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THE ISSUES

Originally Published: 4/2/2008

GLASS-STEAGALL ACT and

the FINANCIAL CRISIS

By The Issue Wonk

 

Many people believed that the stock market and commercial bank crash of 1929 was caused by bank speculation in the markets. Therefore, the U.S. instituted 2 laws, known collectively as the Glass-Steagall Act. It has been modified over the years, most notably in 1956 with the Bank Holding Company Act, which increased restrictions on banks including bank holding companies owning 2 or more banks being banned from engaging in non-banking activity and from buying banks in other states.

 

The first Glass-Steagall Act allowed government obligations and commercial paper to be used as bank reserves. The second Glass-Steagall Act, officially named the Banking Act of 1935, introduced the separation of commercial banking from investment banking and established the Federal Deposit Insurance Corporation for insuring bank deposits. Separating commercial from investment banking was done to prevent banks from using deposits in case of poor underwriting. On November 12, 1999, President Bill Clinton signed the Gramm-Leach-Bliley Act, which repealed Glass-Steagall and allowed commercial and investment banks to consolidate. Many believe the repeal of Glass-Steagall was one of the major contributors to the current financial crisis.

 

Glass-Steagall Act

 

At the time of passage of Glass-Steagall:

 

. . . “[I]mproper banking activity,” or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the [1929] financial crash. According to the reasoning, commercial banks took on too much risk with depositors’ money.”

 

. . .

 

Commercial banks were accused of being too speculative in the pre-Depression era, not only because they were investing their assets but also because they were buying new issues for resale to the public. Thus, banks became greedy, taking on huge risks in the hope of even bigger rewards.1

 

How did Glass-Steagall get revoked? The push started in the 1980s under the Reagan administration. According to Frontline:2

 

In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterpret[ed] Section 20 of the Glass-Steagall Act, which bars commercial banks from being “engaged principally” in securities business, deciding that banks can have up to 5% of gross revenues from investment banking business. The Fed Board then permit[ted] Bankers Trust, a commercial bank, to engage in certain commercial paper (unsecured, short-term credit) transactions. In the Bankers Trust decision, the Board conclud[ed] that the phrase “engaged principally” in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue. This is the first time the Fed reinterpret[ed] Section 20 to allow some previously prohibited activities.

 

In 1987 the 5% was raised to 10%.

 

Also in 1987 Citicorp, J.P. Morgan, and Bankers Trust lobbied the Federal Reserve Board to ease Glass-Steagall regulations to allow banks “to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities.” [Emphasis added.] At the time Fed chair Paul Volcker expressed his “fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.” [Emphasis added.] The Fed approved the measure in a 3-2 vote.2

 

In August 1987 Alan Greenspan, formerly a director at J.P. Morgan, became chair of the Federal Reserve Board. Greenspan is a proponent of banking de-regulation because he says it helps U.S. banks to compete with big foreign institutions. In 1990 J.P. Morgan became “the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10% limit.”2

 

In the 1980s and early 1990s,

 

Attempts to repeal Glass-Steagall typically pit[ted] insurance companies, securities firms, and large and small banks against one another, as factions . . . engage[d] in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.2

 

In 1996 Fed Chair Greenspan increased the maximum amount of securities underwriting business to 25%. In 1997 the Fed eliminated many restrictions stating that “the risks of underwriting had proven to be ‘manageable,’ and [that] banks would have the right to acquire securities firms outright. In 1997, Bankers Trust (now owned by Deutsche Bank) [bought] the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm.”2

 

In 1998 “a $70 billion stock swap merged Travelers [Insurance] (which owned the investment house Salomon [sic] Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world’s largest financial services company, in what was the biggest corporate merger in history.”2

 

The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commercial banking. The merger effectively [gave] regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law. . . After 12 attempts in 25 years, Congress finally repeal[ed] Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic.2 [Emphasis added.]

 

President Bill Clinton signed the law in November 1999.

 

Investment Banking

 

Trying to understand what has caused the financial crisis is difficult. Very difficult. But when you understand it, or even if you only have a mild understanding, it’s easy to see why the repeal of Glass-Steagall probably directly led to the financial crisis we’re experiencing today. David Leonhardt has done a good job of explaining it. I’ll put it in a nutshell.

