Wishful thinking.

Photographer: Bill Clark/CQ Roll Call

Glass-Steagall Is a Debate Democrats Don't Need

Paula Dwyer writes editorials on economics, finance and politics for Bloomberg View. She was London bureau chief for Businessweek and Washington economics editor for the New York Times, and is a co-author of “Take on the Street: How to Fight for Your Financial Future.”
Read More.
( Updated
)
a | A

Democrats have gotten themselves entangled in a nasty, complicated and ultimately unnecessary debate over an obscure financial law that Congress repealed 16 years ago. 

The debate boils down to this: Did the elimination of the 1933 Glass-Steagall Act, which erected a firewall between commercial and investment banking, cause the 2008 financial crisis?

 In Tuesday night's presidential debate, Bernie Sanders and Martin O'Malley said yes; Hillary Clinton said no. 

The Democratic base appears to side with Sanders and O'Malley, whose intellectual guru on this issue is Joseph Stiglitz, the Nobel Prize-winning economist, and whose most vocal proponent is Senator Elizabeth Warren. To them, the return of Glass-Steagall, originally adopted in the Depression after the 1929 stock-market crash, would mean busting up the big banks. 

Many Democrats seem to read into Clinton's rejection of that solution a cynical attempt to keep her Wall Street donors happy. They also believe she is trying to protect the legacy of her husband, on whose watch Glass-Steagall was withdrawn in 1999. 

Here's how Sanders summarized that position in Tuesday night's debate: 

Let us be clear that the greed and recklessness and illegal behavior of Wall Street, where fraud is a business model, helped to destroy this economy and the lives of millions of people. In the 1990s, [with] Wall Street spending billions of dollars in lobbying, when the Clinton administration, when Alan Greenspan said, “what a great idea it would be to allow these huge banks to merge,” Bernie Sanders fought them, and helped lead the opposition to deregulation. Today, it is my view that when … the three largest banks in America are much bigger than they were when we bailed them out for being too big to fail, we have got to break them up.

But whatever Clinton's motivations are, she's got the policy right: Glass-Steagall would not have prevented the 2008 financial crisis, and bringing it back may give false hope that the next one can be prevented. This was her response to Sanders: 

Of course we have to deal with the problem that the banks are still too big to fail. We can never let the American taxpayer and middle-class families ever have to bail out the kind of speculative behavior that we saw. [But] there’s this whole area called “shadow banking.” … The plan that I have put forward would actually empower regulators to break up big banks if we thought they posed a risk. But I want to make sure we’re going to cover everybody, not what caused the problem last time, but what could cause it next time.

Glass-Steagall was a powerful law. It broke up the financial supermarkets that dominated global commerce in the early 20th century. J.P. Morgan & Co., for example, had to spin off its investment bank into what is now Morgan Stanley. Until its repeal, the law supposedly barred commercial banks from selling stocks and bonds and managing initial public offerings.

By 1999, though, the Federal Reserve had loosened the law's handcuffs with waivers that allowed commercial banks to blur the lines between securities and banking.   

Back then, the world of high finance looked nothing like it would less than a decade later. Credit default swaps had just been invented, and were mostly used as intended -- to insure bondholders against the risk of default. There were no "naked" credit default swaps, the pure gambling contracts in which the insured party has no ownership of the underlying security being insured.

Other innovations, including the slicing-and-dicing of risk into tranches of collateralized debt obligations, were in their infancy. True, repealing Glass-Steagall enabled banks to deal in such risky instruments, but keeping the law would not have averted the crisis.

To understand why, take a look at the financial institutions that touched off the crisis and eventually collapsed from their losses. Start with Countrywide Financial Corp., the Calabasas, California, mortgage bank led by Angelo Mozilo. It shoveled billions' worth of low-quality mortgages out its doors for a decade before the crisis.  

By 2008, 70 percent of its liar's loans (in which borrowers aren't asked to verify incomes) were defective. But Countrywide wasn't suddenly freed up to do this when Glass-Steagall was eliminated. No, it was driven by the national obsession with homeownership, the lack of regulatory oversight and the ability to sell flimsy mortgages to Fannie Mae and Freddie Mac, which then packaged them into bonds and sold them to investors (and also weren't motivated by the end of Glass-Steagall).

The same goes for other pure banking institutions, including Wachovia and Washington Mutual. They benefited from all the same regulatory lapses, and suffered from the same excesses, as Countrywide did. They were pure banks with no investment-banking units. They weren't suddenly given a license to gamble by Glass-Steagall's elimination, and their collapse wouldn't have been prevented had the law remained on the books.   

Once dodgy mortgages were sold to investment banks, they were packaged into mortgage-backed securities for sale to investors seeking the higher returns that supposedly safe mortgage bonds yielded over other instruments. Here the main actors were Lehman Brothers, Bear Stearns, Goldman Sachs, Merrill Lynch and Morgan Stanley -- all free-standing investment banks. Some had specialty commercial banking units, but those weren't the source of their problems. Again, Glass-Steagall played no role.

Perverse incentives for excessive risk-taking, which were built into the investment banks' bonus systems, played a much larger role in the financial system's implosion, as did the credit-rating companies, which inexplicably gave the mortgage bonds their highest ratings. Or maybe it's not that inexplicable, considering that the raters are paid by the same companies whose securities they grade.

Lehman Brothers, whose bankruptcy touched off a cavalcade of mortgage defaults and bank bailouts, used deceptive accounting to conceal the size of its debts and the true value of its assets. When other banks realized this, they refused to lend to Lehman, forcing it to default. Once more, Glass-Steagall's repeal was irrelevant.

A third player in the crisis, American Insurance Group, aggressively sold credit default swaps on mortgage-backed bonds. It was this insurance that let hedge funds and other speculators gamble that the great mortgage boom would come crashing down eventually. When the time came to collect on those bets, AIG lacked the capital to pay them off as promised. Here, too, Glass-Steagall's repeal was a sideshow.        

Instead of resurrecting that law, Clinton last week offered a wide-ranging package of financial policies that builds on the 2010 Dodd-Frank Act, which tries to wall off banks from risky activities such as proprietary trading. She would also give regulators more authority to monitor large hedge funds, high-speed traders, insurers and other companies that could trigger the next crisis.

Sanders, however, seems more focused on getting revenge for the middle class by breaking up the biggest banks. Revenge may be sweet, but it's often not the wisest policy.

(Corrects 17th paragraph of article published Oct. 14 to say that some independent investment banks owned commercial banking units before the financial crisis.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Paula Dwyer at pdwyer11@bloomberg.net

To contact the editor responsible for this story:
Katy Roberts at kroberts29@bloomberg.net