GLASS-STEAGALL | Three Myths

Glass-Steagall kept speculative foxes out of the commercial-bank henhouse.

Myth #1: Glass-Steagall is too complex for ordinary voters to understand. An investment banker says: "If one percent of people actually know what Glass-Steagall did and what it would do now, it’s not more than that.”  He says the Glass-Steagall issue will not change anyone's vote.

Fact: The law was simple – that's why it worked fine for half a century.  It traded federal deposit insurance for risk-limiting bank regs. People know the 2007-2009 crisis came from deregulation.

The Glass-Steagall Act (i.e., the Banking Act) of 1933 had two main parts. House Banking Chairman Rep. Henry Steagall, Democrat of Alabama, was carrying water for the banks, which wanted deposit insurance. They got deposit insurance up to $2,500 (soon raised to $5,000) per account.

Not complicated is that the half of the Banking Act of 1933 that the banks liked – deposit insurance – is still with us. The limit to coverage of deposit insurance has steadily increased 100-fold, from the original $2,500 per depositor to $250,000 per deposit account. Depositors are allowed to have more than one covered account (sole, joint, custodian etc.). Beyond that, the FDIC for valid efficiency reasons avoids the costly litigation involved in liquidating a bank and instead negotiates takeover over its assets and liabilities by a solvent bank. This in effect means 100 percent coverage of deposits.

FDR and Treasury Secretary Woodin were initially opposed to this giveaway to the banks. They were only induced to support Federal assumption of banking risks in return for bank regulations imposed in Sen. Carter Glass's bill, which was designed to protect the Federal Reserve System he helped create in 1913. 

Myth #2: Glass-Steagall was eliminated in 1999.
Fact: Only half of Glass-Steagall was gutted, the Glass part.

The Glass-Steagall law was simple. What was complicated was the piecemeal and devious dismantling by its opponents of the Glass component of the law, in the name of "modernization".  

The deregulatory moves culminating in the 1999 Gramm-Leach-Bliley Act kept the Federal deposit insurance and took down the wall between insured banking and speculative issuance of securities.

Harvard B School Prof. David A. Moss in 2009 put it well: [T]he success of New Deal financial regulation [may have] actually contributed to its own undoing. After nearly 50 years of relative financial calm, academics and policymakers alike may have begun to take that stability for granted. Given this mindset, financial regulation looked like an unnecessary burden. It was as if, after sharply reducing deadly epidemics through public-health measures, policymakers concluded that these measures weren’t really necessary, since major epidemics were not much of a threat anymore. [My italics.]

Former Federal Reserve Chairman Alan Greenspan said in October 2008: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” Nothing too complicated about this story. 

Myth #3: Glass-Steagall was about the big banks. Hillary Clinton: "[In my proposed bill] I go after all of Wall Street, not just the big banks"
Fact: Glass-Steagall was not just about the big banks. It was about all FDIC-insured banks. It was about protecting the henhouse assets of all insured banks from foxes selling speculative securities.

Glass-Steagall was about putting a wall between the humdrum business of taking deposits from consumers and making loans back to them (the henhouse), and the risky business of speculating in business equity and debt (the foxes, or wolves).

John Reed, former Chairman of Citigroup, wrote last week in the Financial Times that he has come to the view that the wall between banks and investment banks was a good one.
"As is now clear, traditional banking attracts one kind of talent, which is entirely different from the kinds drawn towards investment banking and trading. Traditional bankers tend to be extroverts, sociable people who are focused on longer term relationships. They are, in many important respects, risk averse. Investment bankers and their traders are more short termist. They are comfortable with, and many even seek out, risk and are more focused on immediate reward. In addition, investment banking organisations tend to organise and focus on products rather than customers. This creates fundamental differences in values."

Swan Song from Floyd Norris on the Financial Foxes

Floyd Norris, Leaving NYT

Floyd Norris, the chief financial correspondent and business columnist for The New York Times, accepted a buyout and is exiting The Times today. A brief note says simply: "This is Floyd Norris's final column for The New York Times."

His departure is part of a reduction in editorial-side staffing of 100 positions, the fourth round of reductions since 2008.

His swan song, after 26 years with the newspaper and 15 years in his current position, is about the financial foxes (not his words), the people who take risks with our money and want taxpayers to bail them out when they destroy the financial system.

His opening question is: "What happens when you turn over regulatory responsibilities to people who think there is really no need for regulation?"

The question answers itself - regulation becomes lax.