 

Leonhardt claims it all started in 1998 but I would argue it started in 1999. The scheme may have been hatched (in fact, I think it was) in 1998 but it wasn’t until the repeal of Glass-Steagall in 1999 that the plan was put in action. It began with taking the home loan business out of the hands of local banks and credit unions and putting it into the hands of investors, through investment financial institutions. With so many global investors, consolidated in a few institutions, competition got stiff and drove down interest rates. Former Fed Chair Alan Greenspan helped this along by lowering the prime and discount rates. The stage was set.

 

With all this easy money to be made, why not make more? The best way to increase profits was to get a bigger return from riskier loans. You know, beyond speculation into gambling. So, the investors started the sub-prime mortgage business. (I’ll not get into the issue that many people steered into sub-prime mortgages were more than qualified for a standard, conforming loan but unscrupulous loan processors put them in risky, sub-prime loans because they were able to earn thousands of dollars from the deals.)

 

The investment brokers then “bundled” the loans and sold them as investments, known as collateralized debt obligations, or CDOs. In this way “different types of mortgages could be sold to different groups of investors.”3 Here is another key to the puzzle. The people making the loans would never be responsible for making loans to people unable to repay them. So, why not loan money to people who can’t pay it back? You get paid to do the loan. You get paid to sell it to investors. And you have no responsibility for the failure. Good work if you can get it.

 

Leonhardt explains the next stage beautifully:

 

Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money. . . If that $100 million investment . . . were to lose just $1 million of its value, the investor who put up only $1 million would lose everything.

 

When the mortgage crisis started, “many policy makers were hoping [it] wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors.” However, many banks had also sold complex insurance policies on the risky investments and they are now on the hook for those policies. Whithouse4 explains:

 

. . . making it easier to create and trade collateralized debt obligations, or CDOs, has helped to bring forth a slew of new products whose behavior it can predict only somewhat, not with precision. . . The biggest of these new products is something known as a synthetic CDO. It supercharges both the returns and risks of a regular CDO. It does so by replacing the pool’s bonds with credit derivatives – specifically, with a type called credit-default swaps. . . The swaps are like insurance policies. They insure against a bond default. Owners of bonds can buy credit-default swaps on their bonds to protect themselves. If the bond defaults, whoever sold the credit-default swap is in the same position as an insurer – he has to pay up. . . Some people buy credit-default swaps even though they don’t own any bonds. They buy just because they think the swaps may rise in value. Their value will rise if the issuer of the underlying bonds starts to look shakier. . . Synthetic CDOs have made the world of corporate credit very sexy – a place of high risk but of high potential return with little money tied up.

 

. . .

 

Someone who invests in a synthetic CDO’s riskiest slice – agreeing to protect the pool against its first $10 million in default losses – might receive an immediate payment of $5 million up front, plus $500,000 a year, for taking on this risk. He would get this $5 million without investing a dime, just for his pledge to pay in case of a default, much like what an insurance company does.

 

Synthetic CDOs are booming, and largely displacing the old-fashioned kind. Whereas four years ago, synthetic CDOs insured less than the equivalent of $400 billion face amount of U.S. corporate bonds, they will cover $2 trillion by the end of this year, J.P. Morgan Chase estimates. The whole U.S. corporate-bond market is $4.9 trillion.

 

Some banks are deeply involved. J.P. Morgan Chase, as of March 31, had bought or sold protection on the equivalent of $1.5 trillion of bonds, including both synthetic CDOs and individual credit-default swaps. Bank of America Corp. had bought or sold about $850 billion worth and Citigroup Inc. more than $700 billion, according to the Office of the Comptroller of the Currency. Deutsche Bank AG whose activity the comptroller doesn’t track, is another big player.4 [Emphasis added.]

 

This is why the Fed bailed out Bear Stearns. It’s bad debts were insured by J.P. Morgan, who would be in trouble if Bear Stearns wasn’t bailed out. And J.P. Morgan, Greenspan’s former employer, along with Bear Stearns, were two of George W. Bush’s primary funders. (See Open Secrets) In fact, Bush’s top 20 donors, with the exception of AT&T, were or are all investment conglomerates.

 

Anyone want to pick up the mantra of “de-regulation?”

 

_______________

 

1 Heakal, Reem. What was the Glass-Steagall Act? Investopedia.com.

 

2 Frontline. The Long Demise of Glass-Steagall. PBS.org.

 

3 Leonhardt, David. Can’t Grasp Credit Crisis? Join the Club. The New York Times, March 19, 2008.

 

4 Whitehouse, Mark. How a Formula Ignited Market That Burned Some Big Investors. The Wall Street Journal, September 12, 2005.

 

 

© The Issue Wonk, 2008

 

 

 

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