A reformed Wall Streeter on unreformed Washington.

by Nomi Prins

Now that Lehman Brothers [1], formerly the fourth largest investment bank in the United States, is first largest in American bankruptcies, it's time to again ask: When will Washington get it? It should never have been the Fed's responsibility, or the government's, to back investment bank speculation. Instilling stability in the financial system should have been goal enough. Unfortunately, neither the Federal Reserve [2], nor the government, nor the presidential candidates (nor, not that it matters, the president) know how to meet that goal, and piecemeal fixes won't do the trick. Only a bout of sweeping and decisive regulation could work.

There's precedent: The last time the banking system stood at the brink of implosion was in 1932, three years after the 1929 stock market crash [3]. Franklin Delano Roosevelt zoomed past Herbert Hoover into the White House, and FDR stood up to the unrestrained power of Wall Street and contained it. The resultant New Deal included a stoplight at the heavy intersection of financial capital and unregulated greed, called the Glass-Steagall Act of 1933.

Decisively, the Act forced institutions within the banking community to pick a side. You want to deal with the population at large, take their deposits, give them a safe place for their savings, and make reasonable loans for which you are as responsible as the borrowers? Terrific. As a commercial bank in 1933, the newly established Federal Deposit Insurance Corporation [4] (FDIC) backed your depositors and the federal government regulated you.

Alternately, as an investment bank at the time you could raise capital through speculative investors at home or overseas. But you wouldn't get federal backing, and you couldn't use the citizenry's capital to fund your trading activities.

That simple Glass-Steagall separation not only kept consumer and speculative capital from intertwining within the same institution, it made it possible to understand the activities of all financial organizations. Transparency was not perfect, but it was more easily accomplished.

Lehman Brothers got a taste of the intent of Glass-Steagall Sunday night. Their demise is ugly, not just because of their 156-year history, the 25,000 employees who are suddenly without jobs, or the long list of institutions to which Lehman owed money that will be slugging it out in bankruptcy court.

It is ugly because Washington still doesn't appear to get it. While Federal Reserve Chairman Ben Bernanke [5] is desperately trying to figure out how to save the banking industry from itself, and Treasury Secretary Hank Paulson can't wait until the election saves him from himself, malignant inertia reigns.

The catalyst for this current crisis may be the housing market, but the larger culprit is the killing of Glass-Steagall, which paved the way for this recklessness.

Yet, rather than considering the massive risks of merging commercial and speculative banking interests, federal officials actually pushed for Bank of America's $50 billion all-stock takeover of Merrill Lynch. That knee-jerk move follows the same dangerous pattern that began when Citigroup took over Salomon Brothers in 1999.

The Fed wants to avoid another huge failure in Merrill Lynch by pushing it under the rug of Bank of America, but B of A can't possibly know the extent of Merrill's potential losses. That a commercial bank is taking over a speculative giant is much more dangerous than Lehman Brothers tanking. The Fed was well within its rights to say 'no' to Lehman's plea for a bailout. But unlike Lehman or Bear, B of A is responsible for the accounts of millions of customers-real people with real money on the line. If Bank of America gets in real trouble, the Fed's hand may be forced.

The speculative nature of the current banking industry, in which commercial and investment banks can borrow beyond their abilities to repay, is a threat to national economic security. Lehman's demise means the dumping of more worthless real estate investments into an already oversaturated market. (If Lehman could have sold its assets for enough capital infusion, it would have done so.) Lehman's bankruptcy will only damage the market further, as other players find even less appetite for their real estate waste.

In all of this turmoil, citizens will see their ability to get loans, even if they are qualified, cut further. Bank of America, as one of the nation's leading lenders, would be wise to figure out what their risk is in taking over the behemoth that is Merrill, and quantify just how much capital it is on the hook for before extending any more.