Over the last eighteen months, Washington politicians, Wall Street Bankers, world leaders, media pundits, special interest groups and millions of individuals like you and me have been playing the blame game. Democrats blame Republicans lax regulatory policy for the recession, while Republicans blame Democrats for creating the Community Reinvestment Act (CRA) in 1977 to force banks to make loans to low-income families. Some say the banks were too greedy. World leaders blame the United States and Wall Street, while others still place blame on the repeal of the Glass-Steagall Act (GSA).
The GSA was enacted in 1933 in response the stock market crash in 1929 that triggered the Great Depression. At the time, commercial banks aggressive underwriting of stocks and bonds, lax commercial lending policies and risky speculation were blamed for the stock market crash. Depositors pulled their money from the banks in droves helping to push the number of bank failures to nearly 5,000.(1)
The purpose of the GSA was to bolster the public’s confidence in the U.S. banking system and begin to rebuild the crashed financial structure. The GSA forced commercial and investment banks to separate. Commercial banks primary purpose was to receive depositor’s money and make loans. Investment banks primarily underwrite and market securities, facilitate corporate mergers and acquisitions, and broker transactions in the secondary market such as issuing corporate bonds.
Additional measures to protect the system included granting the Federal Reserve added oversight powers to monitor national banks. Also created was the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits. Banks would be required to set aside or reserve a percentage of their capital. Member banks pay deposit insurance premiums or assessments to the FDIC. In 1934, families had security knowing they could deposit their money with a member bank and it would be insured to $2,500 increased to $5,000 on July 1, 1934. (2) In 1956, The Bank Holding Company Act, placed further restrictions and companies owning two or more banks.
In the ensuing years, Congressional decrees and judicial rulings would circumvent and reinterpreting major provisions of the GSA culminating in the Gramm-Leach-Bliley Act (GLBA) that President Bill Clinton signed into law on November 12, 1999. (3) The GLBA also known as the Financial Services Modernization Act, ended depression area regulations established by the GSA by allowing commercial banks, investment banks and insurance companies to merge and create huge financial conglomerates. The laws regulating how money could be used were replaced by laws regulating how information could be used.
The law was hailed as a break though for competition allowing U.S. banks a level playing field for competition with foreign banks. Some believe that repealing the GSA helped create conditions favorable to growth after the dot-com bust. Remember in the year 2000 convention wisdom held that regulation stifled growth. What a difference a decade makes, a Harris poll in February 2010 revealed that 82 percent of Americans want tougher bank regulation. (4) Effectively regulating a complex financial conglomerate like CitiFinancial would be like trying to untie a Gordian knot. Apparently, the invisible hand that regulates the free market fell asleep on the job but the idea of free markets in the age of huge conglomerates buying Congress and the Oligarchs manipulating world markets makes the idea of free markets a myth.
After Lehman Brothers began the largest bankruptcy proceedings in history on September 15, 2008, and the credit market froze a couple weeks later, the blame game began. The repeal of the GSA was the reason for the financial meltdown proclaimed many politicians and media personalities. Sen. Russ Feingold, who, in a statement from his office, recalled, “Gramm-Leach-Bliley was just one of several bad policies that helped lead to the credit market crisis and the severe recession it helped cause.” Senator Feingold’s statement is well taken but does it overstate the case? Would have the GSA prevented the credit meltdown had it not been overturned?
With real estate home values skyrocketing in the 2000’s, the GSA would not have stopped Countrywide Mortgage, Wachovia, Washington Mutual or Indy Mac bank from making ridiculous mortgage loans that helped fuel home values. The GSA would not have prevented the banks from offering no income qualifying loans or from writing a $300,000 mortgage with low monthly payments of $875/mo for the first two years. It is unlikely the GSA would have made a difference at bailout time for Fannie Mae and Freddie Mac that received over $100M in bailout funds.
Ludicrous lending policies and easy money that helped inflate residential real estate values nationwide could not have proliferated without a little help. Banks had ready cash by selling their loan portfolios in the secondary market, courtesy of their friends in the investment banking industry. GSA would not have affected investment banks Bear Sterns, Goldman Sachs, Lehman Brothers and Merrill Lynch from purchasing mortgage loans in the secondary market, slicing them into pieces and reselling them as mortgage backed securities and Collateralized Debt Obligations (CDO’s), creating more cash for the mortgage banks to lend. The GSA would not have prevented these same investment banks from taking out insurance policies on these same securities and bond issues they sold on the secondary market. These insurance policies known as Credit Default Swaps are a type of derivative that paid these investment banks if the securities default.
Relating this to the consumer level, imagine you purchase insurance on your neighbor’s mortgage loan. You have absolutely no vested interest in whether your neighbor makes his mortgage payments or not, yet you still insure against your neighbor defaulting on his mortgage loan. Let us say your neighbor is unable to make his mortgage payment and loses his house to a foreclosure. Because your neighbor was unable to make his mortgage payment and the bank was unable to sell the home for the amount owed on the mortgage, you being owner of an insurance policy on your neighbor’s mortgage get paid because your neighbor defaulted on his home loan. As absurd as this sounds, trillions of dollars worth of derivative contacts are written on a similar premises. In October 2008, the estimated value of all derivative contracts was $668 trillion, in contrast the total value of all the assets on the planet are less than $200 trillion.(5)
The GSA would not have prevented the trillions of dollars worth of derivative contracts that are currently in force that have no more relevance to them than the above example of you taking an insurance policy out on your neighbor’s mortgage loan. The GSA would not have restricted the insurance company AIG, from underwriting multiple insurance policies/derivatives on the same securities and bond issues backed by mortgage loans.
When the housing market tanked and homeowners were no longer able to refinance their mortgages, they began to default on their mortgages in mass. The investments backed by those mortgages went into default. The investment banks had insurance called Credit Default Swaps that paid them the estimated value of the security when it defaulted. AIG underwrote many of those policies. When the whole thing collapsed and AIG was unable to pay on the derivative contracts it had underwritten, the Federal Government came to the rescue with $140 billion in bailout funds which AIG in turn paid to the investment banks like Goldman Sachs which was the owner of the Credit Default Swaps AIG was unable to pay. The rich got richer on the backs of the taxpayer. Legal yes, ethical, you be the judge. Would have the world economy collapsed without the bailouts, maybe so?
Okay so how did the derivative market become an albatross that has the potential to wipe out the world economy? The Commodity Futures Modernization Act of 2000 said many derivative contracts like Credit Default Swaps could be traded in the Over the Counter Market (OTC). The legislation of the act essentially eliminated capital and other requirements on banks that entered into OTC derivative contracts. The informed parties entering these contract would regulate themselves. The CFMA has allowed parties to enter contracts where the holder has no interest in the underlying security, in fact, the contract holder in many cases finds the failure and misfortune of others is a very lucrative business. Like a parasite, attaching itself to a host, the bank that owns the derivative contract will nourish itself financially until the underlying security is dead. However, this parasite has the ability to attach itself to another host and root for its death to enrich itself further.
The slow repeal of the Glass-Steagall Act did not cause the recession but its dissolution helped create the atmosphere where an unregulated derivatives market could flourish. Someday historians may look back at the global economy and blame its collapse on, The Commodity Futures Modernization Act of 2000.
(1) http://topics.nytimes.com/topics/reference/timestopics/subjects/g/glass_steagall_act_1933/index.html
(2) http://www.fdic.gov/bank/analytical/firstfifty/chapter3.html
(3) http://banking.senate.gov/conf/
(4) http://www.msnbc.msn.com/id/35817048/ns/business-stocks_and_economy/
Credit This! 