Thanks for your response and for your blog in general. Great work.

I am not a regulatory expert but having worked in the securitization industry for over 20 years, I am quite familiar with the role “commercial banks” have played in originating securities for some time.

Anyway, here is a little history of Glass-Steagall [italics mine]

http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html

Some takeaways I find interesting:

– Following the Great Crash of 1929, one of every five banks in America fails. Many people, especially politicians, see market speculation engaged in by banks during the 1920s as a cause of the crash. [we clearly haven't crashed yet but the din is getting louder now]

– In 1933, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.) introduce the historic legislation that bears their name, seeking to limit the conflicts of interest [as today] created when commercial banks are permitted to underwrite stocks or bonds. In the early part of the century, individual investors were seriously hurt by banks whose overriding interest was promoting stocks of interest and benefit to the banks, rather than to individual investors. [rapidly approaching this stage now] The new law bans commercial banks from underwriting securities, forcing banks to choose between being a simple lender or an underwriter (brokerage). The act also establishes the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthens the Federal Reserve’s control over credit.

– In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote comes after the Fed Board hears proposals from Citicorp, J.P. Morgan and Bankers Trust advocating the loosening of Glass-Steagall restrictions to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, then vice chairman of Citicorp, argues that three “outside checks” on corporate misbehavior had emerged since 1933: “a very effective” SEC; knowledgeable investors, and “very sophisticated” rating agencies. [these checks don't seem to be working anymore] Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures – a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking.

– In August 1987, Alan Greenspan — formerly a director of J.P. Morgan and a proponent of banking deregulation — becomes chairman of the Federal Reserve Board. One reason Greenspan favors greater deregulation is to help U.S. banks compete with big foreign institutions.

and so on.

Many people have blamed today’s problems on Greenspan’s Fed. I think they have the right guy, but it was not the easing of credit that is the cause of today’s systemic problems but rather the easing of regulations that is at fault.

Rich

On the bank equity, there are other phoney-baloney ways to achieve the same end, but yes, I imagine that is what the regulators will do.

There are also other ways to keep depositaries from being in the securities business, like requiring the depositary business to be segregated from the rest of the bank and hold only super safe investments (Treasuries or other full faith and credit obligations).

Just so you know, Glass Steagall was dead long before it was officially revoked in 1999. JP Morgan had become a serious force in securities underwriitng by the mid-1990s; Bankers’ Trust was one of the two top derivatives firms as of 1993; Citibank merged with Travelers, which owned Salomon Smith Barney, in 1998.

After roughly 1994, most of the meaningful barriers to a bank being in a securities business were gone. I’m not up on the regulatory issues; there were certain structural niceties they had to observe.

I don’t believe returning to Glass Steagall will solve the problems we are facing now. We now have securities firms that are too big to fail. If Goldman or Merrill went under, it would be as disruptive as, say, UBS collapsing. They too have become key parts of the financial infrastructure (and this isn’t my opinion; the April 2007 Bank of England Stability report points out that the failure of any of sixteen “large complex financial institutions” could be a systemic event).

Actually, the Clinton years (from adolescent memory) were a bit of both your comments, after the record deficits of the republican years , re Reagan and Bush senior, he managed to come up with surpluses ( a real surprise, which clinton trumpeted every chance he got) , granted that part of it was due to reasons JJJ posited. The healthcare fiasco and those prurient scandals were what spoilt an otherwise rather pretty picture. Let’s see whether the next president reinforces patterns?

anon March 9, 2008 9:23 PM

sounds like a suitably surreal play for surreal times!

Lune

Were the 80s really all that great? The predecessors of Citigroup (from the Weill days) weren’t exactly boy scouts in those days, some of the questionable debt lingered after the 87 crash to be written off later . Milken was the poster boy for a age where greed was idolized. Perhaps it’s the gloom of today that makes the 80s look that much more golden. Frankly, there were plenty of people who worked in banks who didn’t understand the business way back in the 80s, then as is now, controls and risk management are often afterthoughts which occur to blame allocators when something goes terribly wrong. When times are good, controls are those platitudes that you mouth to shareholders but are the pain in everyone’s hinny, to be ignored whereever possible, those who actively pursue or worry about potential problems are invariably labelled as party poopers. It’s just human nature, greed and the blindness it invokeswhich has caused this mess, not bank intermediation in decline nor lack of understanding of securitization. Not supporting a return to the 80s style nor the reckless rush to securitization, perhaps a middle path? Incidentally, was the 80s style of technical traders/chartists what inspired the quant methods of today?Thoughts anyone?

Thus, the only plausible solution to this mess is to reinstate Glass-Steagall and temporarily suspend minimum capital requirements to allow banks to gain compliance with the new (old) regulations. This is what I suspect will ultimately happen.

As I have said before, the problems today are not monetary, fiscal or otherwise economic in nature. They are structural and can only be solved with structural reform.

