ADVERTISER DISCLOSURE

Glass-Steagall 2.0: The Past, Present and Future of Financial Regulations

You can trust that we maintain strict editorial integrity in our writing and assessments; however, we may receive compensation when you click on links to products from our partners. Here's how we make money.

During campaign season, you may have heard congressional candidates like now-Senator Elizabeth Warren harp on something called the Glass-Steagall Act. More than a decade after its repeal, Glass-Steagall is in vogue again because of the obvious analogues between last decade’s recession and the Great Depression. For those politicians and journalists who invoke its name, the Act is a symbol of financial regulation and safe investments.

Are the comparisons appropriate? Well, like any analysis of the recession, the answer is absurdly complicated.

Glass-Steagall and the Great Depression: a history

To begin, let’s look at what happened before the Depression, with the help of a professor and legal scholar at Florida International University, Jerry W. Markham. In his paper, “The Subprime Crisis–A Test Match For the Bankers,” Markham wrote the following: “In 1930, the Bank of the United States failed, reportedly because of activities of its security affiliates that created artificial conditions in the market.”

Let’s break that down into plain English.

The securities he mentions are often comprised of either debt or equity. In both, one party has a stake in cash that hasn’t yet been realized. Debt can be a CD or government bond: you make an investment in the federal government, the government owes you money and, finally, once that financial instrument matures, the government returns the dividends to you. Similarly, equity is ownership interest in a corporation, like a stock.

Securities underwriting is then the process by which an investment bank will buy those securities for resale to the public.

Essentially, underwriters, including Great-Depression-era banks, were selling cash that didn’t yet exist, with the expectation that business would continue to boom. Of course, it didn’t. The market crashed, and, in response, Congress passed the Glass-Steagall Act in 1933.

The Act, among other things, built a wall—a porous one, that is—between commercial banks and investment banks, so that neither could gamble with the average banker’s finances. Commercial banks weren’t allowed to sell securities, and investment banks couldn’t accept deposits.

The recession: evidence for re-regulation?

For some, then, it seems prudent to re-implement the Act in order to curb risk. The answer, again, isn’t nearly as simple.

No doubt, Glass-Steagall was well intended: in separating commercial banks from investment banks, it tried to prevent an economic downturn like the Great Depression that preceded it.

Yet Glass-Steagall didn’t do much to prevent the last few decades of risky investments.

Among the perpetrators: CDOs and CMOs. Both are debts that are sold as assets. CMOs are backed specifically by mortgages, and, in the years before the recession, the worst of them were made up of securitized subprime mortgages. When interest rates skyrocketed, so did the number of defaults, and CMOs and CDOs became practically worthless.

Again, in plain English: CDOs, or collateralized debt obligations, and CMOs, or collateralized mortgage obligations, are complex financial instruments sold to investors.

For example, in the secondary mortgage market, a bank will take one loan—a mortgage—securitize it—or buy it—packages these loans together and then puts them up for sale, as investments. The resulting CDOs and CMOs are sold to investors in slices, or “tranches.” A credit agency rates the risk on those slices, and the higher-risk tranches yield higher profits.

The subprime loans that comprised some of these financial instruments, however, were made without documentation of a borrower’s creditworthiness. Brokers didn’t care about credit quality because the loans were then immediately securitized in a pool that was sold off to investors.

“This all worked fine, until property stopped appreciating at double-digit rates. Defaults began to happen, the MBS,” or mortgage-backed securities, “and derivatives started to tank,” said Joe Parsons, a loan originator in the San Francisco Bay Area.

Brokers and lenders—at the least the ones who successfully passed off those risky loans—wiped their hands clean, while, on either side of them, investors and borrowers were hit hard.

Because of that disastrous intermingling of over-ambitious investors and bad-credit consumers, some politicians are calling for the re-implementation of Glass-Steagall. They want to refortify the walls between investment and commercial banks.

Glass-Steagall’s slow death

Yet it’s clear that Glass-Steagall wasn’t terribly effective. Any power it had was slowly stripped away in the decades after the Depression and in the years before the Act’s repeal in 1999.

In 1982, Congress allowed banks to enter the secondary mortgage market.

In 1984, Congress loosened legal restrictions even further. Private issuers of mortgage securities were better able to compete with similar government agencies, like Fannie and Freddie.

In 1977, the Community Reinvestment Act made it easier to offer subprime loans, specifically in areas where subprime borrowers lived—areas where banks had previously been hesitant to make mortgage loans. These borrowers also happened to be people of color. The Act’s intentions were therefore altruistic, in the name of racial equality, but it helped the number of subprime loans skyrocket: the CRA led to an 80% spike in subprime loans, according to Markham.

