A Little History to Explain a Lot of Tragedy

This bill will also, in my judgment, raise the likelihood of future massive taxpayer bailouts. It will fuel the consolidation and mergers in the banking and financial services industry at the expense of customers”. [1]

Senator Byron Dorgan

Expressing opposition to the bill that removed  Glass-Steagall restrictions in 1999

Our recent and current crisis was the worst economic downturn since the Great Depression and has been aptly named the Great Recession. Experts and talking heads have credited a wide variety of factors as causes of the crisis. But there are three key dates that actually tell much of the story. Those are 1933, when the Glass-Steagall Act (“Glass-Steagall”) was passed, 1999, when it was repealed, and 2000, when Congress effectively banned the regulation of derivatives. Sometimes, history does come darn close to repeating itself.

The 1929 Crash and Glass-Steagall

The stock market crash of 1929 was arguably the worst disruption ever of American financial markets, and it soon led to the catastrophic Great Depression, in which unemployment ballooned from 3.2% in 1929 to 25.2% in 1933.[2] The capital markets similarly floundered after the market crashed, when issuance of corporate securities shriveled from $9.4 billion in 1929 to a mere $380 million in 1933.[3]

In 1932, Congress commissioned Ferdinand Pecora to lead a thorough investigation of the 1929 crash, with the hope of providing guidance to lawmakers on what kind of legislation might avert similar outcomes in the future. One of the Pecora Commission’s key findings was that, leading up to the crisis, investment banks were precariously involved in speculative securities, effectively using the deposits of the ordinary people and businesses who were their customers. Rather than keeping depositors’ money in a vault (or at least in a safe financial instrument), banks were essentially gambling with it and keeping the profits for themselves.

The Commission concluded that the conflict “between the business of marketing securities and the business of protecting depositors’ money” was a key support for the cause of reform.[4] , which, not long afterward, led to the passage of the Glass-Steagall Act of 1933 (“Glass-Steagall”). Generally speaking, the Act restricted commercial banks (i.e. banks that take deposits and issue loans) from engaging in securities dealing as investment banks do (i.e. trading securities for profit).

Glass-Steagall was an unqualified success. From 1797 to 1933, the American banking system crashed about every 15 years. In contrast, during the first half-century after Glass-Steagall, there were barely any bank failures at all.[5] And yet despite this unprecedented financial stability, Glass-Steagall continually provoked fierce detractors who pined for access to the trillions of dollars of depositor money that was sitting in relative safety at commercial banks. In addition, these detractors jealously eyed the flood of capital flowing to banks through the Federal Reserve’s discount window and other monetary programs. At the same time, commercial banks became bored with the incremental profit margins that they could earn from traditional banking and craved the higher earnings that riskier investments offered. But, of course, it was precisely to prohibit such mixing of bank speculation and depositors’ capital that Glass-Steagall had been enacted.

Undeterred, banks kept pushing, and in the 1980s, with the advent of President Reagan’s pro-business supply-side economic policies (known as “Reaganomics”), the bankers began to get their way. Reaganomics brought widespread financial deregulation, including, perhaps most significantly, the financial lobby’s success in convincing the nation’s banking regulators to puncture Glass-Steagall with numerous loopholes and exemptions. As a result, commercial banks began engaging in riskier activities, and, not surprisingly, the late 1980s brought a sharp spike in bank failures. This trend can be seen in the chart below, which chronicles the number of bank failures since 1934, as reported by the Federal Deposit Insurance Corporation.

Source: Federal Deposit Insurance Corporation (FDIC)

This data plainly shows a long period of financial stability following Glass-Steagall’s passage, which then reverses once financial deregulation sets in. It also shows a period of “quiet before the storm” leading up to 2008, with zero recorded bank failures in 2005 and 2006.

The steady gutting of Glass-Steagall continued from the 1980s until its final death knell in 1999, which is when the Gramm-Leach-Bliley Act officially repealed Glass-Steagall, allowing investment banks and commercial banks to once again merge, pool assets, and co-mingle the monies of ordinary depositors with speculative trading operations, as in the pre-Great Depression days. Banks could (and did) return to the good old days of treating assets they held in trust for common depositors as resources available to underwrite higher yielding, riskier securities transactions, with no obligation to share the upside. The problem was that, once again, all the risk on the downside would be everyone’s problem. Freed from the regulatory shackles of Glass-Steagall, banks took risks of increasing magnitude and complexity. And just in case more cheap (virtually free) cash was needed, the Federal Reserve, under the Chairmanship of Alan Greenspan, made absolutely no effort to pushback against the growing speculative tide. Instead, the Fed fueled speculation by lending to banks at very low rates.

