Many people credit deregulation as a large contributor to the 2008/2009 U.S. economic crisis. Part of this deregulation was the 1999 repeal of something called the Glass-Steagall Act, originally passed in 1933.
William Bernstein, in his book Four Pillars Of Investing, had this to say about the Glass-Steagall Act”
“The Glass-Steagall Act separated commercial and investment banking. This last statute has recently been repealed. Sooner or later, we will likely painfully relearn the reasons for its passage almost seven decades ago.”
Interestingly enough, in 1987 the Congressional Research Service prepared a report which explored the case for and against keeping the Glass-Steagall Act. One of the items in the “for” column was this statement,
“Securities activities can be risky, leading to enormous losses. Such losses could threaten the integrity of deposits. In turn, the Government insures deposits and could be required to pay large sums if depository institutions were to collapse as the result of securities losses.”
Despite the strong case for keeping the Glass-Steagall Act, the banks continued to lobby, and the Act was repealed. What happened? Surprise; the government was required to pay large sums to keep our depository institutions from collapsing.
Did the repeal of the Glass-Steagall Act have a negative effect?
Imagine, for example, you are a small bank and you lend money to people to buy homes. If the mortgages you issue meet FHA (Federal Housing Authority) standards you can sell them and you are no longer carrying the loan on your balance sheet. However, what if you want to lend money on mortgages that do not meet FHA requirements?
You can do so, but there may not be a secondary market for those loans so you know it is more likely you will carry those loans on your books. If you have to carry the loan and the risk the borrower may not pay it, then naturally you are quite concerned that the people you lend to will be able to make their payments. However as regulations change, and the lines between commercial and investment banking become blurrier, it becomes easier and easier to package up these riskier mortgages and sell them off to investors. This is called private label securitization. It is now the end investor’s problem if the borrower cannot make their mortgage payment.
As a bank that is in business to make profits, you quickly realize you can make profits by making more loans and selling them off, over and over again. You no longer carry the riskier loans on your books, so your concern for the quality of the borrower diminishes. Riskier loans are made. The goal becomes quantity over quality.
Many believe that this risk-taking culture was encouraged by the repeal of the Glass-Steagall Act, as investment banks typically had used leverage and risk, and their risk-taking culture began to overtake the more conservative nature of the commercial banks as the firewall between the two came down.
Do we ever learn?
You would think that if we had experienced an economic crisis similar to this in the past (a crisis caused by deregulation of the financial markets which leads to an excessive use of leverage (debt) to finance real estate and investment purchases, and low interest rates which encourage just such risk taking) that we would have learned invaluable lessons. Instead, across the globe, such economic crises seem to occur over and over again, all caused by a similar set of circumstances.
Now, at the end of 2009, the government is looking at adding regulations back into the financial markets. I wonder how long it will be before, once again, someone attempts to remove whatever regulations are put in place, and the next bubble begins.
For additional reading about the subprime crises and mortgage securitization check out:
