Remember Why Glass-Steagall Was Passed

A look at the history of the financial shenanigans of the 1920s offers a rationale for why a new Glass-Steagall deserves a serious look.

It seemed like a good idea at the time. After making loans to borrowers who were unable or unwilling to repay them, one of the nation's biggest banks came up with a solution: Take the loans, repackage them and sell them to customers and, in effect, bail out the bank from its money-losing positions. As for telling investors about the distressed state of the borrowers, well, why bother?

The head of J.P. Morgan, perhaps the most respected banker of his era, had already sounded the tocsin about the consequences of deteriorating credit standards. ``A warning needs to be given against indiscriminate lending and indiscriminate borrowing,'' he said.

Yes, this is a trick. The banker wasn't Jamie Dimon, chief executive officer of what now is JPMorgan Chase & Co.; it was Thomas W. Lamont, speaking in 1927. And the bank selling securities in the bum loans wasn't one of today's too-big-to-fail behemoths, but National City Co., the predecessor of Citigroup Inc.

These anecdotes come from a report issued in 1934 by the Pecora Commission, which was charged with digging into the financial industry's misdeeds in the run-up to the stock market crash of 1929. The commission's hearings and findings provided a rationale for many of the laws adopted in the 1930s to regulate banking and the securities markets, including the Glass-Steagall Act, which forced banks to split their lending and securities businesses.

Last week, Democratic Senator Elizabeth Warren and three other senators introduced a new version of Glass-Steagall. It would force banks to again cast off their brokerage businesses, which they were allowed to enter thanks to legislation adopted in 1999.

It's doubtful that the old Glass-Steagall, or a reincarnation of it, would have done much to prevent the recent financial crisis. But a strict separation of banking and brokers might have prevented lenders from fobbing off some of the garbage they sold to the investing public, as Bloomberg View columnist Jonathan Weil has noted.

To take just one example, before the meltdown of 2008, banks hawked what are known as auction-rate securities, often to individual investors. The pitch was that they were as safe as bank deposits and paid higher interest rates than money-market mutual funds or certificates of deposit. The securities were long-term debt instruments that repriced periodically in auctions -- until they didn't, which is what happened in 2008. In the midst of the financial panic, the auctions failed. Those who held the securities couldn't get hold of their money when they needed it.

It took the Securities and Exchange Commission to force the sellers of the securities, including Bank of America Corp., Citigroup, Wachovia Corp., Wells Fargo & Co. as well as a pack of stand-alone brokerage firms to pony up $61 billion to compensate investors.

At a minimum, Glass-Steagall might have prevented bank employees from recruiting retail depositors for these securities. For that reason alone, a modern version of the law is an idea worth considering.

(James Greiff is a member of Bloomberg View's editorial board.Follow him on Twitter.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.