Wednesday, May 23, 2012

President Franklin Roosevelt signed the Glass-Steagall Act in 1935.

Reinstating an Old Rule Is Not a Cure for Crisis

Call it the Glass-Steagall myth.
Since JPMorgan Chase announced its surprise $2 billion, and growing, trading loss there have been renewed calls from economists, pundits and politicians to reinstate the Glass-Steagall Act, a Depression-era law that prevented commercial banks from participating in investment banking activities.
Elizabeth Warren, the Democratic candidate for Senate in Massachusetts, sent an e-mail to thousands of her constituents, pressing to bring back the law, which she said, “stopped investment banks from gambling away people’s life savings for decades — until Wall Street successfully lobbied to have it repealed in 1999.”

A meme around Glass-Steagall has been created, repeated so often that it has almost become conventional wisdom: the repeal of Glass-Steagall led to the financial crisis of 2008. And, the thinking goes, has become almost religious for some people, that if the law were reinstated, we would avoid the next crisis.
The facts — basic facts — just aren’t that convenient. While the repeal of Glass-Steagall has seemingly become the sine qua non of the financial crisis, it is pure historical revisionism.
Before we go any further on this topic — which is likely to incite heated debate — let me stipulate at the outset that this column is not meant to argue against reinstating Glass-Steagall or adopting the Volcker Rule (sometimes known as Glass-Steagall lite.)
Bringing back something akin to Glass-Steagall would clearly help limit risk in the system. And that’s a very good and worthy goal. Letting banks sell securities and insurance products and services allowed them to grow too big too fast, and fueled a culture that put profit and pay over prudence.
But here’s the key: Glass-Steagall wouldn’t have prevented the last financial crisis. And it probably wouldn’t have prevented JPMorgan’s $2 billion-plus trading loss. The loss occurred on the commercial side of the bank, not at the investment bank. But parts of the bet were made with synthetic credit derivatives — something that George Bailey in “It’s a Wonderful Life” would never have touched.
When I called Ms. Warren and pressed her about whether she thought the financial crisis or JPMorgan’s losses could have been avoided if Glass-Steagall were in place, she conceded: “The answer is probably ‘No’ to both.”
Still, she said that the repeal of the law “had a powerful impact to let the big get bigger.” She also contended that its repeal, brought about by the Gramm-Leach-Bliley Act, “mattered enormously. It is like holding up a sign to regulators to back up.”
Let’s look at the facts of the financial crisis in the context of Glass-Steagall.
The first domino to nearly topple over in the financial crisis was Bear Stearns, an investment bank that had nothing to do with commercial banking. Glass-Steagall would have been irrelevant. Then came Lehman Brothers; it too was an investment bank with no commercial banking business and therefore wouldn’t have been covered by Glass-Steagall either. After them, Merrill Lynch was next — and yep, it too was an investment bank that had nothing to do with Glass-Steagall.
Next in line was the American International Group, an insurance company that was also unrelated to Glass-Steagall. While we’re at it, we should probably throw inFannie Mae and Freddie Mac, which similarly, had nothing to do with Glass-Steagall.
Now let’s look at the major commercial banks that ran into trouble.
Let’s first take Bank of America. Its biggest problems stemmed not from investment banking or trading — though there were some losses — but from its acquisition of Countrywide Financial, the subprime lender, which made a lot of bad loans — completely permissible under Glass-Steagall.
What about Wachovia? Its near-collapse was largely a function of its acquisition of Golden West, a mortgage lender that saddled it with billions of dollars in bad loans.
Citigroup’s problems are probably the closest call when it comes to whether Glass-Steagall would have avoided its problems. It gorged both on underwriting bad loans and buying up collateralized debt obligations.
In that case, Glass-Steagall would have done two things: it would have prevented the trading losses and it also would have kept Citigroup from getting so big, which was one of the reasons it required a bailout.
But Citi’s troubles didn’t come until after Bear Stearns, Lehman Brothers, A.I.G., Fannie Mae and Freddie Mac were fallen or teetering — when all hell was breaking loose.
Why do we have financial crises? Why do banks lose money?
If history is any guide, it hasn’t often been the result of speculative bets. It has been the result of banks making loans to individuals and businesses who can’t pay them back.
Yes, standards became so lax that buyers didn’t have to put money down or prove their income, and financial firms developed dangerous instruments that packaged and sliced up loans, then magnified their bets with more borrowed money.
But it often starts with banks making basic loans. Making loans “is one of the riskiest businesses banks engage in and has been a major contributing factor to most financial crises in the world over the last 50 years,” Richard Spillenkothen, former director of the division of banking supervision and regulation at the Federal Reserve, wrote in a letter to Politico’s Morning Money on Monday. He said that if Glass-Steagall still existed, it “alone would not have prevented the financial crisis.”
Still, Mr. Spillenkothen said: “If banks had been limited to ‘plain vanilla’ lending, notwithstanding its admitted riskiness, the financial crisis may well have been less severe or more easily managed and contained.”
In my conversation with Ms. Warren she told me that one of the reasons she’s been pushing reinstating Glass-Steagall — even if it wouldn’t have prevented the financial crisis — is that it is an easy issue for the public to understand and “you can build public attention behind.”
She added that she considers Glass-Steagall more of a symbol of what needs to happen to regulations than the specifics related to the act itself.
So would Glass-Steagall make things slightly better? Sure.
But the next time someone says that it is the ultimate solution, think again.

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