In case you were wondering what specific case Norris had in mind, his column, "High & Low Finance", goes on immediately to talk about Alan Greenspan, a disciple of Ayn Rand who described himself as a "market fundamentalist" who believed "markets were far smarter than governments" and should be left alone to do their work. The term "market fundamentalist" has since the financial meltdown of 2008 become, he says, a term of derision.

Greenspan was made Chairman of the Board of Governors of the Federal Reserve System. I used to work for the Board of Governors as a financial economist when the Chairman was William McChesney ("Bill") Martin, Jr.  His most famous quote, repeated by Norris, is that the Fed's job is like that of a chaperone who orders the punch bowl removed just as the party is really warming up.

Greenspan let the punch bowl stay in place until the place was trashed.

As he surveyed the wreckage from deregulation, Paul Volcker, another former Fed Chairman, summed it up well in 2009 when he said, as Norris quotes:

The most important financial innovation that I have seen the past 20 years is the automated teller machine. 

Comment

It is sad for me to see Norris take so much knowledge with him out of The New York Times, especially since I like the thrust of his swan song.

Janet Yellen is more like Martin than Greenspan, seeing the Fed as having a big job to do not just in controlling interest rates to influence the pace of economic growth, but also - and, in her view, independently - regulate the financial system on a targeted basis to control the risks from too-big-to-fail institutions and from institutions that have been engaging in risks that are far beyond their capital adequacy to absorb.

But the regulatory system we were left with after the go-go Greenspan years is not something we can be comfortable with. During the era of weak financial regulation, the shadow banks - risk-taking sparsely regulated investment banks - were at work leveraging their capital.

This has happened before. After the crash of 1929, the Federal Reserve was paralyzed (the only person who understood what should be done, Benjamin Strong, died the previous year). Eugene Meyer, the head of the Federal Reserve System, wrote a long memo to President Hoover explaining in well-written prose why the Fed didn't have the power to do anything at all. Hoover tried to impress on FDR that the three biggest financial problems facing the country in 1933 were inflation, budget deficits (at all levels of government) and excessive government spending.

FDR wasn't much interested in financial matters and he turned it all over to his team headed by Treasury Secretary Will Woodin, a Republican business executive who came out of the railway rolling-stock manufacturing business. It is remarkable what a great job they did, restoring confidence in banks in a few weeks, performing stress tests on each bank via Treasury auditors before it was reopened (some were not), producing $2 billion in new currency notes by working the Bureau of Engraving and Printing overtime and filming the trucks going out to different cities so that the public could see in their movie theaters that cash was on the way.

Most important, in 1933 FDR's team - with Senator Carter Glass and Rep. Henry Steagall - created a Federal Deposit Insurance Corporation to insure bank deposits and, in return for this gift to the commercial banks, a system for protecting taxpayers from the risk that shadow-banking foxes might speculate with insured deposits. Amazingly, the system worked pretty well for 70 years despite the constant chipping away at the protected henhouse of insured commercial banks by the financial foxes who wanted access to insured (and therefore risk-blind and cheap) deposits.

When the market fundamentalists get to meet their makers and they ask God why She didn't warn them about the possibility of a global financial meltdown of the scale of 2008, I can imagine the reply: "What do you mean? I gave you the Savings and Loan Disaster, Long-Term Capital Management, Enron, Global Crossing, WorldCom... None so blind as will not see."

Enough "Blood on the Streets"?

How low can the market go? In 1815, Nathan Rothschild said that the time to buy stocks was "when there is blood on the streets". Are we there yet?

The Great Depression lasted a decade but the Dow industrial index fell 89 percent from its high of 381 on September 3, 1929 to its low of 41 on July 8, 1932. The economy remained sour for the rest of the decade but the stock market picked up.

For the enthralling story of what happened during those years, I recommend chapters 17-20 of Liaquat Ahamed’s timely Lords of Finance: The Bankers Who Broke the World. I had the pleasure of listening to Liaquat talk at a recent evening event in New York City. He modestly disclaimed knowledge of the financial disasters that were going to happen and simply said that the Time magazine cover showing Robert Rubin, Larry Summers and Alan Greenspan with the caption “Committee to Save the World” suggested to him the idea for his book. The title reminded him of the name given to the top bankers working on global financial problems after World War I, “The Most Exclusive Club in the World.” The book studies the origins of the Great Depression that is clearly told by taking the different perspectives of the four leading actors of the period, the Lords of Finance -- Montagu Norman in the UK, Benjamin Strong at the New York Fed, Hjalmar Schacht in Germany and Emile Moreau in France.

