The Glass-Steagall Act: An Economic Necessity

Manifesting itself with unemployment rates topping 10 percent, the Great Recession in 2008 is well known to all, as it still affects us today. What is not well known is what caused such a rapid and powerful decline. Much of this chasm lies in American understanding of how our economy works. To most people, the American economy is simply a spectrum of buying and selling tangible goods and services. Some of the mechanisms that facilitate this economic action are more visible than others. Easily identifiable are the "brick and mortar" stores, from a mom and pop shop to commercial giants such as Target or Wal-Mart, that allow everyday Americans to purchase tangible goods from food, to electronics, to cars. Perhaps just as easily seen is the physical infrastructure that makes this transfer of goods and services possible: the roads, railways, and bridges that enable huge numbers of people to mobilize each day. If this is the skeleton of our economy, the framework that facilitates economic motion, then the financial system is the circulatory system, the life-blood enabling the American economy to function each and every day. Without this system, the tangible infrastructure is useless, even nonexistent in some cases. While often portrayed or perceived as a tool only for the wealthy, the financial system is, in fact, a tool utilized by all, making loans, credit, and all monetary transactions possible. In fact, without a functional financial system, everyday consumers cannot obtain loans to buy a house or car and, while bank accounts will remain stable, investors in other financial tools (stock, derivatives, and money market funds) will lose significant amounts of money. Naturally, the goal must be to insure that this system is stable, while also allowing for the necessary risks required for banks to prosper. Unfortunately, this has not always been the case, with massive recessions caused by financial instability seen in the Great Depression starting in 1929, and the Great Recession, starting in 2007. In order to combat this, the United States government creates a set of rules and regulations in order to manage the stability of the financial system. While the list of these regulations is numerous, one specifically has been the recent object of academic debate: written in 1999, the Financial Modernization Act is a major catalyst behind the economic collapse in 2007.

Following the Great Depression, in 1933, the Roosevelt Administration looked for ways to ensure that such an economic collapse would not occur again. The main legislation to achieve this goal was the Glass-Steagall Act. This bill created two important mechanisms to prevent further instability. First, the Federal Deposit Insurance Corporation was created. This government entity insured all bank deposits below a certain value (subject to change by the Federal Government), thus forever preventing the bank runs that plagued the early days of the Depression. This provision remains unchanged today (Rahman). Secondly, Glass-Steagall explicitly created separation between two kinds of financial institutions: commercial banks, or banks taking customer deposits and issuing loans to individuals as well as businesses, and investment banks, which sell and invest in complex securities, derivatives, stock and bonds with their investors' money (Rahman). This provision was included under the belief that it would manage the amount of risk banks can take on, as well as insulate everyday depositors from the high-risk, high-reward world of investment banking (Rahman). This provision was negated in 1999 through the Financial Modernization Act. Co-sponsored by two Republicans, and signed into law by President Clinton, a Democrat, this bill was a bipartisan effort to streamline government intervention into the economy. Following the removal of the separation provision, numerous bank mergers occurred, changing the overall makeup of the market (Mother Jones). The question today is whether this change sparked an increase in risk-taking by banks that resulted in the subprime mortgage crisis that became the framework for the "Great Recession" in 2007. Most experts now agree: it has.

While much of American history is well-known, sometimes the untold history is the most important. While not known to the majority of the public, decisions made around financial policy have huge effects on everyday, middle class Americans. In the case of regulation, as America enjoyed fairly stable economic times in the decades following World War Two, the overall sentiment of policymakers in the United States began to change. A country whose economy had been defined by the rules and regulations stemming from Franklin Delano Roosevelt's New Deal was beginning to alter its stance slightly, or at least be open to the possibility. This desire, one aiming for less government regulation in all facets of everyday life, began to manifest itself with the politically conservative idea of less regulation in business, specifically finance. The effects of this movement, beginning with the appearance of ultraconservative Barry Goldwater on the presidential ticket in 1964, culminated with the overwhelming election of Ronald Reagan to the Presidency in 1980. While Reagan began to dismantle the role of government in the lives of Americans more or less immediately, the issue most pertinent to this paper came in 1984, when the Republican led committees in the House of Representatives began to present bills seeking to circumvent the separation provision in Glass-Steagall (Suarez). This action, previously unseen to the public, began to make sense in 1987; the Reagan Administration publicly stated that banks needed to "merge with other financial institutions if they were going to be able to compete in the international arena" (Suarez). This reflects their belief that with less regulation, banks could make more money, believing the old style of regulation was severely choking profits. Finally, towards the end of that year, Reagan's appointee to Chairman of the Federal Reserve, Alan Greenspan, spoke of a need to immediately repeal Glass-Steagall during a speech given in front of the Fed Governors, as well as a presentation to the Senate banking Committee (American Banker). The move to repeal Glass-Steagall was well underway, driven by a desire to see more profitable banks.

