Since Clinton and her operatives have become aggressive in trying to discredit Bernie Sanders on issues where he both has a better track record and better proposals, it’s time for a wee reality check, in this case, on Sanders’ financial reform package.

There’s a lot to like, for instance his insistence that executives be prosecuted for serious misconduct and his backing of a Post Office Bank. There are also some things that need to be reworked, like his usury ceiling proposal. Classical economists like Adam Smith were keen supporters of usury ceilings because they could see the consequences of letting lenders charge whatever interest rate they could get. Creditors targeted wealthy gamblers first and foremost, and the rates they were willing to pay was punitively high compared to what productive enterprises could support. Thus Smith and his colleagues saw usury limits as key to forcing lenders to find the best targets at a reasonable rate of interest, rather than search out the most reckless, who tended also not to be socially beneficial users of funds either. The failing with the Sanders proposal is that he sets as fixed limit of 15.9%; it should be set in relationship to prevailing interest rates, as well as the length of the loan.

Larry Summers, acting as a proxy for Team Clinton, took a swipe at the Sanders’ views in a Washington Post op-ed at year end. Admittedly this was a case of dueling op-eds; Summers was responding to a Sanders article in the New York Times which outlined his reform priorities.

However, one of Summers arguments, and one that Clinton has taken up now that Sanders has set forth his plan in more detail, is that Sanders’ “Glass Steagall” reform idea is all wet.

Clinton has brazenly mischaracterized Sanders’ proposal. She makes it sound as if it is a straight-up revival of the 1933 law, and asserts that it misses “shadow banking” and her reform proposals are much better on that front. We’ll discuss this issue in greater detail in a later post. The short version is that Sanders did not propose restoring the original Glass Steagall. He intends to implement the bill devised by former FDIC chairman Tom Hoenig and Elizabeth Warren which is informally described as the 21st century Glass Steagall Act. And yes, sports fans, it includes provisions to curb shadow banking.

Summers made the same mischaracterization, but took another angle of attack: Glass Steagall had nothing to do with the crisis, ergo restoring it wouldn’t stop future crises.

This line of argument is also bogus, but because most members of the public don’t understand how Glass Steagall contributed to the crisis, they make arguments that can easily be swatted down. So let’s give a little history so that you can better appreciate how Summers distorts the record, and then we’ll turn to his argument, such as it is.

How Glass Steagall Was Dismantled

Too many commentators focus on the formal repeal of Glass Steagall in 1999, as if that were a meaningful event. In fact, by then Glass Steagall was a dead letter. The only reason for dismantling it was to allow for the merger of Citigroup and Travelers.

By then, US banks were allowed to do a great deal of investment banking business through subsidiaries, which were subject to revenues as a percent of total revenue limits that were seen as a nuisance rather than a constraint (as in a bank could book high revenue, low profit trading activities that had always been permissible to engage in, like foreign exchange and Treasuries, so that the non-investment banking operations would show high enough revenues as to not be a hindrance).

It took well over a decade to get to this point. The then-Citibank had been pushing to get into investment banking since the early 1980s, and JP Morgan soon joined them. One could argue that Mike Milken did an Uber-like end run of Glass Steagall, since he famously, and illegally, controlled the investing of the capitve, um cooperative savings and loans in his network. Milken cronies would all be directed to raise more money than they needed through Drexel, typically 15% more. They were then expected to invest the excess funds in new Milken deals. In the case of the savings and loans, they were faxed a sheet at the end of the day telling them what they owned. Milken was effectively trading on their behalf.

But Glass Steagall was undeniably breached by 1990. Commercial bank Credit Suisse acquired a 44% stake in First Boston in 1988, and obtained control in 1990. And First Boston was no small fry. It was one of five “bulge bracket” investment banks and with Salomon Brothers, one of the two biggest bond dealers. As Wikipedia drily notes:

In 1989, the junk bond market collapsed, leaving First Boston unable to redeem hundreds of millions it had lent for the leveraged buyout of Ohio Mattress Company, maker of Sealy mattresses, a deal that became known as “the burning bed”.* Credit Suisse bailed them out and acquired a controlling stake in 1990. Although such an arrangement was arguably illegal under the Glass–Steagall Act, the Federal Reserve, the U.S. bank regulator, concluded that the integrity of the financial markets was better served by avoiding the bankruptcy of a significant investment bank like First Boston even though it meant a de facto merger of a commercial bank with an investment bank.

Astute readers will note it as as failed LBO deal that led to this precedent.

Mind you, other banks didn’t get such big waivers quickly. But over the next few years, Glass Steagall was shot full of holes. Banking regulators accepted the premise that McKinsey was pushing at the time: traditional banks were facing a profit squeeze, hence they needed to be allowed to pursue higher margin activities like investment banking. The other excuse was that US banks were at a disadvantage relative to Eurobanks, which were universal banks (it was hard to take that seriously, since the Eurobanks were also-rans in the US, and once you backed out the profits of private banking, not terribly profitable either, but US regulators weren’t inclined to scrutinize the argument).