Yesterday’s stock-market drop brings us to a cumulative decline that can only be compared with the 1930s. Fearful of today’s jobs report, investors drove the major U.S. stock averages down 4-7 percent. Jack McHugh has tallied from StockCharts.com how far down this took the markets from their peaks.

I think we can all agree that what ails our economy and markets is worse than anything since that awful time [the Great Depression], and the worst punishment Mr. Market has meted out since the 1930’s was a drop in the S&P 500 of just less than 50% (1974 & 2002).

The cumulative drop from their peaks (October 11, 2007 so far is:
Dow Jones Industrial Average — All Time High: 14,198. March 5 - Down 53.6% to 6594.
Standard & Poor’s 500 — All Time High: 1576. March 5 - Down 56.7% to 683.
Russell 2000 — All Time High: 856.50. March 5 - Down 59.2% to 349.45.
KBW Bank Index (BKX) — All Time High: 121.16. March 5 - Down 84.3% to 18.97.

Barry Ritholtz’s blog provides this list of Blue Clip penny and under-$10 stocks:
AIG (39 cents – less than it costs to mail a letter). Citigroup (98 cents). E*Trade (66 cents). Fannie Mae (39 cents). Freddie Mac (39 cents). Unisys (37 cents). Ford ($1.83). GM ($1.83). Las Vegas Sands ($1.97). MGM ($1.99). CIT ($2). Kodak ($2.50). Bank of America ($3.15). New York Times ($4.00). News Corp ($6.15). Xerox ($4.36). International Paper ($4.22). Alcoa ($5.55). GE ($6.75). Dow Chemical ($6.56). Wells Fargo ($7.95). Dell ($8.50).

In terms of timing, the Dow peaked before FDR came to office – before he was even elected. So the fears are lingering longer than they did then.

In what ways are markets and economies possibly worse off than in 1932?
- Expectations are higher because billions of people in the developing countries who were anticipating joining the global economy are seeing their hopes dashed. The 1930s effects were severe but were concentrated on the industrialized countries. The potential for instability in some countries is great and the proliferation of weapons makes this scarier than it would have been in the 1930s.

- The size of the credit overhang is much larger. The gold standard, for all of its faults in extending the distress in the 1929-33 period, kept a lid on the growth of credit. Today’s system has no natural limit to credit growth. Credit-market exposures today exceed GDP – in the United States by 50 percent, estimates Liaquat, in the UK by four times, and in Iceland by eight times GDP.

- In the world’s second-largest economy, Japan, the stock market has fallen 81 percent from its peak at the end of 1989. This 20-year decline raises questions about how quickly the world's current mess can be cleaned up.

FINANCIAL CRISIS | Missing Minsky

Dec. 27, 2008–Martin Wolf, at FT.com, wrote on December 24 that Keynes offers us the best way to think about the financial crisis:

We are all Keynesians now. When Barack Obama takes office he will propose a gigantic fiscal stimulus package. Such packages are being offered by many other governments. Even Germany is being dragged, kicking and screaming, into this race. The ghost of John Maynard Keynes, the father of macroeconomics, has returned [and] that of his most interesting disciple, Hyman Minsky.

Hyman Minsky

I first heard Hy Minsky talk in the 1960s. His main message was:

1. Financial systems have a built-in tendency to euphoria. The financial market does not tend toward stability. The opposite is true. Bankers and other financial actors borrow more and more heavily, making the system increasingly vulnerable to panic. Lenders start after a scare by being conservative, hedging their bets. But eventually confidence returns and speculation takes hold again. Then investors get to the Ponzi phase – manic use of credit, a euphoria or bubble.

2. The credit cycle tends to manic, but ends with panic. The Ponzi phase continues until some investors exit with their profits, or the central bank raises interest rates to reduce investor euphoria, and then a financial institution runs into difficulty. The failure causes a bankers' panic. Turning points in the five stages of the cycle are called “Minsky moments”.

3. The system tends to instability and must be regulated. Fashions in monetary theory have moved from a belief that Keynesian sophisticates could “fine-tune” the economy, to fear that the Fed had lost control of the ability to contain inflation, to a belief that markets work best with minimal interference. Hy rejected all these ideas, preaching consistently about the need for regulation and the importance of leaning against the excesses of what Keynes called the animal spirits of investors.

