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Understanding the Volcker Rule and How It Relates To Wall Street Banks’ Role in the 2007 U.S. Economic Crisis

The Volcker Rule is a part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.  As reported by the Center for American Progress, the Volcker Rule prohibits Wall Street investment banks (i.e., Wells Fargo, Goldman Sachs, Citi, J.P. Morgan Chase, Bank of America) from engaging in proprietary trading.

What is proprietary trading?  Very simply, it is when an investment bank buys a security with federally-insured funds, with the hope of selling the security to an investor for a profit.  In other words, proprietary trading is bad because it is when a big bank gambles with federal taxpayer money.

As explained by Sen. Carl Levin (D-Mich.), proprietary trading played a large role in causing the United States economic crisis in 2007.  Proprietary trading created a market for subprime loans.  It allowed Wall Street investment banks to use federally-insured money to buy subprime loans, bundle thousands of them into securities called “mortgage-backed securities” (“MBSs” for short), and then sell the MBSs to investors for a profit.

Here is how it happened, step-by-step, as explained by Sen. Levin.  First, lending banks, such as Washington Mutual, issued loans to people that it knew could not afford the loans (“subprime loans”).  Second, Wall Street investment banks (i.e., “Goldman Sachs”) then used federally-insured money to buy the subprime loans, which were then bundled into MBSs.  Third, the investment banks would then sell the MBSs to investors such as Fannie Mae and Freddie Mac.

Why did the investment banks engage in this risky activity?  This proprietary trading made the banks a lot of money … at first.  When the banks first started trading the MBSs, property values were booming, and no one thought the housing bubble would ever burst. 

As a result, the investors thought they stood to make money regardless of whether the homeowners defaulted.  If a homeowner paid the mortgage, the investor would earn a profit from the homeowner’s interest payments.  If the homeowner defaulted, the investor would get the property through foreclosure.  The investor thought it would then be able to sell the property for a profit, since housing values were skyrocketing.

Unfortunately, as we all know, reality hit back with a vengeance.  The homeowners predictably defaulted and went into foreclosure.  These homeowners were then without money and financing to buy new homes.  Without potential home buyers, property values fell.  Since the property values fell, the MBSs quickly became worthless.

In sum, investment banks made a horrible gamble with taxpayer money by buying risky MBSs.  When the housing bubble burst, the banks were unable to sell the MBSs, and were stuck with the worthless MBSs.  This caused the banks to suffer catastrophic losses.  Even though the disaster was created by the banks, the government rescued the banks by giving them a $700 Billion Big Bank bailout with taxpayer money.

Clearly, proprietary trading played a large role in causing the economic crisis.  The Volcker Rule prevents proprietary trading.  The Volcker Rule, therefore, is a responsible banking regulation that will help protect our country from future economic problems.

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