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As soon as the Great Crash hit, we were inundated with paid experts explaining to anyone who would listen that the repeal of Glass-Steagall did not cause the Great Crash. That went pretty well for the people who repealed Glass-Steagall, so now they started pushing the idea that Glass-Steagall would not have prevented banks from engaging in the activities that led to the Great Crash. We get a crash course from Andrew Ross Sorkin in the New York Times Dealbook, who begins by blaming the left for perpetuating the meme that repeal led to the Great Crash.
Sorkin argues that you can look at each failed entity and see that it was never covered by Glass-Steagall, like Lehman or Bear Stearns or AIG; and that for banks, which once were covered by Glass-Steagall, the problem came from the commercial side, in the form of bad mortgage loans. That superficiality is the hallmark of the defenders of Wall Street. So let’s try to look a bit deeper.
The most important impact of Glass-Steagall is that it reduced the number of openings for investment bankers. If commercial banks couldn’t have investment banking arms, they would not have needed to hire investment bankers. There would not have been the crushing need to make gigantic profits off those people. There would not have been the enormous pressure to find ways to make money, including cutting corners and outright fraud. And there would have been fewer people trying to make themselves insanely rich with other people’s money, and at no risk to their personal finances.
Just before Glass-Steagall was repealed, the financial sector had consolidated into a handful of giant commercial banks, and another group of giant investment banks. There were overlaps already. Investment banks operated money-market funds with checks, digging into the core deposit-taking business of commercial banks. Commercial banks had trust departments and owned small brokerage operations.
The key change was that investment banks had all gone public. While they were privately held, the owners want to get rich by means making large amounts of money and paying oneself from those profits. In public companies, the shareholders want to get rich, which means they want constantly increasing profits. That’s not so easy in the financial sector. There is a large but limited amount of trading of financial instruments, and there is money to be made in underwriting new securities, but the business is cyclical. Getting insanely rich requires a steady flow of new instruments to sell to the muppets.
The first of that flow of new instruments was junk dotcom stocks in the 90s. A great deal of money was redistributed to the financial sector, and some wound up financing the surviving businesses, and all of it came from small investors. As the 2000s wore on, the game was to find something new to sell to the mooches. The commercial banks saw the possibilities of asset-backed securities. After all, they were lending machines. The could crank up their loan operations, and use their investment banking arms to securitize and sell the resulting paper to muppets all around the world.
The investment banks competed by cutting deals with independent mortgage brokers, even buying them, and setting up their own securitization wings.
Suppose Glass-Steagall had been in effect and had been enforced during the period beginning in the 1990s. The banks might have stepped up their lending, but they would not have had large investment banking arms to package and sell those loans to muppets. Instead, they would have been forced to look to the investment banks for sales arms. In an Alan Greenspan world, or a world in which a not-captured SEC did actual enforcement, the investment banks would have paid attention to the assets behind the instruments they were selling. That would have meant a lot less predatory lending, and it would have meant that the process would have been slowed down so that the sellers could make sure that the loans were actually being transferred.
Equally important, the investment banks would have had legitimate sources of mortgage loans, namely, the commercial banks. Sure, there would have been independent mortgage brokers, but they would have to compete for securitization sales with big commercial banks. The commercial banks had a big edge here: the independent mortgage brokers were thinly capitalized, and depended on commercial banks for the loans that enabled them to grow. The commercial banks could control the amount of money going to mortgages simply by reducing or increasing their loans to their competition. We can assume that they would do so to maximize their own profits.
Guessing at a future with Glass-Steagall in effect is, of course, creating a fantasy world. No one can say that Glass-Steagall would have prevented a housing bubble, given the level of greed among bankers, and given the enormous amount of cash sloshing around the world looking for safe returns. But it’s equally certain that Sorkin is wrong to say it would not have stopped the Great Crash; he doesn’t know any more than I do. But I’m pretty sure we agree that the Great Crash would have been a lesser crash had Glass-Steagall been in effect.
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The other law that was instrumental in creating the economic disaster, besides the Financial Services Modernization Act that repealed Glass-Steagall, was the Commodities Futures Modernization Act, which forbade regulation of CDO’s. Both were the product of bipartisanship that included Clinton’s economic team and the Gramms(Phil and Wendy). Sorkin is just another paid propagandist for the Banksters.
