Why a meltdown could happen again

By Michael Brush

A year ago this week, Lehman Brothers (LEHMQ, news, msgs) blew up, dramatically advancing one of the worst financial disasters in history. The reckless behavior of greedy Wall Street bankers had come home to roost, making life a lot tougher for the rest of us.

Since then, what have President Barack Obama and Congress done to prevent them from doing it to us again?

Pretty much what Obama did when he spoke to Wall Street earlier this week. Talk.

"They really haven't done anything that could prevent another meltdown," says Joseph Mason, a financial-sector expert who used to work for one of the main national banking regulators, the Office of the Comptroller of the Currency, or OCC.

A year after the demise of Lehman, there are no new rules in place to:

• Control the vast "shadow banking industry" of mortgage originators, insurers and investment banks that caused the crisis.
• Limit excessive risk taking by big Wall Street banks.
• Rein in the short-term incentives in lavish pay and bonus packages that tempted executives to take excessive risks.
• Beef up regulatory agencies like the Securities and Exchange Commission so they can do a better job policing Wall Street.

The key takeaway: There's nothing in place to stop another financial meltdown.

Banks at it again

Yes, the president has sent reform proposals to Congress, but they've stalled.

"Quite frankly, they've made hardly any progress," agrees Edward Grebeck, a debt market strategist with Tempus Advisors in Stamford, Conn. "I don't think anything positive has been done."

And while politicians bicker over health care and with the markets up so much that the urgency for financial reform has receded, Wall Street banks are back to work.

Citigroup (C, news, msgs), Morgan Stanley (MS, news, msgs) and other banks are churning out financial instruments similar to the ones that helped cause the crisis. They're producing securities backed by home mortgages and commercial loans, often repackaging their old mortgage securities as new products.

The banks say these products are safe, but that's what they said the last time. Banks still aren't required to disclose exactly what's in them. "There is very little transparency, so it is difficult to understand exactly what risks these firms are taking," says Tim Yeager, a professor at the Sam M. Walton College of Business at the University of Arkansas.

Because these securities are backed by home mortgages and commercial loans, they could easily be vulnerable to home mortgage defaults or a wave of defaults on commercial loans that many analysts expect is on the way. Huge amounts of commercial loans are coming due over the next two years. Many banks are balking at rolling over these loans because the underlying values of the buildings backing the loans have slipped so much and because of uncertainties about the economy.

Video: 'We will not go back to reckless behavior,' Obama says

"We haven't changed the rules. The banks are still allowed to do what they did before, so there's always the threat these products they are issuing can go 'underwater' again," says David Becher, an assistant professor of finance at Drexel University's LeBow College of Business.

Another sign that Wall Street is again taking on too much risk lies in the huge profits bankers are raking in from trading, which can be inherently risky. In the first half of the year, the top five Wall Street banks -- Bank of America (BAC, news, msgs), Citigroup, Goldman Sachs Group (GS, news, msgs), JPMorgan Chase (JPM, news, msgs) and Morgan Stanley -- made $23.3 billion, much of it off their $56 billion in trading revenue, according to an analysis by The Wall Street Journal. That was only slightly below the $58 billion in trading revenue they made in the first half of 2007, the peak of the boom.

One measure of risk -- their own estimates of the amount they could lose on an average trading day -- was running 70% higher in the second quarter of this year than during the boom. It recently stood at $1 billion compared with $592 in the first half of 2007, according to The Journal.

Don't worry; be happy

Some observers say it's OK that a year has gone by without reform; we don't want to get it wrong. But the political reality is that as the urgency passes, it's harder to pass reforms.

"We have lulled ourselves into the mind-set that we are out of the woods, when we aren't," says Cornelius Hurley, the director of the Morin Center for Banking and Financial Law at Boston University School of Law. "I don't think time is our friend here. We risk losing the sense of urgency so that nothing happens."

Continued: What reforms?

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