Would Glass-Steagall Have Stopped this Mess?

First, here's a little history about the Glass-Steagall act, courtesy of PBS's Frontline:

Following the Great Crash of 1929, one of every five banks in America failed. In 1933, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.) introduced historic legislation which sought to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds.

The new law banned commercial banks from underwriting securities, forcing them to choose between being a simple lender or an underwriter (brokerage). The act also established the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthened the Federal Reserve's control over credit.

In retrospect, this ideology was the right prognosis for America; we had just had a nasty stock market crash, and were in the midst of the great depression. Years later, we would exit the depression only to achieve the greatest period of economic growth in our history…yet in 1986, we weren't so sure:

In the spring of 1987, the Federal Reserve Board voted 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. Thomas Theobald, then vice chairman of Citicorp, argued that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC, knowledgeable investors, and "very sophisticated" rating agencies. Volcker was unconvinced, and expressed his fear that lenders would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.

Sorry, I can't help myself…the very argument for repealing Glass-Steagall is monumentally flawed. Let's review each of the three "outside checks" one-by-one, since we have the benefit of hindsight being 20/20:

1. Was the SEC "effective" in granting Goldman Sachs (GS), Morgan Stanley (MS), Bear Stearns, Merrill Lynch (MER), and Lehman Brothers permission to exceed the market mandated level of leverage from 10:1 to 40:1? (Notice 3 of these brokers no longer exist, and 2 of them have become holding banks.)
2. "Knowledgeable investors"…not exactly true. Collateralized Debt Obligations, Credit Default Swaps, Mortgage Backed Securities, Credit Linked Notes….we could spend a day running off all of the instruments of structured finance, which is esoteric by nature - and understood by very few.
3. "Sophisticated Rating Agencies" might be the most laughable of all; not only did they incorrectly gauge the health of the components in our financial system, but they were also stubbornly late in making adjustments to their ratings. In recent months they have only exacerbated problems in the credit markets, because by downgrading a company's debt in the peak of a credit crisis, they are causing investors to demand a higher yield at the very point when the company is most vulnerable; if the damage is done, they shouldn't push companies to the edge of bankruptcy. If you disagree or don't know what I'm talking about, click the link above for more about this point. (It's actually really funny to watch the CNBC anchor rip apart S&P's head of financial institution's ratings.)

Greenspan, who was appointed Fed chairman in 1987, favored the repeal because he felt that deregulation would help U.S. banks compete with big foreign institutions. Leaving the lack of truth aside, his agenda is what developed our financial system into what it is today; Citigroup (C) immediately merged with Travelers Corp., something which never could have happened under Glass-Steagall; a combination of insurance underwriting, securities underwriting, and commercial banking.

So to answer the question above, I say yes.

Stock position: None.

Comments

[ilovesum:]

thanks to greenspan and clinton for the mess. there was a tried and proven protection that was removed . I wonder how much they were paid ?
with his interest rate policy and this repeal , greenspan is most definitely not a genius , he in fact single handedly bears a lot of responsibility for this. it was nice to hear he thought the banks could govern themselves ,
i guess the fox can watch the hen house too cause its in his best interest not to eat the chickens ? or wait maybe thats why guidelines and regulations are in place .
maybe speed limit signs should get removed as motorists can govern themselves ?
the purpose of the goverment is to set limits not to over regulate or under regulate , why would removal of all regulations help.
ohh wait , "its different this time" ,
the investors are more sophisticated , haw haw , introduce complex instruments that buffett said were weapons of mass destruction
for a man who is no spring chicken , ie he was probably around during the depression , he sure forgot his history .
greenspan should just go away , thanks for nothing pal , clinton for his part should have spent more time with monica and less time messing this up

2008 Nov 23 11:39 PM

[ilovesum:]

oh yeah not to mention if its not broken don't fix it ,,
guess they were bored ,

2008 Nov 23 11:42 PM

[ilovesum:]

perhaps greenspan forgot the simple cause of the 1908 and 1929 crashes , over-leverage , oppps
so lower interest rates and reduce banking restrictions and leverage
2008 crash ; overleverage ,, oppps
he's not britney spears but he did it again

ya mean people will borrow too much ,
sacrifice today for tomorrow ,, nawwww say it isn't soooo

maybe just maybe , when these ridiculous arms , subprime loans
were going on it should have donned on a few people this was a big problem , oh yeah MR Greenspan was in favor of arm's
you da man alan
i'm not sure he could have done a worse job if he tried ,
we would be better off if he would have taken a little nap from 87 to when he retired ,,
paul volker previous treasurer fought strongly agains the glass steagall repeal ,, hmmm who knew his stuff better ?

2008 Nov 23 11:51 PM

[AlexS:]

I don't believe that Merrill Lynch, Bear Stearns, Morgan Stanley, Lehman Bros., and Goldman Sachs were commercial banks (please correct me if I'm wrong), so they were already choosing to be brokerage rather than commercial banks. So the repeal of Glass-Steagall would have no effect on what they did to bring on this crisis, since they didn't take advantage of its repeal anyway. But I don't quite understand if the author is attempting to lay the blame for this problem on the repeal of Glass-Steagall (as in the title and first part of the column) or on an ineffective regulatory apparatus (as in the major portion of the text). The two are two different things, and one does not prove the other.

2008 Nov 24 12:09 AM

[john s. gordon:]

rating agencies were corruted by big $.

SEC failed to do its job.

repwal of glass steagal was a monumental f***up.
> jack

2008 Nov 24 08:21 AM

[Christopher...:]

Granting the brokers leverage ratios of 40:1 is an ineffective governing system, as you said. However, a corollary to repealing Glass-Steagall was that we could rely on these very systems of governance...So, AlexS, hopefully that provided clarification.


On Nov 24 12:09 AM AlexS wrote:

> I don't believe that Merrill Lynch, Bear Stearns, Morgan Stanley,
> Lehman Bros., and Goldman Sachs were commercial banks (please correct
> me if I'm wrong), so they were already choosing to be brokerage rather
> than commercial banks. So the repeal of Glass-Steagall would have
> no effect on what they did to bring on this crisis, since they didn't
> take advantage of its repeal anyway. But I don't quite understand
> if the author is attempting to lay the blame for this problem on
> the repeal of Glass-Steagall (as in the title and first part of the
> column) or on an ineffective regulatory apparatus (as in the major
> portion of the text). The two are two different things, and one
> does not prove the other.

2008 Nov 24 10:33 AM

[David in En...:]

It was Clinton's people (Rubin) who led the repeal and now they are back in power, so it will not be re-imposed.
As Galbraith says, the only protection from bubbles and crashes is not regulation but the memory of the last one. So it probably doesn't matter now.

Jan 04 11:15 AM