Sorkin is a hack and so is Liz Warren. I’ll let one of the commenters to the piece explain:
Just read all the comments sorted by “Readers Picks”
Yes between the 2 bills the $$$$ system was at last in the hands of the money changers and their friends were well paid. Main Street died.
http://www.nakedcapitalism.com/2012/05/its-not-about-reelection-bill-clintons-80-million-payday.html
Thank you, masaccio.
Those, like yourself, who are effectively able to speak the truth to counter the paid-for and programmed lying, the “professional” dissembling, are a most precious group, a genuine and most-valued resource of wisdom and truth, for the rest of us …
Your presence and perspective, on these threads, are MUCH appreciated.
DW
Thanks, DW.
Pardon my manners, masaccio. Great post. (I just get so angry reading Sorkin I lose my mind.)
I can’t really make sense of it all. To me it is simply capitalism. The system is unstable and periodically results in a bubble. the general public got to thinking that housing would rise forever. Buy a house and flip it at a profit, no need to even pay the interest, since that too was back loaded. In that kind of world your solvency absolutely depends on selling your asset to a bigger fool. There are any number of enablers in this world all the way from MERS to avoid recording fees to liar loans and credit default swaps and the fed enabling with low interest rates. I think Glass seagall would have helped, but all regulations depend on the regulators. Think any of those assholes did their jobs, including Greenspan at the fed?
But people are also enablers. Anyone recall the dot com bubble and the prices being paid for companies like Csco and Sun Microsystems. It was insane. And it will happen again. Oh looky there is that JPMorgan just lost three billion so soon?
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It isn’t that hard to follow the chains of logic and the practical considerations that lead to the outcomes we have been getting. What’s hard is to cut through the fog of silly statements and justifications the paid professionals churn out.
One of the biggest frauds is the use of math to describe the economy. Paul Krugman and Charles Ferguson write a bit about this, and so have many others, including me. Here’s something interesting on that point: http://www.advisorperspectives.com/newsletters12/pdfs/An_Attack_on_Paul_Krugman.pdf
It’s a short paper and quite clear paper explaining one of the biggest flaws in mathematical modeling as practiced by economists: the failure to define terms adequately. It makes it clear why the analysis you lay out in your comment is just more valuable than a boatload of models: you talk about real people doing real things, instead of incompletely formalized equations which cannot lead anywhere useful.
Book Salon up with David Swanson’s MIC at 50: The Military Industrial Complex at 50 hosted by Eric Stoner
Interesting article. I agree there is much seeming nonsense in the formulas I’ve seen from some economists. But a few of them are simply accounting identities like the sectoral balances. Problem is the data behind them, like GdP are really only rough estimates. But anyone create money. Banks do it regularly with or without deposits. They then may have to borrow from the fed to meet reserve requirements. The fed though cant stop them from lending except through interest rates. I don’t know much of minsky but I think he nailed it when he said the system is unstable. We have seen that for hundreds of years now. Time to believe it. This last one was crystal clear.
“he doesn’t know any more than I do.”; actually, he knows less.
The Glass-Steagall Act of 1933 accomplished what Justice Louis Brandeis advocated in his articles “Other People’s Money” in 1914, namely force the separation of commercial banking from investment banking. The basic problem, as he pointed out, was the inherent conflict of interest in many investment bankers sitting on the Boards of, and actually controlling banks, and insurance companies, (and railroads and other corporations) through stockholdings, and interlocking directors and officers. It was a question of fiduciary duty and the principle that “no man can serve two masters.” Brandeis’s recommendations were adopted to a very limited extent in the Clayton Antitrust Act and in a later hodgepodge of amendments to the Interstate Commerce Act, the Federal Reserve Act, the Public Utility Act of 1935, the Natural Gas Act and the Glass-Steagall Act (although I doubt you’d find any mention of Brandeis or Progressivism in the legislative history of the last one). Plus, somehow, it seems to have escaped the attention of prior Congresses that it might be a conflict of interest for a Bank President like Jamie Dimond to serve on the Federal Reserve Board.
