Reforming Two Decisions That Led To The Recession

While many decisions made over a number of decades created the circumstances that led to the worst recession since the Great Depression, certain government actions were particularly devastating to the US and world economies. Embodied in the Gramm-Leach-Bliley Act (also known as the Financial Services Modernization Act of 1999), the law made two important changes to the securities regulations enacted in response to the Great Depression.

First, Gramm-Leach-Bliley repealed a section of the Glass-Steagall Act (the Banking Act of 1933) that prevented a bank holding company from owning any combination of commercial bank, investment bank, or insurance company. Essentially, if an institution wished to make loans to individuals and businesses, and provide deposit accounts (checking and savings accounts), it could not provide services typically associated with the stock and bond markets or insurance. This meant that wholly separate institutions were necessary if a company wished to issue stocks, sell bonds, or create other complex financial instruments such as mortgage-backed securities1.

The separation demanded by Glass-Steagall was meant to protect commercial banks’ assets (primarily, its customers’ deposits) from the risks associated with non-banking activities. Removing this provision allowed Citicorp (a commercial bank) to finalize its merger with Travelers Companies (an insurer), which had previously been permitted only through a temporary waiver (though the merger would later fail for unrelated reasons). Chase Manhattan (a commercial bank) was also able to buy JP Morgan & Company (an investment bank) to become JP Morgan Chase & Company. While the latter of these mergers did not substantially imperil the overall economy, the former did and necessitated government intervention to survive.

The second significant change enacted by Gramm-Leach-Bliley shielded a specific type of security, known as a swap, from any form of regulation. The Securities and Exchange Commission was barred from requiring that swaps be registered with it (as stocks and many bonds are), and the Commission could not enact any regulations that would mitigate fraud or insider trading related to swap agreements. It is, perhaps, this provision of Gramm-Leach-Bliley that proved most dangerous to the overall economy.

By barring regulation of swaps, American International Group (AIG) was able to sell credit default swaps (a type of insurance to protect against a company’s bankruptcy or a security’s collapse) to any interested party, without regard to whether or not the insurer had sufficient assets to cover losses should an insured party become insolvent. Such an arrangement is akin to buying homeowner’s insurance from a company that won’t be able to make payment when the insured property burns down. As a result, when companies and insured securities began to fail at the height of the economic crisis, the US government was forced to lend billions of dollars to AIG to prevent its collapse.

While regulation of swaps and other types of derivatives2 is part of the financial reform package Congress is developing, reinstating portions of Glass-Steagall has only recently entered the reform discussions. In a December 16, 2009 interview with CNBC, Arizona Republican Senator John McCain discussed creating a “firewall between commercial banks and investment banks.” His proposal, co-sponsered by Washington State Democrat Senator Maria Cantwell, would protect taxpayer dollars by forcing risky investment-banking-type activities to be conducted in a separate legal entity that is neither eligible for government bailout nor protected by deposit insurance such as that offered by the Federal Deposit Insurance Corporation (FDIC). The proposal’s feasibility, however, is unclear given the consolidation seen in the financial sector since the current crisis began. Below is Senator McCain’s complete interview with CNBC.

Unfortunately, Senator McCain’s proposal is not being considered for inclusion in the current financial reform package the Senate Banking, Housing, & Urban Development Committee is preparing. As a result, any such proposal likely would not be considered or enacted until 2011 at the earliest given the midterm Congressional elections that will consume the second half of 2010. As Joshua Rosner, managing director at Graham Fisher & Company, noted in the following interview with Bloomberg Television, reenacting Glass-Steagall “[is] the right thing to do…[but] no one’s gonna want to do anything…” heading into the midterm election cycle.

Election notwithstanding, as Mr. Rosner and Newsweek’s Michael Hirsh both identified, opposition to the proposal is strong and its implementation is fraught with difficult issues. A Glass-Steagall-like act could, without providing a waiver mechanism, pose significant difficulties for companies such as Bank of America, which purchased Merrill Lynch at the government’s urging, and JP Morgan Chase, whose merger occurred after Gramm-Leach-Bliley was enacted. Both companies would, presumably, be forced to create wholly-separate entities to conduct any non-commercial-banking operations, at least in the United States. Acting unilaterally in such a sweeping reform involving global financial institutions only further reduces the likelihood of such reform. But, considering the government lent Bank of America $20 billion to complete its acquisition of Merrill Lynch while JP Morgan Chase received $25 billion in TARP funds, such a separation seems wise to protect US taxpayers and avoid future crises.

  1. Mortgage-backed security: a group of mortgages divided into something akin to a mutual fund.
  2. A derivative is any item whose value is based on that of another item. The most common example is an interest-rate swap, whose value is derived from an external interest rate, such as the federal funds rate or the interest rate on a loan.