In 1986, the Board of the Federal Reserve reinterpreted and loosened up Glass-Steagall. In particular, they targeted the vague language that stated commercial banks couldn’t “engage principally” in investment banks. The Fed thus stipulated that commercial banks could in fact earn up to 5% of their gross revenues in investment banking, or non-financial revenue. Banks could then handle commercial paper, municipal bonds, and mortgage-backed securities: the everyday person’s finances were free to be sold as investments.

In 1999, Glass-Steagall was dealt a fatal blow by the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act. And so, commercial banks, investment banks, security companies and insurance companies were allowed to consolidate. In other words, they were allowed to pool their resources and were free to invest as they chose. The theory was that looser regulation would allow American banks to compete with foreign banks.

All of these decisions were made in an age before the dot-com bubble burst and before 9/11. In short, the sky was the limit. Claims that Glass-Steagall could’ve saved this economy are altruistic, maybe, but a little reductive—it’s clear that these arguments are a little off the mark.

There is already a pseudo-successor to Glass-Steagall, but the federal government hasn’t implemented or even finished drafting it yet. It’s called the Volcker Rule, a part of Dodd-Frank, and it prohibits banks from investing with insured deposits. Yet trading insured deposits is one of banks’ most profitable activities.

The Volcker Rule, again, like Glass-Steagall, is well intended, but what we really need is balance. Glass-Steagall 2.0 would weigh too heavily on safe lending at the expense of lucrative investments, a reality I hope legislators will keep in mind as they decide on Volcker.

  • Margaret Fairchild

    Who paid you to write this garbage? Alan Greenspan? George Soros? Jamie Dimon? Glass Steagall was totally effective until Greenspan and Sandy Weill systematically eroded it, and then killed it with Gramm-Leach-Bliley. And even Sandy Weill recently had the brains to call for the reinstatement of Glass Steagall-he knows we’re heading for a hyper-inflationary blowout with it. The only reason anyone would promote the impotent Dodd Frank and Volcker Rule, and oppose Glass Steagall, is because they want to prop up a bankrupt financial system which can never be saved. This is being done through bailouts (Bernanke calls it “Quantitative Easing”) which are destroying the lives of millions of Americans and destroying the country!
    How can we threaten to cut Social Security and Medicare and lay off a million Defense Dept workers, while we’re pumping billions into buying worthless MBS’s to bail out the gambling debts of billionaire banksters?
    Glass Steagall would end the bailouts and bankrupt the criminals who caused this mess-and enable us to restore a credit system that could fuel a real recovery-invest credit in infrastructure and productive jobs, not bailouts!

    • http://www.facebook.com/joe.parsons3 Joe Parsons

      Ms. Fairchild, may I suggest you do some research before throwing stones? While it’s true G-S had been somewhat watered down prior to 1999, its ultimate repeal through Gramm-Leach-Bliley was not what caused the market to self-destruct. It was the combination of GLB and some later legislation, the Commodity Futures Modernization Act (also written by Sen. Gramm, R-TX) that enabled the crisis to happen. It was CFMA that allowed the unregulated trading of financial derivatives line CDOs, leading to the crisis.

      With respect to Quantitative Easing (now in its third iteration), you would do well to learn what that process actually is. It is not a “bailout” as you incorrectly assert; it is the direct purchase of government securities and mortgage securities by the Federal Reserve to support a market price. In the case of QE3, the Fed has been purchasing MBS at the rate of up to $60 billion per month, thereby supporting their price. As the price of MBS rises, the individual mortgages that comprise them will carry a lower rate for the borrower.

      The MBS purchased by the Fed are anything but worthless; as underwriting sanity has returned, the underlying mortgages that have been purchased or guaranteed by Fannie Mae and Freddie Mac have a far better prognosis than the earlier generation of undocumented subprime loans.

      Joe Parsons
      PFS Funding

      Dublin, CA

  • macwhirr

    Like she said. Glass-Steagall doesn’t prevent greed-driven stupidity, it just stops the government from rewarding and perpetuating it.

    • Margaret Fairchild

      I also stops the greedy stupid speculators from gambling with other people’s money!

  • Pingback: Sandy Hook is Just the Tip of the Gun Control Iceberg | Why I Hate The Joneses

  • Pingback: New clients: PFS Funding and Palm Palace | Socially Networked Detroit