Deregulation, Derivatives, and Brooksley Born

Perhaps needing to shield a more sophisticated public from the degree of risk associated with its behaviors (after all, perhaps folks still remembered some of the lessons from 1929), the banks’ betting strategies increasingly relied on “financial innovations” which mainly served to conceal what they were up to.

As has been discussed in previous chapters, the concept of a mortgage changed from a relatively simple two-party contract into a multi-party apparatus involving layers upon layers of transactions, pass-through entities, and servicers. Bundles of mortgages were pooled together, forming the collateral for new “mortgage backed securities” (MBS). These, and various other instruments that “derived” their value from other financial arrangements, became known as “derivatives.” The risk associated with these and other new-fangled financial products could often be sold in the form of credit derivatives, which further shifted risk away from the original mortgage lender to unknown, distant parties.

Needless to say, the more complex the transactions grew, the more lucrative this was for the investment banks, such as Bear Stearns and Goldman Sachs, which had created them. Like the cost of any highly technical thing, banks charged higher commissions for each level of added complexity. While there is a story that bankers liked to tell about how these products grew the economy by lowering the risk of individual bad loans through their “pooling” with hundreds of other good and (even more) bad ones, a comprehensive survey of empirical economic data has revealed little evidence of such a benefit.[6]

Paul Volcker, the former head of the Federal Reserve Bank, may have expressed it best when he quipped that the most important innovation in finance over the last twenty years was actually the ATM. Volker lamented: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth—one shred of evidence.”[7] And the nation’s leading private investor, Warren Buffet, memorably labeled the new derivative instruments “weapons of mass destruction.”

Much, but not all, of the risk of derivatives came from the fact that banks had virtually no obligation to disclose how many of them they held. As a result, they were able to massively shield their financial health from their many creditors. Derivatives are typically traded off the market, in an agreement between two parties that remains known only to them. This is known as “over-the-counter trading.” These derivative trades are not on exchanges and, typically, nobody (except, just maybe, the parties) knows who owns what or how much anything is currently “worth.” In short, there is absolutely no transparency.

These off-exchange transactions began accounting for an increasing percentage of all trading done by major banks and other financial entities like AIG. Since nothing about them has to be reported, it becomes impossible to know how heavily involved a particular bank or hedge fund might be in a risky deal.

It was not just Paul Volcker and Warren Buffet who recognized the potential for systemic disaster lurking in these hidden trades. In the late 1990s, Brooksley Born was the Chairperson of a small federal agency, the Commodity Futures Trading Commission (CFTC).  She had an understanding of derivatives from her work as a lawyer in the financial world and believed that the sheer volume of derivatives trades coupled with the government’s complete ignorance of what was taking place presented a serious problem. Indeed, it lay at the heart of the unexpected 1998 collapse of the hedge fund, Long Term Capital Management.

Brooksley Born proposed that the CFTC, which regulated other derivatives, create regulations which would permit authorities to at least know what was happening and outlaw certain practices which contributed to instability. In a remarkable narrative of power overcoming good faith and reason, the story ended poorly. She was setupon by the biggest guns of the governmental financial establishment, most notably Robert Rubin and Lawrence Summers, then Secretary and Deputy Secretary of the Treasury, respectively, and Allen Greenspan, then Chairman of the Federal Reserve. Her proposal was decisively defeated.

Born resigned in June 1999. Not long afterward – and with the staunch support of the just-mentioned Clinton-era financial gurus – Congress, as if responding to a national emergency, hastily passed The Commodity Futures Modernization Act of 2000. The CFMA is a remarkable piece of pro-business legislation that virtually bans government regulators from gathering information on, investigating, or making rules pertaining to, derivatives. The law essentially mandates a complete “Hands Off” approach to these transactions despite the fact that a core principle of Wall Street free-market champions is that only with full and free information can markets ever be expected to function productively in the first place!

Indeed, only a few years later derivatives, and the inability of financial institutions to assess the risk posed by them were main contributors to the freezing of international credit markets and the resulting economic meltdown of 2008. And yet even today, the derivative market remains opaque and unregulated.

Thus, in the run up to 2008—with Glass-Steagall gone and the effort to create even a modest regulatory structure for derivatives crushed—banks were engaging in more complicated, riskier, and less transparent behavior than ever before.[8] And so, in retrospect (as understood by a very small community of economists), the crisis was not just the kind of thing that is going to happen now and again as a result of the haphazard economic forces in a capitalist society. Rather, the gutting of the Glass-Steagall Act and other deregulatory maneuvers would be equivalent to the blind mismanagement of a forest system left to grow dense fire-sensitive ground cover. We might not know just when the spark is coming, but can we really act surprised when it hits or feign shock at the extent of the catastrophe it unleashes?