So by the late 1990s, even though there were parts of the business due to historical reasons, such as geographical footprints, reputation, relationships, or the time it took to build sufficient bench depth, where particularly players still had strong or even dominant positions, the various big capital markets firms, which meant Eurobanks like Deutsche, Credit Suisse, and UBS, big US commercial banks like Citigroup, and the old investment banks were all competing in many of each other’s markets. More important all were pursuing the same general strategy: originate, trade and sell the full suite of capital markets instruments (debt, equity, FX, and related derivatives) and related pure advisory services in all the major financial centers in the world. Pretty much all firms were also pursuing asset management too, even though that was not quite as integral.

Now what was the big danger here?

This approach had huge fixed costs: a really big international IT operation and back office, including all those trader stations and data feeds (which were constantly updated, since better risk management tools and trader decision support were one axis of competition), office space in the best part of town in financial centers all over the world, and most important, all those highly-paid and high-maintenance professionals, as in “talent”. Even though management tried to lower how much was fixed costs via performance bonuses, this was often undermined by the practice of poaching senior individuals and even full teams with hefty 2-3 year pay guarantees (pervasive at also-rans seeking to catch up with the leaders).

So what this meant in practice was that a top firm, say a Goldman, would have 100% of a certain cost level. We’ll index their revenues as 100. Its close competitors might have pretty much the same costs but only 90% of the revenues. The next tier players would have only 70-90% of the costs but 50-60% of the revenues.

It was perceived to be imperative to get to at least a perceived-to-be-comeptiive footprint, which for practical purposes would entail something like 85% of the costs of the capital markets leaders. But there was great leverage on that cost base. So getting to the minimum level of geographic and product coverage was merely the very big cost of entry in the capital markets game.

With that as background, let’s turn to Summers.

Summers’ Disingenuous Arguments

Even though this is the warm-up to Summers’ Glass Steagall section, it merits comment:

On regulatory policy, no one is for gambling with insured deposits. But Sanders fails to recognize some of the tensions that make regulatory policy so difficult. Loans to small businesses — which he likes — are far riskier than holdings of securities that are marked-to-market on a daily basis. So if banks focused on traditional lending, they would be riskier than they are today. Indeed the majority of the world’s banking crises — over the past three centuries and over the past quarter-century — have come from traditional lending, especially against real estate. Making banks safer means reducing their dependence on traditional lending activities. Balances must be struck.

Let’s stop with “no one is in favor for gambling with insured deposits.” The major banks all book derivatives in their depositaries, so they most assuredly like and want to continue this practice, Moreover, in 2011, the FDIC sat pat as Bank of America moved Merrill Lynch derivative exposures into its depositary. And as was reported at the time, the Merrill positions were considerably riskier than those of JP Morgan.

And what is Summers talking about regarding risk? Securities inventories can make very large moves in short period of time. That is considered risky, period. And if you are talking about loans, I’d hazard that loans to frackers will fare a lot worse, in terms of credit losses, than a diversified book of small business loans. The real issue with small business loans, as we’ve discussed repeatedly, is that banks no longer have the skills to make loans that require assessment of character and the local market. They disbanded credit officer training programs over two decades ago.

And as for real estate loans being the main cause of financial crises, that’s all wet too. In the 2008 debacle, real estate lending losses would have produced an nasty savings & loan level crisis. What metastasized that crisis into a global financial melt-down was derivatives, specifically credit default swaps written on risky subprime exposures. The synthetic exposures were somewhere between 4 and 6 times the value of real economy subprime risk. And a high percent of the CDS exposures (whose risk was masked by packing them into collateralized debt obligations, see ECONNED for a long-form discussion) wound up at under-capitlized, systemically important financial firms.

It’s also incorrect to say that historically, financial crises were real estate driven. Summers had a front seat at the Asian crisis of 1997, which had nada to do with real estate. The LTCM meltdown, which was a systemic crisis in the making, resulted from LTCM taking an insanely large position in the interest rate swaps market, making a bet that went bad, and having the rest of the market recognize that there was a drowning whale and trade against them. It had zippo to do with real estate.

Similarly, a derivatives crisis in 1994-1995 produced greater losses than the 1987 stock market crash. It also led the US to use the Exchange Stabilization fund, which was intended to support the US currency, instead to prop up Mexico, which was a back-door way to bail out dealers like Morgan Stanley and Merrill, who had made bad derivative bets. The Latin American crisis of the late 1970s was not a real estate crisis. Nor was the Great Depression; the US leg was the result of losses on very leveraged stock market speculation; the international component was the breakdown of the effort to go back on the gold standard (see Peter Temin; I find his thesis most persuasive of all of the prevailing theories).

Now we get to the Glass Steagall part:

Sanders asserts, as many do, that Glass Stegall’s repeal contributed to the crisis. I may not be objective, as I supported this measure as Treasury Secretary, but I do not see a basis for this assertion. Virtually everything that contributed to the crisis was not affected by Glass Steagall even in its purest form. Think of pure investment banks Bear Stearns and Lehman Brothers, or the government-sponsored enterprises Fannie Mae and Freddie Mac, or the banks Washington Mutual and Wachovia or American International Group or the growth of the shadow banking system. Nor were the principle lending activities that got Citi and Bank of America in trouble implicated by Glass Stegall.

