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Letís shatter the myth on Glass-Steagall

Old 08-03-2012, 02:33 PM
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Default Letís shatter the myth on Glass-Steagall

Thought this was interesting.

Let’s shatter the myth on Glass-Steagall

You can blame Aaron Sorkin for this column.

I was watching “The Newsroom” last week, the latest hit show by the producer and screenwriter, when the brainy-but-beautiful economics correspondent for the fictional cable news network was explaining to her gutsy-but-impulsive executive producer how the world’s financial system recently came to the brink of collapse.

“So after the Great Depression, Congress wanted to put a firewall between the [banks and the] investment banks. They wanted to make sure that Wall Street could melt to the ground and the commercial banks wouldn’t be touched. They passed a law, the Glass-Steagall Act. Now you could be Gordon Gekko [tycoon in the movie “Wall Street] or George Bailey [small-town banker in the movie classic, “It’s a Wonderful Life”], but you couldn’t be both.”

Then, explains the brainy-but-beautiful correspondent, Ronald Reagan launched a two-decade push toward deregulation, which culminates in the repeal of Glass-Steagall in 1999. Suddenly, Gordon Gekko could make risky bets with George Bailey’s deposits, and the rest, as they say, is history.

It was vintage Sorkin: eloquent, fast-paced dialogue that perfectly channels the liberal political/cultural zeitgeist, transforming what appears to be a complex story into a simple morality play.

The only thing is, it’s not true — not even close. Yet it has been repeated so many times — on PBS and NPR, in the liberal blogosphere, on very-serious Op-Ed pages, in an Oscar-winning documentary — that whenever I give a talk to a group of college students about the financial crisis, the first question predictably is, “Yeah, isn’t it all really about the repeal of Glass-Steagall.”

It’s not just students, however. Paul Volcker, the former chairman of the Federal Reserve, surely helped to validate the Glass-Steagall fable with his fixation on a new rule barring banks from using their own capital to speculate in securities. And British regulators are considering a proposal to put a fence around their banks. Then, just last week Sandy Weill — who flouted Glass-Steagall in creating today’s Citigroup before Congress finally repealed it — even the wily Weill said the old law should now be reinstated.

Repeal of Glass-Steagall has become for the Democratic left what Fannie Mae and Freddie Mac are for the Republican right — a simple and facially plausible conspiracy theory about the crisis that reinforces what they already believed about financial markets and economic policy.

But why let facts get in the way of a good screenplay?

Facts such as that Bear Stearns, Lehman Brothers and Merrill Lynch — three institutions at the heart of the crisis — were pure investment banks that had never crossed the old line into commercial banking. The same goes for Goldman Sachs, another favorite villain of the left.

The infamous AIG? An insurance firm. New Century Financial? A real estate investment trust. No Glass-Steagall there.

Two of the biggest banks that went under, Wachovia and Washington Mutual, got into trouble the old-fashioned way – largely by making risky loans to homeowners. Bank of America nearly met the same fate, not because it had bought an investment bank but because it had bought Countrywide Financial, a vanilla-variety mortgage lender.

Meanwhile, J.P. Morgan and Wells Fargo — two large banks with big investment banking arms — resisted taking government capital and arguably could have weathered the crisis without it.

Did U.S. investment banks create a shadow banking system and derivatives market outside the normal regulatory framework that encouraged sloppy lending and created what turned out to be toxic securities? You betcha.

And did regular banks make some of those bad loans and buy up some of those toxic securities? Yes, they did.

But that was as much a problem at the banks and investment banks that combined as those that remained independent. More significantly, the bulk of the money that flowed through the shadow banking system didn’t come from government-insured bank deposits. It came from money market funds, hedge funds, pension funds, insurance companies, foreign banks and foreign central banks.

Confronted with these inconvenient facts, the conspiracists like to double-down and argue that the real damage caused by repeal of Glass-Steagall is that it triggered a wave of bank consolidation — which has now left more than half of the country’s banking assets under the control of a handful of institutions that are so big that the government has no choice but to bail them out if they risk a meltdown of the financial system.

No doubt about it — too-big-to-fail is a problem. It turns out, however, that it was also a problem in 1984, when Continental Illinois, the seventh-largest U.S. bank with a whopping $40 billion in assets, had to be rescued. It was a problem a few years later when the Fed quietly rescued Citicorp because of mountains of loans to Latin American governments that turned sour. It was a problem in 1998 when the Fed had to orchestrate the rescue of Long-Term Capital Management, a hedge fund with less than $5 billion in capital. And it was the reason behind the Fed’s 2007 rescue of Bear Stearns, with less than a quarter the size of its biggest Wall Street rivals.

A bank doesn’t have to have $1 trillion in assets to be too big to fail. Context matters. It depends on how much it has borrowed from, or lent to, other financial institutions. And it depends on the degree to which the banks are a counterparty on futures, credit-default swaps and other derivatives contracts.

The decision of whether an institution needs to be rescued also depends on the overall state of the market. When markets are strong, the failure of even a highly visible institution might be dismissed as a one-off event. But when markets are nervous, even the failure of a second-tier institution can spook investors and lenders to begin pulling back from all similar institutions, creating a contagion effect that can send global markets crashing.