Though change may have appeared imminent, it took over a decade for any substantive change to take place in regard to banking regulation. In 1998, the government allowed Citibank to merge with Travelers Insurance; following Citi's spending of "millions of dollars lobbying for the change," even though this violated the "separation provision" that was the centerpiece of the Glass-Steagall Act (Inside Job). This merger was allowed on a "temporary" basis, but in reality forced a permanent change in this law, a change Republicans fought for immediately.

With the start of the 106^th United States Congress, House Republicans began ushering this plan into action. Sponsored by Phil Gramm (Texas Senator-Republican) , The Gramm-Leach-Bliley, or Financial Modernization, Act passed both chambers of the house on November 4^th, 1999, and was signed into law by President Clinton eight days later (Grant).

Upon its passage, some in government expressed dismay, led by John Dingell (Democrat-Michigan), who said "we are creating now a group of institutions which are too big to fail… Taxpayers are going to be called upon to cure the failures we are creating tonight." Dingell stated this in order to make the implication that this deregulatory process would grow banks to unmanageable size. This statement today holds a well-known meaning, one separate from its clear English use. Today, "too big to fail" has become a rallying cry, a derogatory term for banks that, while not truly too large to fail, are instead so large, so vital to the economy, that there is no economically feasible way to allow them to fail. This allows them to take on huge amounts of risk with little consequence. These banks were the creation of those adamant for less regulation, die-hard supporters of unfettered capitalism, a methodology that would end in ruin. As Craig Farrand would discuss years later, Dingell saw this as clearly as anyone (Farrand).

Conversely, Gramm, Chairman of the U.S. Senate Committee on Banking, stated confidently, "I believe we have passed what will prove to be the most important banking bill in 60 years" (Senate Document). Today, it is clear that both were correct, though Gramm was right in precisely the opposite manner from what he then believed. This law would become, over the next decade, notorious in economic circles for the immense damage it would cause.

When people think of the financial crisis, "subprime mortgage crisis" is the term often used. But what exactly does this mean? How could such a regulatory change create a crisis, and what happened to make this particular recession so severe? As Suarez stated, "the expectation was that the market would regulate itself" (86), meaning risk would be managed by corporations looking to prosper. We soon learn this did not come to fruition. In fact, the market, facilitated by the Gramm-Leach-Bliley Act, began to change in two major ways. The first was through mergers, the act of one company buying another to enlarge or diversity itself. In terms of the makeup of financial institutions this change happened rapidly. First, the merger of Citi and Travelers/Smith Barney, the transaction that was the driving force behind GLB, was allowed to remain. Wachovia, an investment bank, merged with First Union, a retail bank, in order to increase lending. In 2000, JP Morgan, the most notable investment bank on Wall Street, bought Chase, simply defined as a retail bank, in order to increase its access to lending and deposits (Mother Jones). This continued for a decade, as part of a 20-year window in which ten large financial institutions went from holding 20 percent of our nations assets, to 54 percent, a 270 percent increase in size, unprecedented in our history (Mother Jones). The immense size of these companies quickly created the very system that Dingell feared. Described as "too big to fail" these huge banks were destined, from the start, to require massive bailouts at direct cost to everyday Americans, the taxpayers, due to the increase of risk-taking in these banks.

To see how Gramm-Leach-Bliley caused the financial collapse, one must also examine the industry's business reactions to the law. In terms of financial practice, the change was slower-moving. Sparked by the increase in conglomerate banks, merged banks comprised of retail and investment arms, lending practices began to shift in a new way. Quantities of loans considered to be "subprime" began to be issued as never before. These loans are given to borrowers with poor or risky credit scores who have a less than perfect history of paying back loans on time. Due to these factors, these loans have a much higher chance of being defaulted on (not paid back), while also holding a higher interest rate, allowing for higher profits for the bank if all goes well. Due to the high risk, high reward nature of subprime loans, prior to 1999, they made up 5 percent of all issued loans. However, following the legislative change, these loans increased substantially, to 20 percent of given loans by 2006, representing $800 billion of lent money (The Big Short). This problem was even more substantial than it first appears, as many loans issued had no chance of success. Building off this theme, the so-called "NINJA" loans (No Income, No Jobs or Assets), became commonplace as lenders took advantage of the new structure to increase profits for themselves. In his book The Big Short, Michael Lewis notes that, "In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000" (Lewis). There was no reason for them to worry about what this could eventually do to the bank, as they were no longer liable for the future outcome of these loans. This occurred because of the change in makeup of these institutions.

