Repeal of Glass-Steagall: Not a cause, but a multiplier
Barry Ritholtz
August 5, 2012
When the Titanic set sail from Southampton on April 10, 1912, bound for New York, it was called “unsinkable.” This was before that chance encounter in the North Atlantic with a large iceberg. You know how that movie ended.
Many people died, of course, because there were too few lifeboats. But even if the luxury liner had four times as many, the Titanic still would have ended up on the bottom of the ocean, done in by a captain more concerned with speed than safety — and that iceberg.
This simple reality, however, obscures a broader truth.
Before it sank, more than 700 passengers loaded onto the 20 lifeboats on board and escaped with their lives. More than 1,500 others died. The Titanic had the capacity for 64 lifeboats, which could each hold 65 people. Fully loaded, they could have carried more than 4,000 to safety — or every man, woman and child aboard. Thus, many more could have survived.
While the shortage of lifeboats didn’t cause the sinking, this insufficiency after the crash was a factor in the 1,502 deaths.
I was reminded of this recently after reading articles that argued over the role the repeal of the Glass-Steagall Act played in the financial crisis. The Depression-era regulation that separated Main Street banks from Wall Street investment firms had a huge impact on the finance sector.
The repeal of Glass-Steagall may not have caused the crisis — but its repeal was a factor that made it much worse. And it was a continuum of the radical deregulation movement. This philosophy incorrectly held that banks could regulate themselves, that government had no place in overseeing finance and that the free market works best when left alone. This belief system manifested itself in damaging ways, including eliminating regulation and oversight on derivatives, allowing exemptions for excess leverage rules for a handful of players and creating dangerous legislation.
As the events of 2007 to 2009 have revealed, this erroneous belief system was a major factor leading to the credit boom and bust, as well as the financial collapse.
I have been unable to find any evidence that the Gramm-Leach-Bliley Act — the legislation that repealed Glass-Steagall — was a primary cause of the financial crisis. Imagine a “but for” scenario where Glass-Steagall had not been overturned but the rest of the deregulatory actions had still taken place. Would the crisis have occurred? Without a doubt, yes.
The Fed still would have taken rates down to unprecedented low levels. This would have led to a global spiral in asset prices. The nonbank, lend-to-sell-to-securitizer mortgage originators were still going to make subprime-mortgage loans to unqualified borrowers. Bear Stearns and Lehman Brothers would still have overwhelmingly increased exposure to subprime mortgages. AIG would still have written trillions of dollars in credit-default swaps and other derivatives with zero reserves set against them. The largest security firms and deposit banks would still have charged headlong into the subprime securitization business. And Fannie Mae and Freddie Mac would still have belatedly chased these banks into the same subprime market, just at the peak of the housing boom.
Lastly, housing prices would still have run up to absurd levels and then collapsed.
So no, the repeal of Glass-Steagall was not a proximate cause of the crisis. But its impact was both nuanced and complex. Consider the context in which it occurred:
● The repeal of Glass-Steagall in 1999 was part of a broad deregulatory push, championed by the likes of Fed chief Alan Greenspan, Sen. Phil Gramm (R-Tex.) and Treasury Secretary Robert Rubin, that eliminated much of the oversight on Wall Street. Freed from onerous regulation, the banks could “innovate” and grow.
● After the repeal, banks merged into more complex and more leveraged institutions.
● These banks, which were customers of nonbank firms such as AIG, Bear Stearns and Lehman Brothers, in turn contributed to these firms bulking up their subprime holdings as well. This turned out to be speculative and dangerous.
So we can say that Glass-Steagall’s repeal allowed the credit bubble to inflate much larger. It allowed banks to be more complex and difficult to manage. When it all came down, the crisis was broader, deeper and more dangerous than it would have been otherwise.
Glass-Steagall’s repeal, after 25 years and $300 million worth of lobbying efforts, culminated decades of deregulation.
Newfangled derivatives? No oversight, reporting or reserves necessary, courtesy of the Commodities Futures Modernization Act of 2000. Subprime-lend-to-sell-to-securitizers business model? Those are the financial innovators! At least, that is what Greenspan called them, and why he refused to oversee them as Fed chairman. Rules on SEC leverage? Let’s create a special exemption from the law for just five investment banks.
Of course “reputational risk” would serve as a deterrent to poor decision making! No bank would ever behave so recklessly as to put their own hard-won status on the line — or its very existence.
How’d that idea work out?
With Glass-Steagall, there would not, could not, have been a Citi/Travelers merger, and competitors would not, could not have bulked up the way they did. Major money center banks most likely would have been smaller, more manageable, more easily wound down. Arguably, too big to fail might not have been the rule, and bailouts might not have been necessary. This is, of course, mere supposition.
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.