Recent Attempts to Approximate the Glass-Steagall Standard

In 2010, in response to the crisis, Congress did do something: it passed the Dodd-Frank Act (Dodd-Frank) to implement some restraints on banking and financial activities. We should point out the Dodd-Frank fell far short of what many felt was needed. Nonetheless, there were useful parts to and a key provision was Section 619, commonly known as the “Volcker Rule,” named, yes, after the same former Fed Chairman, Paul Volcker, noted above.

Volcker had been one of the most prominent critics of the repeal of Glass-Steagall, perhaps because he had been around long enough to live the history we just described. Volcker began working as an economist at the Fed in 1949, led the organization during the tumultuous stagflation days of the 1970s, and, in his old age, had become a “wise-man” of sorts on Wall Street (however oxymoronic that may sound). In an uncharacteristic choice of someone outside the core community of the revolving door group of bankers-today-regulators-tomorrow, Obama brought Volcker to the White House during his first term to serve as the head of his Economic Recovery Advisory Board.

In 2009, Volcker presented Obama with a two-page white paper that outlined a modern-day version of Glass-Steagall. The proposal involved placing limits on proprietary trading (e.g, self-interested securities trading, or speculation) by regulated commercial banks. Obama actually adopted Volcker’s idea in January 2010 and christened it the “Volcker Rule.” It is vital to note that neither Glass-Steagall nor the Volcker Rule ever put limits on securities trading by traditional broker dealers or investment banks. Rather, these laws only sought to address the glaring conflict of interest recognized by Ferdinand Pecora eighty years ago: a bank that benefits from public money (whether in the form of customer deposits or Federal Reserve loans) should not be permitted to gamble with that money in the highly speculative manner characteristic of investment banks or securities traders.

By the time the Volcker Rule made its way from the President to Congress in the summer of 2010, deregulatory interests had already prevailed in riddling it with numerous loopholes and exemptions. As a result, the final version of the Rule that was passed as Section 619 of Dodd-Frank in July 2010 bore little resemblance to the simple proposal that Volcker had originally presented.  For instance, while the Rule prohibited proprietary trading by commercial banks, it permitted such banks to engage in “market-making,” which involves taking the opposite position on a customer’s securities order in order to prop up the market for that security. Unfortunately, the market-making exemption can be easily exploited, especially in cases of highly illiquid over-the-counter (OTC) securities that have no real market. For such securities, a purely speculative trade by a bank can be easily disguised as an attempt at “market-making.” The Volcker Rule’s exemption for “hedging activities” presents a similar problem.

The five federal agencies charged with implementing the Volcker Rule — the Fed, the SEC, the CFTC, the OCC, and the FDIC (the Agencies) — issued proposed regulations in October 2011, shortly after the inception of the Occupy Wall Street movement.  Under the Administrative Procedure Act (APA), any “interested party” affected by a federal agency’s proposed rule can submit a public comment to the agency, and, by law, the agency is required to consider such a comment before finalizing the rule. A significant amount of corporate lobbying exists at this level of would-be lawmaking, which, given the obligation of the Agencies to consider everything submitted to them, can pretty much drown the process in paperwork.  As recently reported in the National Magazine, the flood of such comments from the financial industry, along with the crushing flow of financial sector lawsuits the government has had to defend (at taxpayer expense) has pretty much thwarted implementation of the 2010 law.

One Occupy group, Occupy the SEC (OSEC), has recognized the inordinate lobbying pressure that was being placed on the Agencies (from banks, politicians, and even foreign countries) to gut the Volcker Rule, so it decided to fight fire with fire by submitting its own 325 pages of comments, which were submitted in February 2012. Those comments took issue with loopholes and exemptions that could be found in the proposed regulation and suggested regulatory changes that would strengthen the Volcker Rule’s containment of bank excesses. As of this writing, the Agencies have yet to issue final rules implementing Section 619, which means that banks continue to pose many of the same systemic risks that caused the 2008 crisis. In addition to submitting comments, OSEC has also brought a federal lawsuit in the Eastern District of New York against the Agencies (and also the Department of the Treasury) for their delay in finalizing the Volcker Rule. [9] That legal challenge remains pending.