Born in Chicago, Hy taught at Brown, Berkeley and Washington University (St. Louis). He died 12 years ago in Rhinebeck, 77 years old, near Bard College’s Levy Institute, which has a special interest in business cycles and treated Hy as a star in his last six years. Hy didn’t live to see how closely this year’s meltdowns would follow his predicted scenario, with the Lehman failure being one of several clear Minsky moments.

Former Fed Governor Laurence Meyer, who spoke in New York City last week, has said of Minsky: “few have influenced my thinking about economics more than Hy.” If Hy had been listened to, we would have seen less permissiveness, fewer NINJA (No Income, No Job nor Assets) mortgage loans and more aggressive Federal Reserve and SEC oversight over highly leveraged instruments and institutions.

Fed Chairman Alan Greenspan and then-Governor Ben Bernanke were anxious not to “pop the bubble” because (citing the Milton Friedman-Anna Schwartz history) that’s the mistake the Fed made in 1928 - after the guy who knew what he was doing, FRBNY chief Benjamin Strong, died of TB. The Fed was concerned not to stifle financial innovation, arguing that it is ready with new weapons in the event of an asset-destroying credit freeze.

This last theory is now being tested. The stakes are high, beyond an academic debate. Whatever side one takes, any sensible person should be rooting for the outgoing and incoming Fed-Treasury teams to succeed in restoring confidence and the flow of credit.

Time for Reform of Financial Regulation

After the meltdown of the savings and loan industry in the 1980s, the Federal Home Loan Bank Board was ended and the Office of Thrift Supervision was put in its place in 1989 to end mortgage chicanery once and for all. With Meltdown II originating in the subprime loan business, it is clear that the 1989 reform was inadequate. Risks were mispriced, mortgage lenders were out of control and the effects are being felt with foreclosures and financial losses in every community in America.
A December 27 Wall Street Journal article, Wall Street Wizardry, showed how subprime mortgage loans were repackaged and resold at prices that did not reflect their risk, using the example of Norma to show a "hairball of risk".
It's no surprise that Wall Street was able to engage in such practices because the financial regulatory system is a hairball of its own. The Comptroller of the Currency, Federal Reserve, the Federal Deposit Insurance Corporation and 50 state bank regulators share with the Office of Thrift Supervision and the SEC the responsibility for overseeing financial institutions and their innovations. Bankers prefer multiple regulators because they can then shop among them for the one they like best. The idea of a super-regulator "sends chills down the spine" of bankers, says a 2003 memo prepared for the FDIC, which observes that calls for consolidation of bank regulation are "nothing new" and argues for competition among regulators.
However, the outcome of the existing system has been the subprime meltdown, which has also sent chills down the spine of bankers, with more chills and spines to come.
One problem is that bank supervision is not a priority for the top management of the Federal Reserve System, which clusters around the FOMC and the federal funds rate like moths around a flame. An article by Gretchen Morgenson of the NY Times describes Fed Chairman Alan Greenspan's meeting with two representatives of the 15-year-old Greenlining Institute, who expressed concern about the lack of oversight over subprime mortgage lending practices. Greenspan is reported as not being interested because he did not wish to interfere with financial innovation.
To be fair to Mr. Greenspan, he and his colleagues have had other things to worry about besides bank supervision. The Fed was originally created in 1913 to maintain orderly financial markets and maintain the value of the dollar. In 1946 it was given the additional task of ensuring full employment. These multiple tasks conflict. How does one tackle a threatened debt-induced recession in 2008 when oil hits $100 a barrel and commodity prices generally are rising along with global growth? If orderly markets require continued infusion of liquidity, how does one battle inflation? What is the long-run impact on the Fed's ability to control inflation of perennial budget deficits?
The problem with the lack of oversight over the Wall Street wizards is that when their innovations blow up, the taxpayer histroically picks up the pieces, and the breakdown in financial markets poses problems for monetary policy.
When President Bush addressed the hairball of multiple agencies involved in homeland security, he consolidated the agencies under one leadership. We have a problem now with financial security. The subprime crisis is worse than the savings and loan mess. As subprime losses are revealed in other countries, it can't be good for the future of Wall Street as a global competitor.
The agency best equipped to assess and charge for financial risk is the FDIC. Washington legislators should hold hearings about possibilities for consolidating financial regulatory functions under the FDIC, which can price risk and assess insured institutions a deposit insurance premium based on this risk. This would encourage market-based incentives to disclose and control risks.