Prior to GLB, retail banks kept loans on their books, and therefore were directly responsible for their success or failure. As Hedge Fund manager Sy Jacobs explained, "Because the lenders sold many… loans they made to other investors, in the form of mortgage bonds, the industry was also fraught with moral hazard… any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people" (Lewis). This is precisely the way that Gramm-Leach-Bliley changed bank composition: by allowing for retail and investment banks to merge, risk was altered to remove personal accountability.

Once these subprime loans were issued, they were commuted to the investment portion of a bank and then turned into Asset Backed Securities (ABS, MBS, CDO) (Sorkin). These are bonds made up of thousands of loans in order to limit a banks risk to failure. The investment banks made profits off the interest rate on these loans while simultaneously encouraging its customers to invest in the newly created bonds. The retail arm, the lender, made money on the fees on the front end of an issued loan, fees that were substantially higher for subprime loans. What all of this meant on the surface was that more Americans could own houses and banks were making more money, using the higher interest rate on a subprime loan in order to spin profits that were thought to be impossible. Unfortunately, the underlying truth of this reaction was that more money was being borrowed by people who, in the past, would not have been able to borrow it. This, obviously, poses a threat to economic stability, as loan defaults are never good, economically. However, Gramm-Leach-Bliley created one other avenue for financial institutions to create increased profits, while taking on enormous amounts of risk, creating a casino-like atmosphere that would prove to be nothing short of fatal.

Change to the finance system, however, was not limited to the institutions to which legislative change was applied. While it is very clear how financial institutions legally tied to the law changed (mergers and redesign of lending standards), the reaction other corporations had to that change are equally as important. Most notably, as detailed in Lewis's The Big Short, AIG had a particularly aggressive strategy to profit off the new system. Because banks were issuing more loans, and riskier ones at that, there was a larger business opportunity created for AIG to insure these bonds and the banks issuing them. This instrument, called a Credit Default Swap, or CDS, should be thought of as insurance; a premium is paid in order to allow the investor to recoup the full value of the entity if it is to fail (Paulson). These vary from standard insurance, such as car or homeowner, in one very important sense; anyone can take out a Credit Default Swap on any bond, or, any company. This creates an implicitly speculative dynamic allowing for bets on failure of these securitized loans (Lewis). While this may seem benign enough, think about what that really means: investors can make a bet on something failing, even if they do not own it. This idea would be akin to your neighbor insuring your house, meaning they lose a small denomination of money if nothing happens to it, but make enormous profits if your home burns to the ground. Such a system sounds ludicrous, and an invitation for immoral practices and profit off of misfortune. Unfortunately, this system was reality and became a key component of financial markets flowing GLB (Inside Job). While this idea was not created by Gramm-Leach-Bliley, that does not remove the connection between the two. In fact, this change illustrates how large of an effect that GLB had on the financial services industry. The extreme interconnectedness that is a product of technological change and industry advances exacerbated the effect of the GLB Act by affecting every individual aspect of the economy (Paulson).

It is here that Gramm-Leach-Bliley begins to have tangibly harmful effects on the United States economy. Because the new financial system removed the risk behind lenders issuing subprime loans, they increased, as has been discussed. This significantly altered the makeup of the Asset Backed Securities that were being invested in. Changing their composition so that they contained 400 percent more subprime loans than before made these securities more risky, although they were not rated as such (Inside Job). The subsequent reaction from other firms such as AIG created a system that was entirely leveraged on the new subprime mortgages that were a direct result of GLB. The real-world consequence was enormous. When the housing market finally slowed, after a 16-year period of uninterrupted increase in home values, mortgage defaults escalated, rendering the majority of the asset backed securities worthless (Dow Jones, Schiller Price Index). As government sponsored mortgage giant Freddie Mac shows, these loans' failure rates began to spike from rates of 2 percent to over 25 percent at the height of the crisis (Freddie Mac). This started a chain of events that resulted in AIG being forced to pay the holders of Credit Default Swaps the full amount of money that they were owed, a sum valued at a minimum of $57.8 billion, and requiring $85 billion from the government in order to prevent the immediate failure of AIG (Sorkin). By the end of the recession, stock values had plunged nearly 50 percent, unemployment doubled to over 10 percent of the workforce, and Americans lost a combined $16.4 trillion in wealth as the markets dropped for almost two years. A problem originating with an increase in subprime lending had infected the entire financial system in a way that was irreversible in the immediate; though that is not to say it cannot be altered today.

