Forget Glass-Steagall repeal. It's the Securities Acts Amendments of 1975 That Really Did Us In
Regular readers of this blog are aware that I'm extremely dubious of the argument that the 1999 repeal of the Glass-Steagall Act, which separated banks from securities firms, is to blame for today's financial crisis. But it keeps coming up, so let me try to smack it down again.
First, I think it's fair to say that 90% of the people who blame today's troubles on Glass-Steagall repeal have no idea what they're talking about. It's just that the whole thing has a deregulatory sound to it--and deregulation is bad. That, and one of the names on the law that repealed Glass-Steagall, the Gramm-Leach-Bliley Act, belongs to John McCain's Treasury-Secretary-in-Waiting Phil Gramm, who is not just Satanic but Texan. Nobody seems to care that another of the names on the law belongs to saintly Iowan Obama supporter Jim Leach. Or that Bill Clinton signed it. But whatever: Let's focus on the 10% who do have some idea of what they're talking about.
First there's the Robert Kuttner argument--which is basically a much broader indictment of financial deregulation over the past 40 years that happens to make a big deal out of Glass-Steagall repeal because it's convenient to make a big deal out of Glass-Steagall repeal. I find this at least a little bit perverse because many supporters of Gramm-Leach-Bliley--Leach among them--backed it because they thought it would result in more of the financial system coming under the oversight of bank regulators and the Federal Reserve. So for them it amounted to reregulation, not deregulation. But Kuttner's critique contains some sensible points, too, so I don't want to dump on him too much.
Then there's the Oh-the-Poor-Investment-Banks argument, which I've seen a lot in the financial media lately and was just succinctly (and approvingly) summarized by John Cassidy in the New Yorker:
Commercial banks, such as Chase Manhattan, merged with investment banks, such as J. P. Morgan. The remaining Wall Street firms, grappling with new competition in their traditional businesses, increased their borrowing and made riskier bets. Last year, Bear Stearns, Lehman Brothers, and Merrill Lynch had more than thirty dollars of investments on their books for every dollar of capital. Having borrowed so heavily, the firms were hostage to a withdrawal of credit on the part of their lenders. After the sub-prime-mortgage market collapsed, that was precisely what they faced.
The first problem here is that J.P. Morgan was a commercial bank, which had been separated from its investment banking arm--Morgan Stanley--by the Glass-Steagall Act. Chase could have bought it in 1963 or 1936 if it had wanted to (and could have afforded it).
The big commercial bank/investment bank combination that everybody was really focused on in the years after Glass-Steagall repeal was Citibank/Salomon, which was created in the Citicorp-Travelers merger (which happened the year before the law was repealed, but was basically ratified by Gramm-Leach-Bliley). In the early 2000s, there was a lot of talk about how Citigroup was successfully pressuring (or tempting) its banking customers to use it for M&A and underwriting work. That was of course back when Citigroup was perceived as a juggernaut and not a bunch of jugheads, and more recently I had heard far less about it taking away business from the standalone investment banks or anybody else.
But let's just assume that Cassidy is--once you get past his boneheaded J.P. Morgan error (I've made my share of boneheaded errors over the years, too)--right: The entrance of commercial banks into investment banking created more competition for investment banks, causing some of the remaining standalone investment banks to take suicidal risks. So the issue is that competition, and competitive pressures, are dangerous--at least on Wall Street. If that's the case, though, why are we so fixated on Glass-Steagall repeal in 1999? The really important competitive shift came when Congress voted in the Securities Acts Amendments of 1975 to deregulate brokerage commissions.
From the earliest days under the Buttonwood Tree on Wall Street, brokers had all charged the same (high) commissions for buying and selling stocks. They were members of a lucrative if usually dull club. With California Rep. John Moss, a noted consumer-rights crusader, leading the way and the securities industry squealing in outrage, Congress banned that patently anti-competitive practice in 1975.
After May Day in 1975, brokerage firms had to reinvent themselves to survive. Charles Schwab famously went for the low-fee, low-service model. Merrill Lynch kept its commissions high, but compensated with all sorts of new services--like the Cash Management Account--that encroached on the territory of banks. And the firms that came to dominate Wall Street itself, like Goldman Sachs, Morgan Stanley, First Boston, and Salomon Brothers (Merrill eventually joined this group too) began in the 1970s and 1980s to aggressively pursue new lines of business: M&A, securitization and, perhaps most important, making bets with their own money.
