Wonk Wednesday: Glass Steagall

Hello, dear readers, as of today I am rolling out a weekly educational series entitled “Wonk Wednesday,” wherein I will deliver to you the background on important financial concepts and institutions, bios on the relevant figures, and book reviews of classic and modern political and economic works.  I intend it to be informative, easily digestible, and perhaps a little humorous.  Too often, I read political or economic fare that is bogged down by arcane terminology and pedantic posturing…  That is to be avoided here.  With all of that said, laissez les bon temps rouler!  First up:  the Glass Steagall Act of 1933, often mentioned by Washington politicos and Occupy Wall Street protesters alike.

The Glass Steagall Act (GSA), financial reform legislation that emerged during the Great Depression as a safeguard to the highly speculative banking practices that led to the 1929 stock market crash, was written by Senator Carter Glass, who incidentally also authored the legislation creating the Federal Reserve system.  GSA built a firewall separating commercial and investment banking activities to eliminate the conflict of interest between the cultures of protection and risk.  This firewall was necessary because firms were becoming overly greedy and taking excessive risk with deposits, despite their fiduciary duty to act in the best interests of the investor.  Wall Street had become a casino where the players were betting with OPM– other people’s money inducing a powerful narcotic effect similar to opium…  Drugs are bad, kids!  House member Henry Steagall joined the regulatory party when the legislation was amended to include bank deposit insurance, i.e. the Federal Deposit Insurance Corporation (FDIC).

In 1956 Congress passed an extension to GSA called the Bank Holding Company Act to prevent large banking and insurance conglomerates from forming.  The rationale was that sound commercial banking practices precluded the high risks of underwriting insurance…  so banks were forbidden from underwriting insurance, but could still sell insurance products.  Again, remember:  the separation of protection and risk, avoiding conflicts of interest.

During the 1980s many efforts were made to curb and repeal Glass Steagall.  GSA rules were loosened by the Federal Reserve Board in 1986 to allow banks to engage in a small amount of securities trading.  In 1987 the Fed Board voted to allow a greater range of trading, against the wishes of Chairman Paul Volcker, using the free market argument that three system checks, namely the SEC, knowledgeable investors, and ratings agencies, were more effective regulators than prohibitive legislation.  Volcker thought that bankers would recklessly pursue higher rates of return, e.g. issue bad loans, at the expense of depositors.

The anti-regulatory argument was conveniently championed by none other than Alan Greenspan, a former director of J.P. Morgan and Volcker’s successor to the post of Fed Chairman.  Throughout the ’90s, Greenspan and the Fed further gutted the GSA at the behest of the banking industry.  In 1997 the Fed began allowing banks to own securities firms, and a series of high-profile mergers ensued.

In 1998 Sandy Weill of Travelers Insurance and John Reed of Citicorp sought to merge their insurance/securities underwriting and commercial banking businesses to create the world’s biggest financial services conglomerate, Citigroup.  Such a merger was exactly what Glass Steagall was intended to prevent.  Greenspan green-lighted the deal, with the understanding that the merger would have to conform to existing regulation, but in anticipation of the repeal of the GSA.  Bank lobbying went into overdrive, and in 1999 the Gramm-Leach-Bliley Act (aka the Financial Services Modernization Act) was passed, successfully repealing Glass Steagall and ushering in an era of bank industry consolidation.

So why is this all important?  The repeal of Glass Steagall provided the anti-regulatory framework allowing the risky securitization practices Volcker had feared and too-big-to-fail financial behemoths to emerge.  Banks engaged in predatory lending to secure more higher-interest, sub-prime loans for packaging into mortgage-backed securities which would then be sold as AAA investments.  Ratings agencies and the SEC aided and abetted this fraud.  Insurance companies such as AIG allowed multiple entities to insure the same asset in what is known as a Credit Default Swap (CDS).  Eventually Goldman Sachs realized it had such a huge stake in credit default swaps with AIG, that when the bubble burst, it would effectively bankrupt AIG.  Thus, Goldman began buying insurance against AIG’s collapse.  When the real estate bubble finally burst, bringing down home values as well as several venerable financial institutions like AIG Lehman Brothers, the economy tanked and the unemployment rate soared as companies, investors, and the American public scrambled for financial cover.

The American taxpayer has largely footed the bill for this disaster, as the government propped up institutions deemed ‘too big to fail.’  Perversely, as a result of the collapse, these institutions have become even bigger, and the conflict of interest between protection of assets and risk-taking of assets has grown exponentially.  The reinstatement of Glass Steagall is an important first step in righting our economic ship.  We must erect the firewall once again to eliminate the conflicts of interest that threaten our financial safety.  Though many disagree with Occupy Wall Street’s methodology, it is hard to argue against its motive of financial reform.

http://www.investopedia.com/articles/03/071603.asp#axzz1btndeleP
http://www.businessdictionary.com/definition/other-people-s-money-OPM.html
http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html
“Inside Job” Documentary

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