It is probably overly simplistic to claim that this one thing or other would have prevented the 2008 Crash. But it’s equally simplistic to try to make the argument that repeal of Glass-Steagall was not related or had no effect on the crash which is what Sorkin appears to be trying to do. He would do as well to investigate how a few investment banks and one large insurance company got to where the failure of one lead the entire global economy to the brink of economic catastrophe, which was only averted by the government bailing them and a number of others out.
This comes back to credibility and how any of these people and their entities who lobbied to repeal Glass-Steagall still manage to have any against anyone who suggests the contrary.
Sorry but I believe your assertion is wrong and Sorkin is correct – indeed most in my little corner of the finance world – including names like Krugman – would agree with Sorkin.
You say “If commercial banks couldn’t have investment banking arms, they would not have needed to hire investment bankers.” – that is hard to follow. If you are asserting that by starting investment banking arms the deposit taking institutions became a major part of the derivative debacle, I believe the data shows you are incorrect.
You preface the above with “Suppose Glass-Steagall had been in effect and had been enforced during the period beginning in the 1990s.” – seemingly forgetting the date (1999) that the modification to G-S was passed.
In the mid-90′s Grenspan at the Fed – the only regulator of the investment banks – told everyone that he would never regulate the investment banks because he wanted more competition in the mortgage market – and within months the investment banks replaced the commercial banks as the largest in the US maker of mortgages as they got “product” for securitizations. The loan origination networks of the commercial banks, were replaced by independent mortgage brokers finance by the investment banks as the prime source of new loans – exceeding the commercial bank volume by a large amount.
The replacement of actuaries by economists and PHD math guru’s in the securitization process was via a simple hiring of these math types – and only these types – as securitization expanded – and the long term capital disaster that these math types caused was ignored as they went on to producing idea that the “C” bonds are “AAA” bonds if there is diversity of geography – selling this con-job to the ratings folks – a process not possible with actuaries because of the discipline rules on ethics that the Society of Actuaries enforces on actuaries.
As to “it’s equally simplistic to try to make the argument that repeal of Glass-Steagall was not related or had no effect on the crash” that is correct only to the minor extent that having deposits provided size/capital that masked the risk being assume – and the stats show the risks that were assumed by deposit taking banks via derivatives were minimal even after G-S was modified.
The crash was caused by Greenspan – and the GWBush admin allowing liar loans – and the investment banks/hedge funds lack of regulation allowing them to sell the C bond equals AAA bond nonsense because of the Fed (Greenspan) not regulating (and by a SEC that regulated little). As to AIG placing bare bets with no reserve that was due to Greenberg – an insurance salesmen successful in China pre-WW2, who used his influence on the inheritors of the Star fortune to control AIG, tossing the AIG actuaries every 5 years – as he violated ethics left and right. Greenberg by the way is now a CNN/CNBC talking head guru these days as he promotes Simpson and his new hedge fund.
The claim that G-S was a prime mover was developed by Obama as a way to take down the Clintons – that the left still repeats it is sad. That said, Volker is or at least could be the new and better expanded G-S. In any case while the increase in security is minor, there still really is an increase in security to having G-S – or a strong Volker rule.
Good comment. You make an excellent point about the shifting of mortgage loan origination away from deposit banks to mortgage brokers. But I’d note that Barry Ritholtz, who did an outstanding takedown of the bailouts in “Bailout Nation”, wrote that Glass-Steagall was repealed in part to accommodate Citibank which wanted to acquire Travelers Insurance at the time. Repeal of G-S allowed that to happen. Citibank and a few other very large depository banks were very overexposed in 2008.
Even if only a few banks were exposed to risks from arbitrage and hedging, the breach in the firewall caused by Glass-Steagall repeal made the risks systemic because of the government’s guaranty of deposits. Deposit insurance is only limited as long as the government can control and manage the risk of the banking system. When G-S was repealed, it lost that ability. So the exposure of a few banks to risks which were interconnected to the risks of investment banks created a systemic risk to the banking system, the basis of currency.
We should not forget that it wasn’t entirely clear that the bailouts were going to work or that the government could really stem the panic if all of the trillions of CDS’s and CDO’s were called. It’s my impression that we’re still not through the woods and that the banking industry is holding our country and its finances hostage to that fact.