Former Salomonite Michael Lewis addressed this nicely a while back in trying to explain how Wall Street firms had become so "shockingly opaque":
It dates back at least to the early 1980s when one firm, Salomon Brothers, suddenly began to make more money than all the other firms combined. (Go look at the numbers: They're incredible.)
The profits came from financial innovation--mainly in mortgage securities and interest-rate arbitrage. But its CEO, John Gutfreund, had only a vague idea what the bright young things dreaming up clever new securities were doing. Some of it was very smart, some of it was not so smart, but all of it was beyond his capacity to understand.
Lewis went on to explain that Gutfreund's successors on Wall Street have continued to look uncomprehendingly upon the money-making activities of their bright young employees, but have seldom reined them in because to do so would mean losing their most promising charges to competitors.
And that may actually get at the competitive force probably most responsible for pressuring investment banks into overleveraging themselves in recent years. They were desperately trying to find ways to pay their best employees enough to keep them from jumping ship to hedge funds and private equity firms.
I don't know quite how you put that back in the bottle, although the credit crunch will do the trick at least temporarily. So will the fact that there are now no longer any major standalone investment banks. Which is a state of affairs enabled, at least in part, by ... the repeal of Glass-Steagall.
Update: Lack-of-originality alert! John Gapper at the FT floated the May Day argument weeks before me (thanks to The Epicurean Dealmaker for pointing this out). At least he quoted a TIME article (from 1975) to make his case.
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Of course, the only talent investment bank CEOs want to retain is the ability to make money in any way possible. They just care to understand the results, not the process, which is what causes them to bid for the talent that made the most money over the last year. There's no analysis of what a particular business might do to them over time.
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Yeah, maybe "talent" is the wrong word for it.
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Justin,
Concerning superbanks and Glass-Steagall, I have been posting comments on your blog for a while now and have been frustrated by the lack of response. I now realize that I have not explained myself fully and have not described what I see as the bigger big picture that is the basis for my concerns.
Why I oppose this particular bail out plan (and probably all others except for a direct yet temporary takeover of the banking industry by the government) boils down to this fact: we have to stop being a credit-based society. That's right – no more credit or credit as a much smaller percentage of our economy. To survive, we have to develop a completely new business model for the nation's economy and we need to do it now. That's why the details of the type of bail out plan that we adopt matter so greatly and why I oppose the current approach.
I have come to realize that you and others in the media view the development of “superbanks” as a stabilizing force. I think the underlying assumption of your position is that economies of scale are a stabilizing force and produce better long-term results. I say that they are a destabilizing force long term and create pernicious side effects that are exacerbated and accelerated by the fact that these economies of scale distort pricing mechanisms in the real economy. Consumers view these distorted low prices as a boon and they have come to believe these prices of real goods can be sustained indefinitely. However, I believe pursuit of economies of scale has caused cycles in which we use resources far more quickly than they can be naturally regenerated causing shortages of real resources that result in massive price spikes as all these commodities are naturally forced back to their true price points. I think the credit crisis is a manifestation of the same cycle applied to the financial industry and the crisis is the re-pricing of credit back to its true level. Getting past this crisis will require a lot more time and a whole new way of thinking about commercial transactions because we have applied economy of scale practices to every sector of every industry (and we have encouraged other nations to do so as well). Thus, if my analysis is correct, we cannot grow our way out of this because we have not only given away our true productive capacity but we have also stripped the world of resources to such an extent that price spikes for all resources are coming as a natural effect of having to recognize that all resources are more scarce than previously believed and that there are more people competing for ownership. Globally, we are all unprepared for this, but we have to accept reality to have the best chance of working through this process.
I think what illustrated this best for me was a 60 minutes report on blue fin tuna, the commercial fishing industry, and Japan. I think it's a good illustration because it demonstrates these mechanisms on a natural commodity that is measurable by objective standards and as this is not American consumer behavior, it illustrates how this is not solely a domestic cycle and why the conduct is not inherently “evil” but just produces horrific results. My argument is that this cycle applies equally to tangible resources as it does to abstract resources such as credit and money (even in our fiat currency).