I wonder where the Washington Post copy editors were on the spelling of Glass Steagall; was that a wee bit of sabotage?

To the substance: let’s first consider that Sanders is not making a very strong claim. He is merely saying the slow motion death of Glass Steagall contributed to the crisis, not caused it.

Now go back to the strategic picture I painted above, that the erosion of Glass Steagall led major financial firms, namely universal banks, big US commercial banks, and traditional investment banks, all to pursue the same capital markets strategy. Given that they all traded with each other, it had the bad side effect of making them what Richard Bookstaber called “tightly coupled” or overly connected, so that if Something Bad happened, the domino effect could move through the system before anyone could stop it. Now Glass Steagall’s fall wasn’t the sole cause of the overconnectedness, but it led to far more firms being tied up in what amounted to a single electrical grid.

We pointed out the danger of being a subscale player. You were already under pressure to increase your infrastructure (products depth and range, as well as geographic footprint) when you didn’t have the revenue of the top players. If you were subscale and had any pockets of strength, you were in constant danger of having those teams raided by firms that had a bigger platform. Odds were high they’d do no worse and would probably be more productive if they jumped ship. And once you had teams being picked off, you were on your way to losing your independence. The businesses were tightly integrated enough that losing a team would damage your standing in related businesses, making those professionals less productive (as in lowering their bonus prospects) and increasing the odds they’d leave or be recruited away.

It was thus imperative for a subscale player to work like mad to climb his way up the food chain. He had to to have any realistic chance of long-term survival.

Since these firms couldn’t match the raw revenue generation power of their bigger peers, they had to focus their resources on higher potential profit businesses. They’d wind up making bigger bets on what they thought were the best opportunities. And since the profit model in the late 1990s and early 2000s, thanks to falling and ultimately negative real interest rates, shifted the business model away from lower-risk fee businesses to higher risk trading businesses, it also entailed taking more balance sheet risk.

Who were the most subscale players? Bear Stearns and Lehman. And what was their big strategic bet? Real estate, particularly the seemingly high profit subprime sector. And for Bear, that also meant becoming a big player in credit default swaps (recall that Bear was one of the few players that John Paulson approached early on to create CDOs that were designed to fail).

So Summers is dead wrong in his simple-minded version of “Glass Steagall had nothing to do with Bear and Lehman.”

AIG, Fannie and Freddie were among the biggest customers of the Wall Street subprime bonds and CDO factory. AIG had accidentally created a firm within a firm and had gotten rid of its real risk managers, leaving Joe Cassanno, a bully who didn’t understand the downside until way too late, in charge. Fannie and Freddie both talked themselves into the foolish practice of using the fees they got for insuring mortgage bonds and investing that dough in subprime bonds and loans. Freddie and Fannie (as we discussed in 2007) were already thinly capitalized; they could not afford a bone-headed bet like that. So AIG, Fannie and Freddie were all insurers that made terrible investment decisions by virtue of falling for Wall Street’s latest apparent high return opportunity. AIG was systemically important by virtue of its CDS serving effectively as synthetic equity to the banks, since it allowed them to greatly understate the capital needed to support their CDS and/or credit default swaps. Again, had banks been separated from investment banks, AIG would have been the counterparty to far fewer institutions with much smaller balance sheets (ie, under a traditional banking regime, it would be less likely that US and UK banks would have been allowed to play in the CDS casino, but you would have seen similar casualty levels among the Eurobanks).

Oh, and who else disagrees with the Summers argument? Both of the UK banking regulators, the Bank of England and what was then the FSA. Bank of England governor Mervyn King, Executive Director of Financial Stability Andy Haldane (widely seen as one of the most creative economists of our day, and whose understanding of the financial crisis runs rings around Summers’) and Adair Turner all pushed hard for a breakup of the banks in the UK along Glass Steagall lines. They were bitterly opposed by the bank-cronyistic UK Treasury, with the result that the UK has moved to internal balkanization of the investment banking businesses, as opposed to a full split.

One of the Haldane’s insights that led him to support breaking up the banks was the analogy of financial systems to biological systems. Biological systems dominated by a few or one species are less stable than more diverse ones. As we illustrated in our history of how banking changed as Glass Steagall was torn down, financial firms that had once had different regulatory charters and resulting differences in product and customer focuses increasingly converged as the regulatory barriers were torn down. Haldane argued that a world of more specialized players would produce more diversity, and would also lead to less concentrated economic and political power (smaller, more varied firms would often wind up on different sides of pending regulatory issues).

So Summers has played his typical role, a defender of bad orthodox thinking, and in this case, as he admits, of his own dubious track record. It’s remarkable anyone still listens to him. Failing upward, or at worst, sideways, is apparently even more common in the Beltway than it is in Corporate America.

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* In one of the few times in my life I’ve gotten to play Zelig, I was sitting in Steve Benson’s office in 1989 when he burst into the room and said, “We just won the bid on Ohio Mattress.”