The Market Solves While Congress Debates A Bad Bill

As I wrote yesterday, in this post, it seems that several steps to rationalizing the US financial services sector are already underway, with or without Congressional action.

For example, Glass-Steagall has, in a sense, been re-instituted in a de facto manner. No large, publicly-held investment bank exists anymore, nor will one likely again for at least a few decades.

The integrated commercial banks which absorbed Bears Stearns, Merrill Lynch and parts of Lehman are unlikely to ever operate those remnants with the leverage or innovation- for better or worse- as they were in the past.

FDIC and SIPC insurance provides some measure of safety for depositors in those institutions that were absent before the original Glass-Steagall bill of the 1930s.

The emergence of three gigantic financial 'utilities'- Chase, Citigroup and BofA- marks the evolution of financial services, after a period of expansive innovation, to a quasi-governmental oligopoly.

John Bogle, the farsighted founder of the Vanguard Group, has stated for years that, as a sector, financial services cannot add value, per se, and certainly not at a rate greater than the long term growth of the economy. He's right.

Thus, as I wrote here, after a nearly 50-year period in which private investment banks sold themselves at peak prices to the public, the sector had taken on too much risk and caused so much counterparty risk as to result in the seizure of credit flows among large financial service players.

Excess capacity has been removed. Excessively risky activities such as securitizing mortgages and selling credit default swaps have been curtailed.

And all this before any Congressional action.

At this point, a very minimal solution from Congress would provide the needed respite for publicly-held banks. The Republican House idea of using Federally-sold credit default insurance for structured finance instruments, backed by mortgages of dubious, or unknown quality, would effectively solve the counterparty risk debacle now affecting financial markets.

I don't know why Paulson and his team either failed to conceive of that brilliant idea, or dismissed it. In no way is it necessary for the Federal government to purchase structured finance paper in the amount of some $700B. All that is required is to cause that paper to be valued on bank balance sheets at their longer term, economic, 'hold to maturity' value, rather than the near-zero value they have in current, non-actively traded markets.

Perhaps the 107 point drop in the S&P reflects the market's concern over the basic lack of understanding of this issue in Washington. Because, as Ben Graham noted some 50 years ago, it's unlikely that the real, tangible value of US business assets in the S&P500 fell by over a trillion dollars yesterday.