THE GOVERNMENT OF THE UNITED STATES VS FINANCIAL REGULATION – Two Sad Stories
First Story:
We had a law on the books that might have prevented the present financial crisis if it had been left alone. The Glass Steagall Act was passed in 1933 to get us out of the great depression. It was doing okay for years until it became the victim of some unwise surgery.
In 1999, that good old Glass Steagall Act, was eviscerated when the Gramm-Leach-Bliley Act was passed by Congress. (Note well: One of the authors, Phil Gramm, had been an adviser to John McCain’s 2008 Presidential campaign, until he said that US consumers were “whiners.” President Clinton signed the Gramm-Leach-Bliley Act but if he had vetoed it, the number of votes in Congress was high enough that it was said to be veto-proof.
This change to the Glass Steagall Act allowed investment banking, insurance, and commercial banking to be mingled in firms, rather than being kept separate.
Why is this important? Investment banks help companies raise money by issuing stocks or bonds. Usually they keep some of the stock for themselves, and this stock becomes part of their capital; they also earn fees for issuing and distributing the stock. These activities can be risky especially if the stock declines in price.
Conversely, commercial (and savings & loan association banks) were prohibited under the Glass Steagall Act from the above-noted activities; they could take deposits, and lend money in many ways, especially cheap mortgages. They had to keep on hand enough money to pay out on demand. That all changed in 1999.
Insurance companies jumped into the mix. Insurance companies had a lot of money to invest, so they wanted to combine with investment banks and commercial banks.
Once the two types of banks and insurance companies could be combined, the riskiness of the investment banking activity could affect the health of the resulting institutions and their ability to pay money on demand and, even more important, their ability to continue making loans. However, there were rules, such as the net capital rule, that required maintaining a certain ratio of capital to debt, just in case.
In 2004 the Securities and Exchange Commission met for 90 minutes in April and eliminated the net capital rule for the largest banks, with over $4 trillion in assets. Examples are Bear Stearns and Lehman Brothers. The banks were supposed to monitor themselves. The SEC was supposed to oversee this but not regulate it, but they only had 7 people to do so, and after a while the unit’s chief resigned and was not replaced.
During 2005-2008 people who thought they were very smart bundled mortgage loans and “sliced and diced” them giving portions to companies that serviced the loan and creating mortgage backed securities for sale to investors, i.e., the securities were collateralized by the mortgages. However, these securities included many mortgages that were sub-prime, although they had higher interest rates on them than prime loans they were, of course, also more risky because the people had less secure jobs or were not careful or able to understand what they were signing. (Dollars & Sense “Predatory Lending story)
Second Story:
Fannie Mae was created in 1938 – the year I was born. It was a government institution created to help people keep their homes. It purchased Veterans Administration (VA) mortgage loans and Federal Home Administration (FHA) mortgage loans, which it then pooled and sold to investors in the open market. It had a goal of making housing affordable. This worked pretty well for quite some time.
In 1968, because of the Federal budget problems caused by the Vietnam War, Fannie Mae was made a semi-private Government Sponsored Enterprise (GSE). It was then allowed to purchase conventional loans originated in thrift institutions (Savings & Loans banks). When Freddie Mac began operations in 1970, it was specifically created to compete with Fannie Mae for the secondary market for the conventional loans.
In 1995, Fannie Mae began including sub-prime securities (bundles of mortgages) in its purchases; this continued with increasing encouragement until 1999. In 2000 rules were put in discouraging the inclusion of risky mortgages, but in 2004, those rules were dropped.
Call your Senators. Call your Representative. Tell them to reinstate the provisions of the Glass-Steagall Act. Then join us in the streets.
– Edith Cresmer
for the Granny Peace Brigade
Granny Peace Brigade 
This is the kind of constructive, logical thinking we need right now.
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Edith put together well-researched, thoughtful and intelligent comments. Unfortunately, their basic premise and therefore the conclusions are incorrect, in my opinion. Specifically:
* The key to this situation — and indeed to practically everything else that’s nasty, brutish, and unfortunate in the world — is to be found in Freud. I.e. Human nature, universal and eternal. What Keynes simplistically called “animal instincts†and others may call greed, the pursuit of power, and all the rest. Fight or deny it as much as you like, it’s simply there. Always has been. To sweep that under the rug because it’s ugly EXCERBATES THE SITUATION, AND MAKES DEALING WITH PROSPECTIVE SOLUTIONS DOOMED TO FAIL.
* I doubt if Edith would consider the scientist Sir Isaac Newton a crazy and stupid speculator. Guess what? He lost his shirt in the South Sea Bubble in the 18th. century. Even more interesting: he was the equivalent of the Comptroller of the Currency at the time. Even MORE interesting: he exited, then watched others make a killing, AND RE-ENTRERED.
* Not much different from those solid Dutch burghers who lost their shirts and wooden clogs in the tulipmania frenze in the 17th. century. Or the Brits and Spaniards losing their shirts right now in overleveraged overbuilding. Do you know that until a few months ago a large percentage of Polish mortgages were denominated in Japanese yen (where interest rates were much lower)?
* This is NOT an American problem alone, much as the schadenfreude babble emanating from Europe and much of the rest of the world would have us believe. Example: based on U.S. GAAP (generally accepted accounting practices) the assets of Deutsche Bank — the largest, iconic bank in Germany, normally thought of as the most solid in Germany —- total $1.35 trillion, EXCEEDING TANGIBLE EQUITY BY OVER 55 TIMES, COMPARED WITH A LEVERAGE OF 32 TIMES FOR J.P.MORGAN.
* If you seriously want to look for the culprits responsible for this mess, here’s my list:
1. Greenspan, who kept interest rates too low for too long (near-negative in real terms), thereby disincentivizing savings and encouraging risk-taking. He should have read Freud in addition to Ayn Rand
2. Bill Clinton, who pushed Congress to accommodate borrowers who should never have been borrowing in the first place
3. A corrupt Congress, who benefit hugely from pushing that agenda
4. Wall Street scum
5. The partial dismantling of regulation and supervision Edith references.
* Bottom line: HOWEVER PAINFUL — AND IT UNDOUBTEDLY IS AND WILL BE —- IT IS JUST ONE MORE EPISODE IN THE ETERNAL SAGA OF PROGRESS —– WHAT THE ECONOMIST SCHUMPETER CALLED THE GENIUS FOR CREATIVE DESTRUCTION.
Trust me, new regulations will be circumvented at some point by a new generation of whizz-kids.
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