Consider where we would be today if we put Citi and Bank of America into prepackaged bankruptcy (as was done with GM). It would have been much more painful, but ultimately, much healthier.
The past 50 years have seen a dramatic financialization of the American economy. Wall Street has morphed from serving industry to a Titanic leaving a damaged economy in its wake.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Twitter: @Ritholtz
Category: Really, really bad calls, Regulation
Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.
Excellent piece!
No arguments with any of it… only maybe a thought on an even larger context.
RE: ‘influence of crony capitalism”
Of course true!
And true of virtually any other political economic model either designed or evolved over the last several thousand years… crony Monarchism, crony Communism, crony Facism, crony whatever.
In other words the problem is connected to drives and influences entirely independent of any ideology.
The problem is that NO POLITICAL OR ECONOMIC MODEL HAS EVER UNDERSTOOD LET ALONE ATTEMPTED TO ADDRESS THE ISSUE OF SCALE AND HOW THAT INTERACTS WITH MANAGEMENT AND DECISION WITHIN INSTITUTIONS.
You touch on this when you suggest no Treasury secretaries from Wall Street… and that’s because its an implicit recognition of the bias that arises w/o mechanisms facilitating (or even forcing) a broader spectrum of opinion input.
” This would have led to a global spiral in asset prices”. This from the guy who at one point didn’t see how a bubble in the US could cause a bubble around the world? I hope this doesn’t sound critical because this is good personal growth.
“… Newfangled derivatives? No oversight, reporting or reserves necessary, courtesy of the Commodities Futures Modernization Act of 2000. Subprime-lend-to-sell-to-securitizers business model? Those are the financial innovators! At least, that is what Greenspan called them, and why he refused to oversee them as Fed chairman. Rules on SEC leverage? Let’s create a special exemption from the law for just five investment banks…’
…have nothing to do with Glass-Steagall. In fact it’s like saying tax cuts multiplied the crisis. Carried interest rates allowed hedge funds et al to have more capital to buy leveraged CDS etc… so? Computers made it worse too.
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BR: This is a straightforward explanation:
“Of course “reputational risk” would serve as a deterrent to poor decision making! No bank would ever behave so recklessly as to put their own hard-won status on the line — or its very existence.”
This is where those people are so out of touch, that it hurts to think about it. Modern companies are run by sociopaths because those are the types that are willing to maximize profits no matter what (e.g., fire a 58 year old guy after 19 years of service so he wont be eligible for retirement pension and health benefits, etc.). But a sociopath don’t give a sh!t about the company or shareholders – he just want to harvest his 20, 50, 100 million so he can live a comfortable rest of his life doing nothing but indulging himself with whatever he likes. He doesn’t care if he destroys the companies reputation and future in the mad dash to his personal goal – because he is a sociopath he cares about nothing else but himself. Were these people really so stupid that they thought they could hire a guy who was willing to do whatever to the employees he faced every day, but would not screw the shareholders he might meet once a year.
A “root cause”?
I dunno, but when somebody places a firecracker next to a house and nothing serious happens, and then a bundle of dynamite is exploded next to that same house, and it blows the wall in, I think that few would argue that the exploding dynamite was a “root cause” of the wall’s failure …
Financial leverage is a powerful force. It was a “root cause” of the Crash of ’29 (with everyone having — and nearly everyone using/pyramiding 10-to-1 leverage), and is why the non-professional gamblers are restricted to 2-to-1 leverage in the stock market today, and why mere mortals are also scrutinized for their ability to withstand leveraged failure before being permitted to trade options and futures (a safety net that is being weakened with leveraged ETFs, which is a problem that needs to be addressed).
I think that NO PUBLIC COMPANY should be permitted to deal in unrestricted leverage financial instruments, and no leveraged instruments that are not standardized products traded on public exchanges (good-bye, swaps). For privately-owned corporations, that’s fine, but for publicly-owned corporations, it’s an invitation to disaster.
Whether or not you want to label it as a “root cause” is mincing words. It should not be allowed to occur the way that is has been here in a sane society.
BArry?
WSithout removing Glass-Steagall in combination with the CFMA, we’d never have had the sub-prime crisis at all, I’m confused here.
Didn’t Gramm-Leach-Bliley make it possible for banks to lend and then directly securitize their own originated loans into assets?
The CFMA removed regulation & public disclosure requirements over derivatives, OTC & futures, converting garbage loans into derivatives then made it possible to sell them as “triple A” and short them behind the scenes without public disclosure.
Add to that, the timed cornering of oil futures in 2008 that soared RBOB prices at the height of a consumer sub-prime debt binge, recently exposed in CFTC records from the Summer of 2008, banks have been rendered all but omnipotent over the economy – we are the ants, they have the magnifying glass.
What did I miss?
