Glass Steagall: A Protection Against Time Itself?

Are you curious about the events that sunk Bear Stearns and other financial institutions, kicking off a series of financial catastrophes that torpedoed the global economy? You might want to read William D. Cohan’s House of Cards, which occupies the #3 slot on the New York Times bestseller list for hardcover nonfiction this week. You can peruse the first nine paragraphs at no charge, courtesy of our friends at NPR; unfortunately, you’ll then need to purchase the remainder of the book if you wish to continue reading it!

Those first nine paragraphs, though, say quite a bit about the nature of Bear’s downfall … and they leave us feeling reminiscent about the good ol’ days of Glass Steagall. That particular legislation didn’t simply prevent banks from entering inappropriate lines of business; in a sense, it served to protect bank depositors and investors from the ravages of time itself.

What did Glass Steagall do? Passed into law during the heart of the Great Depression in 1933, it established the FDIC to ensure that money placed in savings accounts would remain protected. It also prohibited bank holding companies from operating investment houses, thereby compelling investment bankers at institutions such as J.P. Morgan to spin off into firms like Morgan Stanley.

The FDIC still exists, of course, but the investment banking prohibition was repealed in 1999. When President Bill Clinton signed the repeal into law, Senator Phil Gramm proclaimed “”We are here today to repeal Glass Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.”

Huh? Was Glass Steagall a law that was anti-freedom, anti-competitive, anti-growth, and anti-stability? From the post-meltdown perspective of today’s environment, a more nuanced view emerges.

Timing Is Everything

If preventing an organization from “doing whatever it wants” is anti-freedom, then Glass Steagall can certainly be considered anti-freedom. And to the extent that certain investors do face less competition when commercial banks are constrained from entering their investment space, then Glass Steagall can be considered anti-competitive as well.

But anti-growth? Citigroup took advantage of the repeal to enter the investment banking sector, and it certainly isn’t growing today. Instead, it’s shrinking its way to insolvency. And anti-stability? The financial sector is no longer looking very stable as it crashes to the earth, dragging the world economy with it.

One can only speculate what Senator Graham had in mind when he labeled Glass Steagall as anti-growth and anti-stability. Truth be told, Glass Steagall was never designed to preclude banks from operating in all other industries; it simply precluded them from entering the investment banking industry. And, as the first few paragraphs of Cohan’s House of Cards so clearly indicates, the problem that Glass Steagall addressed wasn’t one of competitive instability … it was simply one of timing.

A Time Bomb, Ticking For 30 Years …

Cohan clearly explains why firms like Lehman Brothers and Bear Stearns suddenly collapsed. Namely, for 30 years, these firms financed their operations by borrowing huge sums of money on the overnight debt markets.

The problem was that the collateral they pledged to secure their borrowings suddenly became unattractive to lenders late last year. Much of that collateral was invested in real estate mortgage securities, securities that will eventually recover in value as the real estate markets stabilize and then resume growth. But lenders in the overnight markets aren’t willing to wait years for the value of that collateral to recover. As overnight lenders, they continually demand repayment within 24 hours, and the real estate mortgage securities of Lehman and Bear will remain unmarketable for many years to come.

In a sense, Lehman and Bear faced the same problem that any homeowner would face if his mortgage banker were to demand “You’ve pledged your home as collateral to secure your mortgage. Now prove to me that you could sell your home tomorrow if I decide to call your loan for repayment tonight.” As long as the residential real estate remains healthy, that wouldn’t be a problem. But as soon as the market takes a dip, the homeowner might not be able to meet the mortgage banker’s demand, and might end up defaulting on his debt.

The Glass Steagall Solution

How did Glass Steagall address this problem? Simply enough, the law forced bankers to make a choice. If they wanted to continue to accept savings account deposits from the “man on the street,” deposits that they might need to repay in full at any time, they couldn’t invest those deposits in complex securities that might remain depressed in value for many years.

That’s why bankers like Henry S. Morgan and Harold Stanley spun off and established their own investment houses. They wanted to continue investing in securities that might remain illiquid for many years, and thus they agreed that they wouldn’t accept savings deposits from the “man on the street.” But beginning in 1999, banks no longer needed to make such decisions; instead, they were given the freedom to “do whatever they wanted” with their funds.

And now, what is the federal government’s solution to the problems that were caused by the repeal of Glass Steagall? Apparently, investment houses like Goldman Sachs and Morgan Stanley are being encouraged to convert to bank holding companies to gain access to federal bail-out funds. Such a policy arguably moves our economy even further away from the constraints that were originally established by Glass Steagall.

Is that a wise move? Time was an enemy of Lehman and Bear, and now only time will tell whether Goldman and Morgan will suffer the same fate.