Rich

To 9:22’s comment, the FT article itself talks extensively about John Law, but yes, the headline is a tad misleading.

I don’t have access to the analyses now, but trust me, they were done YEARS before anyone was doing these complicated structured credits or credit enhancement.

The cost of bank equity and deposit insurance as part of the total cost of making a loan is sufficiently high as to make loans uncompetitive relative to plain vanilla securitization, no CDOs, no tranches, no fancy footwork.

And the securitizations done in the mid-late 1980s (some mortgage deals were tranched then but the only form of credit enhancement was overcollateralization) didn’t blow op in the 1990-1991 recession. And that was a very bad recession, lots of banks were undercapitalized and there were worries about how long it would take banks to rebuild their equity bases.

So there are ways to do these deals that don’t stick investors with toxic product. But the designers pushed it way way too far.

I don’t understand why this is so hard to accept.

That’s precisely the point: they didn’t deliver a competitive product. We now know that a AAA CDO tranche is not the same as a AAA corporate bond is not the same as a AAA muni bond is not the same as AAA treasuries. The fact that some marketing droid convinced a stupid buyer that they were all the same doesn’t mean they actually were. IMHO, even a mortgage originated and held by a bank is not the same as a basket of mortgages in an MBS. Why? Precisely because the regulations involved in orginating a mortgage make the former product a lot more reliable than the latter, plus, if the bank must hold the mortgage and therefore be on the ropes if it defaults, it will likely be of higher quality than the crap they passed through to be sold to some chump at the other end of the MBS. Regardless of whether some clueless ratings agency rated both products as AAA.

In the end, I don’t think that cost advantage you speak of was real. There’s a reason why banks must comply with all that “burdensome” regulation. Every single piece of “red tape” was put in place by someone because of some violation that occurred in the past. Throwing out that body of rules in the name of efficiency without understanding why those rules were there in the first place isn’t the type of innovation we need.

With regards to your bridge analogy: bridge building is boring. Precisely because “innovation” is viewed suspiciously until it’s been proven sound and everyone understands why it’s sound. Try selling a bridge technology to an engineer by saying “don’t worry about working through the math yourself, this guy down the street has rated it AAA; it’ll last for a 100 years. And it can be done at 50% the cost. Trust me.” That’s not a cost advantage any sane engineer would go for.

While you’re correct that it’ll be a huge upheaval to get back to the 80s model, it’s not impossible. and I think the benefits outweigh the costs/complexities.

You’re correct that a lot of money is now held by institutional investors, but part of the problem these days is that quite frankly, institutional investors are stupid and get taken for a ride by Wall St. every single time. They should not be investing in car loans, credit cards, nor mortgages unless they have special expertise. What expertise does Calpers have to evaluate whether Joe down the street is able to pay back his mortgage? It doesn’t, so it shouldn’t be allowed to invest. Leave that to the neighborhood bank.

What does that leave for institutional investors? Govt bonds, and long-term equities. Just like in the 80s. I realize that such conservative investments don’t yield much return, and part of pension funds’ forays into exotic financial products is that they’re desperate to boost their returns in order to be able to pay for skyrocketing medical costs and other rapidly increasing obligations without requiring drastic infusions of new money.

But there’s an old saying in investing: “amateurs chase returns, professionals manage risk.” Much of today’s mess is because people who don’t know how to manage risk (including some of the best and brightest in Wall St) took on products they didn’t understand in the name of higher returns. The financial markets would be a lot more stable if people who knew about auto loans bought auto loans, people who knew about credit cards bought credit card debt, and people who knew about mortgages invested in mortgages. The idea that debt is debt and everything is fungible is proving now to be very untrue.

Will this raise the cost of borrowing for those debt markets? To the extent that the dumb money is squeezed out and the only ones left are ones who know how to evaluate the products and price accordingly, yes the cost will go up. But people were buying cars, living in houses, and using credit cards back in the 80s. They will do so again, even if the spreads go back to historical norms (perhaps after a deep recession, I grant you).

In the end, I’m not necessarily arguing that banks have to be the intermediary between investors and debtors, just that the intermediation process must be easy to understand, predictable, reliable, stable, and even boring, even if that means costs go up and financial “innovation” is curtailed. In the 80s we had that (until Milken, I suppose . If we can’t go back strictly to the 80s, then at least the principles from that era need to be applied to today’s world.

Think of it another way: how could so many players in the securitization process pull out up front fees and still deliver a competitive product if it didn’t enjoy major cost advantages?

The problem is that what could have been a sound process has been badly adulterated. Bridges are valuable, but if the designers start trying to make them in the most “efficient” fashion and worry about their profits over the quality of the product, you’ll have them cutting corners on design and materials. Everything looks great until that once in every 25 year storm comes along and you have widespread bridge collapses. In essence, that’s what happened here.