The Press and Glass-Steagall: A Truth Half-told

A lot of Googling of the phrase "Glass-Steagall" has been going on across the country, following the Democratic debate. We at Better Banking Law welcome this and see it as a tremendous potential benefit to American taxpayers going forward. Unfortunately, the press is often half informing readers on just what Glass-Steagall was and is. And I intentionally said “is” as well as “was” because, though that section of the Banking Act of 1933 (AKA Glass-Steagall) that separated investment banking from commercial banking was repealed by Congress in 1999, the other section, which created Federal Deposit Insurance for commercial banks is still very much intact. And of course FDIC insurance is what assures depositors that: (1) their money will be safe; and (2) their financial transactions will go through. This is why Congress voted to bailout the commercial banks in 2008, after such banks incurred tremendous losses from underwriting mortgage-backed securities.

Neil Irwin's recent New York Times article titled "What Is Glass-Steagall? The 82-Year-Old Banking Law That Stirred the Debate" failed to even once mention Federal Deposit Insurance (FDIC) in his comprehensive piece. It’s hard to believe that had Federally insured commercial banks not been allowed to underwrite such securities that it would ever have been necessary for US taxpayers to bail them out at all.

Assuming only investment bankers could have underwritten such securities, the losses incurred throughout the financial system would have been far less and it is inconceivable that Congress would have bailed such investment bankers out. After all, Lehman Brothers was permitted to go bankrupt in 2008 and hundreds of investment banks had gone bankrupt or forced into mergers over the years. A prime example a generation ago was when Drexel Burnham, the then leading underwriter of high yield bonds, went bankrupt and the financial system hardly shrugged. 

The crux of what you need to know about Glass-Steagall can be found in our Legislation 101 series here.

A Response to William D. Cohan's July 30th NYT Dealbook piece

The post I write today is a response to William D. Cohan's July 30th New York Times Dealbook piece:

I am mystified as to why Mr. Cohan is so vehement in opposing the reenactment of those sections of The Banking Act of 1933 (Glass-Steagall) that separated investment banking and commercial banking. As he is well aware, the sections of that Act that created Federal Deposit Insurance are still very much intact. I say mystified because William D. Cohan has written some excellent books and thoughtful articles on American business and finance. The arguments he raises in this article are not consistent with his former work. 

While on the subject of mystification, why on Earth should “the idea of separating investment banks from commercial banks is again the rage” be mystifying to Mr. Cohan? After all, as he also stated in his opening paragraph, this was “the law of the land for more than 60 years.” During that period there were few bank failures and these were dealt with by the FDIC, not the taxpayers. Not surprisingly, since it’s a risky business, a large number of investment bank failures occurred during that period, resulting in either bankruptcy or merger with a stronger firm. In neither case, however, did these failures affect the financial health of the nation. Therefore, why should it be at all mystifying that members of Congress and most citizens/taxpayers would like to return to such a relatively benign financial environment?

In his next six paragraphs, Mr. Cohan's piece constitutes a reasonable and thoughtful report on the current status of the bipartisan Senatorial bill to re-enact these critical sections of Glass-Steagall. The sponsors are two Democrats - Elizabeth Warren and Maria Cantwell, one Republican - John McCain, and an Independent - Angus King. My only objection here is his statement that the reason the bill was not adopted in the 113th Congress was “because it was a bad idea.” He gives no support for such a conclusion. In fact, based on the sponsoring Senators’ quotes that he cites, most readers would conclude that it is a fine idea. For example, he quotes Senator McCain as follows: “Big Wall Street institutions should be free to engage in transactions with significant risk, but not with federally insured deposits.” On what basis should that not be a true statement on which virtually all Americans can agree and think a very good idea?

Unfortunately, in paragraph seven, Mr. Cohan makes an inaccurate assertion when he states “the fact that commercial banks are in the investment banking business and investment banks are in the commercial banking business had almost nothing to do with causing the financial crisis of 2008.” In the next paragraph he compounds that faulty assertion by blaming “primarily pure investment banks” (and he names four of them) which had “generally gone hogwild in the manufacture and sale of mortgage-backed securities.”  Certainly the pure investment banks were equal opportunity offenders, but no more so than the commercial banks.  

Please observe the table on the left from the Wall Street Journal. It lists the top 10 CDO underwriters in 2007, the year before the financial crisis. Note that commercial banks, domestic and foreign, are ranked as #1,3,4,5, 6 and 8, whereas pure investment banks are #2, 7, 9 and 10. Further note that Bank of America did not make the top 10, but neither did Bear Stearns.

Citigroup, as pointed out by Mr. Cohan, was certainly the worst offender among the commercial banks “in large part because of the behavior of its investment bankers” but, as shown in the table, definitely not as he states “the glaring exception.” However, even if it were the exception, how can our nation again justify bailing out Citigroup for its investment banking and underwriting speculation? In August of 2012 Citigroup settled with its stockholders for $590 million because it misled them. Apparently, according to the New York Times, “Citigroup represented that subprime exposure in its investment banking unit was $13 billion or less, when in fact it was more than $50 billion.” Had the bank not been permitted to underwrite securities how on Earth would it ever have accumulated even $1 billion of these toxic assets in inventory, let alone $13 billion, or God forbid, more than $50 billion. 

In his paragraph 11, Mr. Cohan eludes to JP Morgan Chase’s “rescue” of Bear Stearns.  Having written House of Cards, a history of the last days of Bear Stearns, this statement is surprising. He surely must know that, while JP Morgan invested $1.2 billion in its acquisition of Bear and agreed to absorb any losses on the first $1 billion of $30 billion of Bear’s riskiest assets, the Federal Reserve guaranteed the remaining$29 billion of those assets.

It’s interesting to note that 18 years earlier, the Securities Industry Association requested that, should commercial banks ever be permitted to also become investment banks, then pure investment banks, based on simple fairness, should have access to the Fed window in times of financial crisis - just as their commercial banking competitors did and do. After all, when your main source of financing is your commercial bank, which is also your fierce investment banking competitor, that bank may not always take your calls during a financial crisis regardless of the quality of the collateral you offer.  We shall never know, had that request to access the Fed window been accepted, whether the fates of Bear Stearns, Merrill Lynch and even Lehman might have been different. We do know for certain, however, that in the fall of 2008 Citigroup received, in addition to access to the Fed window and other substantial federal benefits, a $45 billion taxpayer funded bailout.  Today, Citigroup is still very much with us while those three pure investment banks are history.

The following is Mr. Cohan’s final paragraph:

While I disagree with the first sentence above, I certainly agree with the next four. However, I take great issue with his final sentence. With respect to the initial phrase of that sentence, he gives no suggestion as to how he would change the culture of Wall Street unless he plans to either: (i) change human nature; and/or (ii) convert all the gigantic publicly owned commercial bank corporations into privately owned partnerships. Both changes are near impossible.

With respect to its final phrase, WOW! That “outdated, cockamamie notion” kept America’s financial system safe and sound for over 60 years. How can preventing Federally insured banks from speculating with Federally insured deposits be considered outdated and cockamamie? For capitalism to function, failure as well as success must be allowed to occur. How can it be capitalism when we once again privatize gains and socialize losses? Why were all the lenders to failing commercial banks made whole in 2008, thus perpetuating moral hazard? If commercial banks want to speculate with minimal regulation, they should change their charters, give up FDIC insurance and become truly private banks. However, if they choose to remain Federally insured banks, they must stop speculating with Uncle Sam’s money. America must protect its taxpayers.