I have had a number of debates as to what caused the financial crises. They range from securitization, repeal of Glass Steagall, to all the blame on Fannie Mae, lack of regulation etc. I know it is very much like the 4 blind men describing the elephant. It all depends on ones perspective. As a MBS trader told me there is plenty of blame to go around, which there is in fact.
As I see it the genesis began with the low interest environment when investors which are always looking for a higher rate of return without additional risk. That has usually meant mortgage backed securities back by the government. Because the demand for these bonds was so great the market, as usual will supply the demand. So the cycle of pressure began to force more “safe” higher yield investments. Because the profits in creating these investment was so great all the players looked the other way as long as no one was watching i.e. regulators.
The mortgage brokers sold what the market was demanded, so with a real estate market that was touted to always go up, the growing demand for subprime mortgages, the need to sell the securitized mortgages required, what I believe was the linch pin, the phony ratings, with which the investments could not have been sold to the largest investor – (institutions). If they could not sell them the demand would have diminished.
As for the default swaps – AIG and others sold insurance against default ridiculously cheap because there were no regulations as to cash reserves as there is with other insurance products, and the fees were irresistible.
As mentioned above leveraging is a great tool for multiplying gains and loses. When a AAA security is use to back leveraging that turns out to worth a fraction of its face value the bubble is ready for the inevitable.
So there were a number of factors that made the crises possible. Each element help make it potentially worst. And all the different perspectives are right to some extent. And the extent of the damage may have been curtail some without one or more of the contributing factors.
Blaming home owners, as some have, suggests that loans safety rests with the borrower and not the lender. The banks did not care how risky loans were, because they were not holding them but selling them to Fannie Mae and the big banks.
Furthermore, the notion that the government was to blame because they wanted to increase home ownership suggest that everyone could qualify and reducing requirement to qualify for a mortgage was not a bad idea in a rational market, which did not exist.
Can regulators and financial analysts do system engineering such as apply fault tree analysis, (FTA from Boeing in the 60’s doing ICBM design allocations)?
A “system” performs based on identified outcomes, with the related design features of the parts of the operating system, as well as related external supports (enablers and controls) to get the operating system to deliver the outcome.
The Titanic’s Captain today would have had as his requirement to get to America swiftly. He would have had on board radar to see ahead, and a system to react to signals from the radar. From the third off ship aspect he would have input from an iceberg warning system to tell him to change course, slow down or sensitize his radar in certain locations. Regulation or operating procedures would have required sufficient life boat capacity supplied to the ship prior to leaving port for its operating cycle.
System engineering requires all three aspects to be in concert for efficient performance.
Good thing the FAA is better at system engineering and regulating than whoever runs wall st.
If only global warming had progressed sooner, that iceberg never would’ve caused the Titanic to sink! More deregulation would’ve saved the day.
Ironic that in the increasingly regulated society, the five TBTF takers managed exemption to their own prosperity with the help of empty suits in government. While I believe in kindness, generosity and compassion, I demand he right to give of my own free will. I will not be forced to be my brother’s keeper and will stand against government crooks making the rules that take my money. I refuse to allow corrupt collectivist ideals to manage me with guilt.
Where is John Galt? I will find him and follow….
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.
Because there is a well-finded and extremely loud Idiot Chorus who, at any hint of criticism of crony capitalism, corruption and deregulation, scream “Marxist” and decry the impending destruction of the universe and the abolishment of apple pie. Oh, and you “hate America” as well.
A detailed history of the repeal of Glass-Steagall can be be at http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html. Also see “Let’s shatter the myth on Glass-Steagall” by Steven Pearlstein (http://www.washingtonpost.com/lets-shatter-the-myth-on-glass-steagall/2012/07/27/gJQASaOAGX_story_1.html) for a well informed contrary view. Note that Steven Pearlstein opposed and opposes bank consolidation.
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BR: I thought Pearlstein radically over-simplified things — my WaPo column was in 0art, a response to his.
Several thoughts:
“No more Wall Street bankers as Treasury secretaries.” I hope that includes Fed personnel, too
We will never get self regulation unless we do force the losers through bankruptcy. Probably most of us now agree that would have worked a lot better than TARP and all its progeny.
“Currency Wars” has a nice discussion on derivatives. By and large, the idea is not bad. A CDS is a great idea as well as other swaps. The problem arose because of the interlocking complexity of the derivative systems, but even more because the financial outfits thought they were safe as long as they had their books balanced. However, the did not really consider the risk somebody on the other side would default. Rickards says they need to consider gross exposure, not net.
Since may of the junk MBS’s were rate AAA, even if we had Glass Steagall, the big banks would have had that exposure. The banks could still have given loans and sold to Fannie or Freddie or the investment banks for packaging. As I recall, the lure to the banks were the servicing fees and getting the loans off their books.
Finally, I don’t think there are many people who favor crony capitalism except those who benefit. Those would be the politicians and the big companies who think they have an “in” somehow.
