicle? Would it rein in the derivatives markets?

Federal Reserve Chairman Alan Greenspan and Securities and Exchange Commission Chairman Arthur Levitt and Treasury Secretary Robert Rubin counseled against it to varying degrees and Clinton relented.

Repeal of Glass-Steagall

But perhaps the biggest mistake of the Clinton years regarding Wall Street and the one that rings loudest today was the repeal of Glass-Steagall, a 1933 law that effectively split investment banking and brokerages from commercial banks.

In the years leading up to the repeal, Wall Street had been grumbling that the law had become an anachronism. Financial technology was sophisticated. We were so much smarter than they were back in 1929 that there was no way a financial services conglomerate could pose a threat to the system, Wall Street experts said. Besides, they argued, it was a good idea for a bank to handle customers' investments and savings as a hedge in the bad times.

The Clinton administration effectively had its hand forced in 1998 by the merger of Citicorp and Travelers Group in 1998. The creation of Citigroup Inc. /quotes/comstock/13*!c/quotes/nls/c (C 3.01, +0.01, +0.33%) required a lot of chutzpah by its CEO, Sandy Weill, because it was effectively prohibited under Glass-Steagall.

Enter the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which not only allowed Citi to exist but also eliminated key barriers between bankers who are supposed to limit risks and investment bankers who were supposed to take them.

The biggest argument critics have against bringing back Glass-Steagall is that it would be too chaotic. Whole companies would have to be cleaved. Relationships would have to be unwound.

Well, back in 1933 the law effectively split J.P. Morgan /quotes/comstock/13*!jpm/quotes/nls/jpm (JPM 33.88, +1.01, +3.07%) , the bank, from what would become Morgan Stanley /quotes/comstock/13*!ms/quotes/nls/ms (MS 26.97, +0.34, +1.27%) , the brokerage. Both seem to have come through the disruption fairly well.

Aides who abetted

Clinton didn't do it all alone. He had a lot of help from Congress. He was under pressure from a legislature controlled by laissez-faire Republicans who were hell bent on taking up the Reagan ideology of deregulation and free markets. The repeal of Glass-Steagall passed 90-8 in the Senate and 362-57 in the House.

Greenspan, the universally loved chairman of the Federal Reserve, gave everyone bad advice in regard to interest rates, home ownership and derivatives. Under Levitt at the SEC, Wall Street accounting reached its nadir only to reveal itself with WorldCom and Enron after he left office.

Then, Clinton's Republican successor closed the deal. George W. Bush took the ball into the end zone, and making buying a home easier than spelling FNMA or FICO and removing the last vestiges of capital requirements at U.S. brokerage firms.

Ultimately, however, the big bang -- the wall torn down between brokers and banks -- happened on Clinton's watch. It's largely the problem that's being tackled in the current administration's 85-page white paper on reform. After all, Citigroup's banking side probably would not have loaded its balance sheet with toxic loans had it not been under pressure from the arm making all of the stuff.

Citi also wouldn't be the size it is today, a monster that the government deems "too big to fail" and required more than $300 billion in cash and guarantees to stabilize.

Citigroup's drag on the nation probably isn't what Clinton envisioned, but that's the problem with modernizing markets and making our financial system cutting edge. Too often we get cut.

David Weidner covers Wall Street for MarketWatch.