This is what has happened: 1. Japan loves sushi but it has historically been expensive and so it is not available to the masses. Fish stocks remained relatively stable as the fishing industry had a more boutique, specialty look to it. 2. Japan got wealth and more people had money and wanted sushi. Thus, the fishing industry paid attention and there was "technological innovation" of the super-sized fishing boat. These fishing boats do not require the same levels of staffing as the more boutique type boats and can catch much greater numbers of tuna at a time out of a wider area, but do so much more indiscriminately. 3. Now Japan can offer sushi to a wider customer base and can supply cheap sushi to the masses because of large supplies of low-cost, low-quality tuna. The boutique fishing industry now faces new problems because its catches continue to decline in size and quality forcing smaller businesses out of the market. The large ships face similar issues but do not suffer as much because they don't have the labor and other costs. Plus, they have now decided to take smaller, low-quality tuna to large pens where the artificially fatten them up to increase their sale price.
Thus, "technological innovation" has changed the scale of blue fin tuna fishing to such a degree that the industry catch is now out pacing nature's ability to replenish tuna stocks. But, the tuna market price for consumers does not currently reflect this condition.
The tuna industry is now at the same point as our banks. To keep market price of tuna low, the large boat companies will merge to be “superboat” companies. This even larger economy of scale will produce short-term inflated profits for the new super firms. But, the superfirm phenomenon will not arrest the problem of the industry's catch size outpacing nature's ability to replenish the resource.
Additionally, I think our banks have tried the artificial-fatten-up approach that the tuna industry is applying to fish. This has had devastating effects and compounds this particular crisis. My visual example is this: Lets say these big industrial tuna farms don't know the risk of artificially fattening up tuna. The new process makes them more prone to disease and death and that this might even be infectious. The disease starts with just 1% of the fish and they try to separate out the bad fish from the good. This approach doesn't work because 1 bad fish in a pen infects and kills all the others. Now you have natural ocean fish stocks that are too small and "artificial" food stocks that are disappearing rapidly and will not only not be salable but also cannot be used to replenish other stocks. Thus, the end result is no tuna for anyone. All the money in the world can't bring the tuna back.
Leverage has caused our system to outpace our natural ability to produce valuable goods and services to support our debt load. To disguise this, the subprime mess was an attempt to fatten up borrowers to make them look credit worthy. This has resulted in our artificial borrowers making all the pens of loans infected with a deadly virus that we have exported globally. In my opinion, this has killed off the credit market and all the money in the world cannot bring it back.
Thus, the Glass-Stegal repeal did not cause this crisis but is setting the stage for the last and largest portion of this crisis because superbanks are only more stable in the short term, but they are highly dangerous in the long term. We do not have enough time to replenish our productive industry capacity in sufficient quantity to have value behind the superbanks debt load. The end result of this is not just the total destruction of credit but also the destruction of real money through continuing lower housing prices, continued stock market value losses, and huge price spikes for our most precious and most highly undervalued resources (this includes health care, oil, gold, electricity, food, etc.)
We don't just need a bailout; we need a whole new business model to adapt to the lower resource world we now inhabit and one that is no longer based on credit. What I am trying to express is not that the Glass-Steagall repeal caused the crisis, but that the repeal instead sets the stage for a collapse of a size and scale that cannot be absorbed. I really hope that you can convince me that I am totally wrong about this because thinking about this terrifies me beyond description.
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@Linda S: I can't convince you that you're totally wrong because I'm not totally sure that you are. Continental Europe has had these kind of superbanks for decades, has bailed them out occasionally, and has muddled through all right. I think there is a path to safety we could follow over the next decade where we deleverage as a nation and either break the superbanks up or treat them more and more like utility companies. But there's no guarantee that we're gonna follow it.
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@Linda: As near as I can tell, you're drawing a connection from financial capacity to production capacity to natural resource utilization. In the very long run (at least thousands of years in the future), that is almost certainly correct to some degree, but in the meantime, innovation leads to different and often more efficient use of natural resources.
For example, 50 years ago, household appliances used much more electricity, and required much greater resources to produce, than they do today. So they are more affordable, and we build many more of them, and it gives society a higher standard of living. More people become more highly educated, because they are wealthier and have more time, and the pace of innovation increases. In time the model may fall over, if only because of entropy, but I don't think you can make the case that it is right around the corner.
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Thanks, your answers make me feel better now.
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Reminds me of Warren Buffet during the Internet boom.
WB: "I don't know how any of these companies are making money, I can't in good conscience buy them."
Wall Street: "Hah! Not so smart after all are you, we're riding the wave dude!"
