Reinstituting Glass-Steagall: the only way to fix financial markets

Obama was absolutely right when he said, on September 16th (2008), that modern markets have completely failed not just for the last 8 years but for most of the last 28—whenever Republicans were in charge, and a fair bit when Democrats were in charge. Ordinary people haven’t had a raise in nearly 30 years. Which leads to the question: why is Obama now letting Geithner, Summers and Bernanke spend trillions to reboot a fundamentally flawed market, one based on securitization and leverage?

I simply, completely and utterly fail to see what is so wonderful about the process of securitization or why the government should reboot a market which still includes it as a fundamental feature. What securitization does is take the risk and spread it from the people who might be able to understand it and control it (the people actually issuing the mortgages, for example) to a ton of people who could not possibly know the risk even if they wanted to. Yes, it allows you to create more financial products. Yes, it reduces the cost of capital somewhat. But are we really better off because of securitization?—Of course we aren’t. Without securitization this current market meltdown would have been a heck of a lot milder.

Ratings agency reform is not the solution: ratings agencies completely fell down on the job, and even if incentives were changed they are still not in a position to know whether a mortgage from Mr. Smith is legitimate. Are they going to visit the property? Talk to Mr. Smith? Call his employer? Of course not, they can’t. The only people who can are the people who issued the original mortgage.

Nor should risk be transferred much if at all. Risk must stay with the people who issue the mortgage. If they know it will be off their books they won’t do proper due diligence, and no one else can do it. At most, risk should be transferred once and must be transferred in whole and understandable form. In contrast, the current system takes multiple different incomes steams (say 20 or more), melds them together, chops them into tranches, and sells them to people who really have no idea what they’re buying—with middlemen at every step booking profits and washing their hands of responsibility. Risk must be assumed only by people who can understand it and manage it and who are exposed to the consequences of their decisions. In other words, risk must be assumed by people with the ability to manage that risk,who know that if they fail then they will pay the price themselves.

It is necessary for the Fed to basically regulate everyone, with the SEC occasionally peeping over it’s shoulder to see whether market manipulation is occurring. This is necessary because there are, as Obama points out, no longer clear cut differences between banks, insurance companies, investment banks, brokerages and so on. The repeal of the Glass-Steagall Act put an end to those differences.

Glass-Steagall, remember, was put in place during the Great Depression to stop another Great Depression from occurring. People who lived through the 1920’s believed that one of the causes of the the Great Depression was not having clear-cut boundaries between the businesses, meaning risk was not divided appropriately and companies became “too large to fail”. The Glass-Steagall Act was passed in 1933 to mandate separating bank types according to their business (commercial and investment banking), thereby preventing the formation of banking conglomerates, and also founded the Federal Deposit Insurance Corporation (FDIC) for insuring bank deposits.

But somehow we think we know better today than the people who lived through the last Great Depression, the people who lived through the 1920’s and the last great market crackup. So we’ve repealed most of Glass-Steagall and allowed everyone to be in everyone else’s pockets, allowed huge financial conglomerates to mushroom into monstrosities, and allowed unregulated “innovative” financial “products” like collateralized debt obligations (CDOs) to grow into such huge bubbles that financial markets were huge multiples of the entire real world economy.

Then it all comes crashing down and people claim to be surprised.

Enough, already. Yes, the world is not exactly the same as it was in the 1920’s and 1930’s, but we didn’t start having these disasters till after Glass-Steagall and other Depression-era securities laws started getting repealed. The first set were repealed in the 1980’s, followed by most of the remainder in 1999 (e.g., Depository Institutions Deregulation and Monetary Control Act, 1980; Garn-St. Germain Depository Institutions Act , 1982; Gramm-Leach-Bliley Act, 1999).

It’s time to reinstate the financial reforms of the 1930’s that worked:

Force financial conglomerates to cut themselves up and divide back into brokerage houses, investment banks, retail banks, and insurance companies.

Put finance companies under the clear control of regulators.

Reinstitute Glass-Steagall, with very mild modernization.

Get rid of most complex derivatives, excessive leverage, the carry trade, etc.

Obama was right: the philosophy of the past 28 years has been a failure. Let’s treat it a failure then, and re-institute what worked, re-regulate, then slowly modify from there, with complete transparency and strong regulation.

Financial markets exist to serve ordinary Americans and non-financial American businesses. They haven’t been doing that properly. It is time to make sure that they do.

Originally published in slightly different form September 16th at FDL. Still sadly pertinent.