“The past 50 years have seen a dramatic financialization of the American economy. Wall Street has morphed from serving industry to a Titanic leaving a damaged economy in its wake.”
There was demand for faster / safer ocean travel, but there was still risk in ocean travel.
We have implicitly demanded from Wall Street faster / safer growth for our pension schemes (archaic defined-benefit plans, or new normal defined contribution 401k plans, or final-salary based inflation/deflation proof government plans) that have built-in assumed growth rates higher than Wall Street has been providing. Everybody wants more growth; but at what risks?
Rick Caird – The banks could not have converted loans into CDO’s without Glass Steagall, they could not have hedged risk onto the open market.
They no longer had incentive to write good loans, instead, they turned consumer debt into a shell game, rating garbage as “triple AAA” selling it to an uninformed public as such and shorting them without disclosure, as “derivatives”, which the CFMA allowed them to do.
Considering the past 2 cycles were powered by the computer revolution, everybody was far to confident by the late 90′s that the wave would last forever and passed poor stuff that came back to bite them later on. That is the way innovation booms end. When the industrial revolution was winding down in the 1910′s-20′s in America, nobody thought the wave would end either. Probably the top 2 confident periods of capitalist history. Alot of the investment from the housing bubble was ROI saftey and nothing more. Allowing outshoring backfired as well, as “traditional” industry focuses were gone further making RE investment hedge. This hedging got out of control by 2003 and the herd began to follow. This is what prompted the “low interest rates’ as well when the global market wanted the financing to push the investment. Central Banks followed the market……….as usual. But what choice did they have? Try and control the capital flows, you get to much saving and the economy suffers creating political headwinds.
The problems go far beyond glass steagall and the possibility of no housing bubble could have just lead toward a series of “strokes” rather than one big one leading us to where we are now. When innovation slows to such a point as we have now, growth becomes hard to muster……….
The growth party of the 20th century ended in 2000. The 2001-07 expansion was lot like the 1868-73 period or the 1922-28 period. The fuel was gone and the sun turned into a Red Giant……………..Buy 1873,1929 and 2007, the supernova happened.
RC,
“We will never get self regulation unless we do force the losers through bankruptcy. Probably most of us now agree that would have worked a lot better than TARP and all its progeny.”
Very true. One of the reasons that Sweden is doing better now is that its failing banks were not bailed out. Instead, the were taken over by the Swedish government, reorganized, and sold off later.
That said, Sweden’s recovery from the crash of the early 1990s took a while.
“But even if the luxury liner had four times as many, the Titanic still would have ended up on the bottom of the ocean, done in by a captain more concerned with speed than safety — and that iceberg.”
According to the subsequent inquiries, that’s a true statement. Notably, the SS Californian was stopped in an ice field just a few miles from the Titanic for safety reasons. Sadly, the SS Californian saw the flares from the Titanic and failed to respond. Another story…
However, the real analogy (actually lack thereof) to our times is how the principals behaved. Captain Edward Smith responded poorly to the disaster and failed to handle the evacuations properly. However, he at least had the decency not to try to save himself, and went down with the ship. Thomas Andrews, the ship’s designer, examined the damage and informed the Captain that the Titantic would sink. He devoted the rest of his time to organizing the evacuations and also died. He is generally regarded as the greatest hero of the disaster. Bruce Ismay did manage to save himself and was condemned for it for the rest of his life.
Not merely does our era lack any Thomas Andrew’s, it doesn’t really have any Captain Smith’s or even Bruce Ismay’s. Who exactly has been condemned for his or her failings in the Great Recession or the year leading up to it? Phil Gramm? McCain made him his economic adviser… Robert Rubin? Still very much at the top of the establishment in spite of his conduct as Secretary of the Treasury and as Director of Citicorp. Greenspan? Perhaps his reputation is somewhat tarnished. Had he resigned a year earlier, he would probably still enjoy mythic hero status. Larry Summers? Obama made him the director of White House National Economic Council. James Johnson? Obama put him on his VP selection committee… Until JJ’s sleazy ties with Mozilo were revealed. He remains at the pinnacle of the establishment.
George Bush? Widely criticized for his foreign policies and blamed for the Great Recession (with plenty of reason). However, his role in promoting deregulation remains generally obscure. Bill Clinton? He has never apologized for GLB and has basically gotten a pass for his role. Bruce Ismay must be rolling in his grave.
No doubt that many names are missing from this list…
A final note, a few years later, one of Titanic’s sister ships, the Britanic went down (German mine or torpedo). Almost everyone was saved. Many lifeboats went unneeded and unused. The system worked.
Women and Children, first!
The “Birkenhead drill”.
A poem by Kipling: Soldiers an’ Sailors, Too.
http://thinkofengland.blogspot.com/2006/11/birkenhead-drill.html