Year 2000: "Hey, none of these companies actually have like, revenue streams. Screw that, I'm selling 'em."
WB: "Guess I was right after all eh?"
Wall Street: "Screw you Buffet, I just discovered MBS's"
Just like the internet boom, the guys in charge weren't really sure how this was working, but they liked the results and weren't about to rock the boat.
Linda S.
I'd like your reasoning a lot better if it wasn't neo-Malthusian based. Malthus' real point was that there will be transitioning periods between different technologies and resource periods where resources are scarcer than normal and therefore there will be increased turmoil during those periods.
His point was NOT that we're going to run out of anything and he spent the rest of his life trying to explain that to people who mostly didn't listen.
I get your point on a new business model for the financial system, but I'm not nearly as convinced as you are that its needed. Look, most of these banks and firms were going along fine playing system blackjack at the casino. Then they saw one guy playing (and winning) system craps. The craps guy was making TONS more than them, it seemed kind of shady, but boy was it working out well. So they all decided to jump in. The only thing is, big wins=big risk, a lot of these jokers forgot about that and when snake eyes finally hit the table, they were wiped out.
Or you can look at it as essentially an industry-wide ponzi scheme that no one could opt out of because the pressure from stakeholders to keep the music running was too strong.
Either way, that's a structural and regulatory issue, not a blow up the world and forge radical new business models and rework the entire xxx trillion world financial system issue.
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Justin, why are you going on about this red herring? No, repealing Glass-Steagall didn't cause this.
In fact, deregulating didn't cause this. (I know, lots of people believe these things.)
*Not* regulating caused this. We needed new regulations for a new financial order. (i.e. capital/leverage requirements for CDO issuers.) We didn't get them.
That, in turn, was caused by thirty years of theological Reaganomicism.
You are the only econoblogger who has given more than a passing mention to Gramm's Commodity Futures Modernization Act. As you know, that was a regulation that made regulation illegal.
In particular, it specifically banned regulation of credit default swaps.
More in the same vein on my site:
Can we have some more from you on this failure to regulate?
Thanks,
Steve
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@Sean: You said it better than I ever could.
Interesting point about defending your business model to your stakeholders. Buffett doesn't seem to have to, because he knows what business he's in. Wall Street CEOs think their business is to make money. Ultimately, in and of itself that's not a productive use of capital.
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Oh, and Justin, on your terrifying Exporting Promises article, would love to see data on that, a pie chart or some such, in a future post.
I assume the data's here:
http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=1&area_id=3
But I don't know how to parse it.
Thanks.
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@True Conservative: Yeah, the OTC derivative thing is something I keep meaning to learn more about and write more about. And news keeps intervening. Sorry.
As for the BEA data, the current account deficit is on line 77. But you've got quarterly numbers there, not annual. Anyway, yeah, I'll try to work on making a pretty chart.
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Congressman Moss was more than a mere consumer rights advocate, he was a champion of a strong independent regulatory system consisting of agencies, such as the SEC. In his day, the SEC was the pride of the regulatory fleet.
I am sure he is rolling in his grave given the dismal performance of this agency of late.
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He was also the father of the Freedom of Information Act.
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Your argument considers why the investment banks rely on risky investments for earnings, but not how they were able to use so much leverage, which was a bigger factor in their downfall.
How and why the SEC allowed them to leverage themselves to the hilt:
http://www.nytimes.com/2008/10/03/business/03sec.html -
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I think that the issue about Gramm-Leach-Bliley is that it created regulatory competition that resulted in a race to the bottom, of sorts. The politicians were foolish to think that more institutions would come under the supervision of the Fed, the OCC, etc. Remember that GLB allowed for the idea of functional regulation, which meant that the Fed didn't necessary have oversight over all areas of a bank.
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You are right, Justin: May Day was the proximate cause. Wall Street had to figure out a way to pay for the substantial ongoing human and capital investment it made in its sales and trading operations, and proprietary trading was a small step from using firm capital to make markets.
Subsequent huge momentum plays in equity and fixed income markets provided the profit making opportunities.
http://epicureandealmaker.blogspot.com/2008/09/k-t-boundary.html
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[...] Posted by Justin Fox | Comments (0) | Permalink | Trackbacks (0) | Email This I've done a lot of bashing here of those who think the 1999 repeal of the Glass-Steagall Act separating banking from the [...]
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