Tuesday, February 5, 2008

Housing, the Credit Squeeze, and Glass-Steagall Act

The current United States economic crisis is a direct consequence of the repeal of the Glass-Steagall Act [passed as the Banking Act of 1933]. While restoring the act's provisions will not end the crisis, it would go a long way to preventing future economic near-meltdowns.

The Glass-Steagall Act was enacted in 1933 after Congress had looked into the causes of the Great Depression. It was a wise law and did much to protect the American economy until it was effectively repealed by the passage of the Gramm-Leach-Bliley Act in 1999.

Before Glass-Steagall a bank was a bank and could even be a stock brokerage house. We can categorize banks into three varieties. Retail banks mainly take deposits for checking and savings and make loans for housing, consumer items, and business needs. You can include Savings & Loans and Credit Unions in this broad category.

The second type is an investment or merchant bank. A merchant bank deals mostly with businesses and mostly lends out its own capital. It may take ownership stakes in businesses, or speculate in stocks. It may arrange for corporations to raise money by selling bonds. It do other services for fees, like arranging mergers and acquisitions.

The third type of bank is usually called a brokerage house. It might do some things a merchant bank does, but its principle business is buying and selling securities for clients for a fee. If it helps launch new stocks or bonds for companies, or speculates with its own money, it may become more of a merchant bank.

In many cases as a brokerage house or merchant bank grows it adds functions and the two categories start resembling each other. Before Glass-Steagall a banking corporation could legally function as all three types of banks, though many banks, especially smaller ones, kept to their specialties. So, for instance, a bank could take retail deposits from customers, lend money out for residential house mortgages, run an internal brokerage operation, and even originate stock and bond offerings.

There were many reasons for bank failures during the depression, and economists still argue about what made the stock market and economy collapse. The congressional committee that wrote the Banking Act of 1933 concluded that a major cause of the economic collapse that followed the stock market collapse was the blending of functions in banks. Basically, instead of taking non-business deposits and lending them out as mortgages, some banks had used those funds to speculate in the stock market in the late 1920's, or had loaned them to investors (margin loans) who speculated in stocks. When the market crashed these banks then were unable to repay their ordinary depositors. In addition Citibank's brokerage arm had advised clients to buy stocks that it knew were overpriced and at the same time shorted those stocks so as to profit from the downswing.

Glass-Steagall forced banks to chose between being what we now call a bank, an institution that takes retail deposits, and a brokerage house or merchant bank that specialized in stocks, bonds, and related activities.

In the 1990's a concerted effort was made to overturn Glass-Steagall. While the banks and brokerages pushed at Congress and the Clinton Administration, the Federal Reserve led by Alan Greenspan and other regulators looked the other way while retail banks started merchant bank activities and vice-versa. Leading the charge was Robert Rubin, U.S. Treasury Secretary from 1995 until 1999 (he was a former Goldman Sachs partner). Having done the dirty deed, he joined Citigroup and still serves as its chairman.

Citigroup has been highly involved in the mortgage-based economic meltdown of 2007. Citigroup now consists of a retail banking arm, a merchant banking arm, and a stock-brokerage arm, an insurance arm, etc. Other large banks such as Bank of America, and JPMorgan Chase, all engage in multiple activities that would be prohibited by Glass-Steagall if it were still a law.

So has does that figure into the current credit and liquidity shortage resulting from the deflating of the housing bubble?

Banks, that is retail or consumer banks, used to hold mortgages. They took in deposits and made loans including mortgages. However, back in the 20th century mortgages started to be resold. After a bank lent money to buy a house, it had less money to lend. By selling the mortgage the bank received its money back and could make another loan. When this happened a bank was acting more as a mortgage broker than in its old capacity of lending out its deposits and making a profit from the difference in interest rates.

Next came repackaging. The idea was to spread risk and allow the lenders to select a level of risk, and of return on investment, that they liked. This is also called the securitization of mortgages. Mortgage origination companies suddenly had a new economic role. They originated mortgages and made their money on the transaction fees. The mortgages were repackaged by banks, which also repackaged their own mortgages. The mortgages were blended and sliced and diced to be sold as securities. Often the end holder of the mortgage-backed security was a pension fund, a financial institution, or a wealthy individual or family trust looking for higher returns (interest) than could be gotten by buying U.S. treasuries or corporate bonds.

It all smelled so sweet while the bubble was inflating. People got houses. Rich people got high-dividend securities that were AAA rated because, after all, housing prices always go up so all that risk was more theoretical than real.

Or you could look at it this way: what appeared to be a security was actually a loan. They people who borrowed the money don't know who the lenders are and would not care about them anyway. And loans don't always get paid back.

The problem for the banking system, beyond individuals failing to make their mortgage payments, is that the very credibility of the system was endangered by combining retail and merchant banking. Many of the mortgages were made with some fraudulent misrepresentation to the buyers. At the other end banks minimized the risks involved when selling the mortgage securities to the end lenders. Citicorp and Merrill Lynch, among others, came out looking particularly stupid because they bought their own sales pitch.

Some banks lost a lot of money quickly because they had speculated in the securities they had created. They also had become dependent on the fees generated at each stage of the process.

So the banks became illiquid in 2007 and had to be bailed out by the Federal Reserve. Now we are in February 2008 and many people can't get the loans they need to buy houses, even if they have downs and good credit records. So banks that made foolish loans two years ago can't make good loans today.

Citicorp's retail operations, its banks that take in deposits, have been endangered by its merchant arm that created and held mortgage-backed securities. We are really lucky that there is federal deposit insurance to reassure depositors. If Citicorp depositors had decided to more their deposits to other banks in 2007, we might be in a Depression already today.

We need a clear firewall between retail banking and the securities market. Hopefully the current hard weather will convince people to fix this problem instead of waiting for another Great Depression.

I believe the criminal behavior that led to the passage of the Gramm-Leach-Bliley Act needs to be investigated and punished. But that is a pipedream given how corrupt America's political and economic systems have become.

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