Don’t infer that I think bank consolidation has been a good thing. There aren’t many who have railed against it in print for as long, or as consistently, as I have — to no particular effect, I might add. But repeal of Glass-Steagall has not been the key driver of this consolidation, which began long before 1999.

Excessive bank consolidation has left us with megabanks that are too large and complex to properly manage and regulate. The evidence is now overwhelming that top executives and directors and regulators are often clueless about risks deliberately taken and corners knowingly cut by people working under their direction. The chances of that happening grow with the size and complexity of the bank.

Perhaps more important is that consolidation has created the kind of oligopoly that has reduced price competition in the market for many financial services. That has allowed the industry to earn operating profits well above those of more competitive industries. And those excess profits — largely captured by the top executives, bankers and traders in the form of bonuses — create the perverse incentives to take excess risk and cut corners.

Any number of factors led to the recent financial crisis. At the top of the list — and rarely mentioned — is the willingness of our trading partners to finance our trade deficit with an artificially low interest rate and an artificially high exchange rate. And right behind it was the growth of a vast new shadow banking system largely outside the reach of regulators. Shoddy lenders, foolish borrowers and investors, greedy investment bankers, compromised appraisers and ratings analysts, clueless regulators — all of these were also part of the story — along with excessive consolidation.

I suppose even a screenwriter as gifted as Sorkin would find it impossible to boil all that down to a secondary storyline for his ripped-from-the-headlines TV drama. The problem with his pinning the blame on the repeal of Glass-Steagall, however, is that millions more Americans now believe it to be true.
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Old 08-03-2012, 03:37 PM
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If "the myth of Glass-Steagall" is that "the repeal of Glass-Steagall caused the financial crisis of 2007 - 2008," you'll get no argument from me.

If you say that the repeal of Glass-Steagall was not one of the many in a confluence of bad ideas that culminated in the financial crisis of 2007 - 2008, I would beg to differ.
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Old 08-03-2012, 07:21 PM
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Originally Posted by scrappy jack View Post
if "the myth of glass-steagall" is that "the repeal of glass-steagall caused the financial crisis of 2007 - 2008," you'll get no argument from me.

If you say that the repeal of glass-steagall was not one of the many in a confluence of bad ideas that culminated in the financial crisis of 2007 - 2008, i would beg to differ.
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Old 08-03-2012, 07:24 PM
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Originally Posted by scrappy jack View Post
if "the myth of glass-steagall" is that "the repeal of glass-steagall caused the financial crisis of 2007 - 2008," you'll get no argument from me.

If you say that the repeal of glass-steagall was not one of the many in a confluence of bad ideas that culminated in the financial crisis of 2007 - 2008, i would beg to differ.
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Old 08-04-2012, 12:00 PM
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Because Glass-Steagall was passed during the Depression, it is assumed that it was addressing a pressing need of the time. In fact, the lack of government-enforced division between commercial and investment banking had precisely zero to do with bank problems during the Great Depression. The 9,000 bank failures during the early 1930s had far more to do with the damage done by government regulation ó namely, the unit-banking laws that made it difficult for banks to diversify their portfolios (by limiting them to a single office and making branching illegal) ó than with a lack of regulation. These were small banks, not the behemoths for which Glass-Steagall would have been relevant. Canada had none of these stifling regulations, and had zero bank failures. (Incidentally, Canada also avoided all the post-Civil War bank panics that struck the U.S., even though Canada did not have a central bank until 1934 ó yet again, reality refuses to conform to the where-would-we-be-without-our-wise-overlords comic-book version of events.)
ĎRepealí of Glass-Steagall Irrelevant to Financial Crisis | Tom Woods
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Old 08-06-2012, 11:12 AM
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The repeal of G-S was part of a larger de-regulation or relaxation of existing regulation or poor execution of regulation. What you saw was larger banks that were leveraged with the benefit of extremely low interest rates via the Federal Reserve that became customers of some of the investment banks mentioned (like Lehman and Bear Stearns). Add in Congressional pushes toward higher home ownership, rubber-stamped AAA ratings via the ratings agencies, and these megabanks adopted a business model of lending to anyone in order to sell those mortgages to securitizers.

Five of the largest investment banks were then provided a special exemption from SEC leverage rules.

AIG's trillions of dollars in credit-default swaps with practically no reserves or capital set against them existed in a derivatives market largely without oversight due to the Commodities Futures Modernization Act of 2000.

Jason - I know you like to quote editorial sources. Here's my offering:

Originally Posted by Barry Ritholz
What we should be discussing is the corrupting influence of crony capitalism and radical deregulation. Instead, we find ourselves forced to defend capitalism and free markets. We should be finding ways to definancialize the U.S. economy and reduce bankers’ influence.

There are lots of thing we can do about this, but I have a modest suggestion that would be a good start: No more Wall Street bankers as Treasury secretaries. It would be much better for the nation to find someone from industry who understands finance rather than finding someone from finance who understands industry.
Link to full article
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