If implemented in a form that is similar to the proposed version that came out in October 2011, the Volcker Rule would merely be a middling half-step towards reinstituting the sweeping safeguards that Glass-Steagall originally imposed. That is, the Rule would certainly improve the status quo because many types of overt proprietary trading would be prohibited, but it would not be the case that we have successfully re-learned the lesson of the 1929 crash and kept banks from betting widely with consumer deposits and the essentially public monies made available to them at the Fed’s discount window. Given the breadth of the Rule’s market-making, hedging, and securitization exemptions, many unsafe banking practices would still continue unabated. Of course, as noted, even the watered-down text of 2010 financial reform legislation has come to naught because of massive bank obstructionism, led by none other than Eugene Scalia, son of Supreme Court Justice Anton Scalia, and a Washington DC partner at the global law firm of Gibson, Dunn & Crutcher.  Unfortunately, we stand no better protected today than we did before the 2008 collapse.

Senator Elizabeth Warren has tried to address the Volcker Rule’s deficiencies by proposing a new version of the Glass-Steagall Act. Remarkably, Republican Senator John McCain is a co-sponsor of her bill.[10]  As of this writing, the bill seems very unlikely to pass, despite tepid support from some Wall Street veterans like Sanford “Sandy” Weill, former Chairman of Citigroup, who is widely credited as the mover-and-shaker behind the repeal of Glass-Steagall during the late 1990’s.

The nation’s financial system continues to be at risk so long as the Volcker Rule — Section 619 — is a weak substitute for Glass-Steagall and, even in that watered-down form, remains unimplemented. Unfortunately, even if the Volcker Rule eventually becomes law in a form vaguely resembling the 2010 Congress’ intent, banks will, to a considerable extent, still be able to engage in speculative trading funded by public money. Only a full return to the Glass-Steagall standard originally championed almost a century ago would appropriately safeguard the interests of depositors, average investors, and the public generally as the true intended beneficiaries of Federal Reserve lending activities. Such a return seems unlikely at this stage, which means that the 99% has yet to adequately express its indignation and outrage about the regulatory work that needs to be done to avert the next Great Recession.

[1]       James Lavin, “Many warned deregulation would cause financial crisis & taxpayer bailouts”, jameslavin.com, March 26, 2009


[2]              Steven A. Ramirez, Arbitration and Reform in Private Securities Litigation: Dealing with the Meritorious as Well as the Frivolous, 40 Wm. & Mary L. Rev. 1055, 1066 (1999).

[3]               Ibid.

[4]               Statement by Senator Frederic Walcott, 75 CONG. REC. 9904 (1932))

[5]               Interview with Elizabeth Warren, CNBC, Jul. 12, 2013, available at http://video.cnbc.com/gallery/?video=3000182337.

[6]             See W. Scott Frame & Lawrence J. White, “Empirical Studies of Financial Innovation: Lots of Talk, Little Action?”, 42 J. Econ. Lit. 1 (2004).

[7]            Interview with Satyajit Das, “The Financial Zoo: An Interview with Satyajit Das – Part I, Naked Capitalism, Sep. 7, 2011, http://www.nakedcapitalism.com/2011/09/the-financial-zoo-an-interview-with-satyajit-das-%E2%80%93-part-i.html (last visited Nov. 12, 2011) (“US financial services increased its share of value added from 2% to 6.5% but is that a reflection of your financial innovation, or just a reflection of what you’re paid?”).

[8]           Even sophisticated parties may not be aware of or fully appreciate the risks involved in their own activities. For example, Long Term Capital Management was managed by Nobel-prize winning economists and financial modeling experts, and yet it failed in epic fashion in 1998, almost taking the economy down with it. See Roger Lowenstein, “When Genius Failed: The Rise and Fall of Long-Term Capital Management(2001).

[9]              Paul McMorrow, “Occupy the SEC Takes on Big Banks on Their Own Turf”, Boston Globe, Mar. 5, 2013, available at http://www.bostonglobe.com/opinion/2013/03/05/occupy-sec-takes-big-banks-their-own-turf/xRmDFTt81dTpuP1CJzio5O/story.html

[10]               Carter Dougherty & Cheyenne Hopkins, “Warren Joins McCain to Push New Glass-Steagall Law for Banks”, Bloomberg, Jul. 12, 2013, available at http://www.bloomberg.com/news/2013-07-11/warren-joins-mccain-to-push-new-glass-steagall-bill-for-banks.html.

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3 Responses to A Little History to Explain a Lot of Tragedy

  1. Pingback: What is the Occupy Finance book? | Occupy Finance, the book by Alt Banking

  2. Pingback: The Banking System isn’t getting better — it’s getting worse. | The Universe According To Samuel Cummings

  3. Pingback: Occupy Finance, the book: announcement and fundraising (#OWS) | mathbabe

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