Remember, all of the issues that caused the financial crisis, from Asset Backed Securities, to Credit Default Swaps, all hinged on an increase in subprime lending. These problems, and the issues they create, are all a byproduct and unintended consequence stemming from increased subprime issuance. Therefore, in order to be a catalyst behind the financial collapse it must only be proved that the Gramm-Leach-Bliley Act caused an explicit reason to increase subprime lending that was acted upon by various banks. It does not need to be determined that this act directly caused decisions made by AIG or any other affected companies; it did not. What it clearly did do was create incentive for companies, and individuals, to increase the number of subprime loans that were created. This change reverberated through the system in ways that are clearly related, as all of the aforementioned changes, later becoming problems, are based in the subprime increase. Based off of the statistics seen, the sharp increase of bank mergers, increase in percentage of subprime loans, and change in business model, after the passing of GLB, fought for by banks for years, it is entirely clear that the Gramm-Leach-Bliley Act, by ending the line drawn between retail and investment banking, was at some level, a cause of the Great Recession.

This act clearly altered the risk structure of a bank so that the onus for poor lending was placed on the shareholder and on the investment bank, and, ultimately, the taxpayer (Lewis, Sorkin, Paulson), Unlike before, the goal was to maximize total lending, not quality of lending, and with this came years of landing practices destined for failure. Based on the percentage of subprime loans given before, and then after, the Gramm-Leach-Bliley Act, it is entirely clear that it had a causal effect on lending standards. By combining variations of banks, thus opening more possibility for profit through merger or change in practice, Gramm-Leach-Bliley created a system where the final backbone of finance was the United States Government. Banks got larger after GLB, clearly. In fact, they got much larger (Mother Jones). As John Dingell said, prophetically, the banks became "too big to fail"; the major banks were so large, and so diverse, that their failure would impart catastrophic damage upon the global economy. As the famous saying goes, banks developed a "heads I win, tails you lose" mentality. Hungry for profit maximization, banks engaged in practices involving enormous risk, all while knowing they had very little to lose. Those who truly lost, the demographic that "bore every burden" for banks greed, not Democracy as Kennedy stated a generation prior, were the United States taxpayers. The government, for the people, and by the people, had let down the very men, women, and children that it was created to stand for. The era of deregulating in the name of Wall Street profits, began in the 60's, culminated in 1999, and should, today, be over. Forever.

If the United States of America wishes to remain the land of opportunity, if it wishes to be the Greatest Nation on Earth, if it wishes to become once again a beacon of hope, and if it wishes to prosper for our children, and our children's children, government must begin to reregulate the economy immediately. This change has begun, and the Dodd-Frank Act does numerous things in order to limit leverage and risk-taking by banks. But, change is not over. In order to recreate the financial, and, therefore economic, stability that existed in America in the decades following the Great Depression, it is clear that lawmakers must reinstitute the separation provision of the Glass-Steagall Act as soon as possible. This act must, once again, become a functional part of the regulatory scaffolding that holds the economy together.

The framework for this is not impossible, the idea no longer holds partisan bounds, and the counterargument is weak. Certainly there are those who still argue against reinstituting it, though their argument is the same as it was in 1999. Banks, and their lobbyists, insist that there must be no separation provision and that its nonexistence poses no significant economic threats. They further state that it will limit profits and because the removal of Glass-Steagall did not singularly cause the economic collapse it therefore it is not important to reinstitute it. This argument is so weak, so transparent, that it is accompanied by support from lobbyists being paid a total sum of approximately $159 million each year to support the banks' claims. This huge sum, greater than all industries except pharmaceuticals, is the only roadblock left separating our current financial system with one of stability. Perhaps most importantly, as Elizabeth Warren and John McCain, two senators who are very ideologically opposed, have shown with their "21^st Century Glass-Steagall" bill, there are no longer the strict ideological bounds behind Glass-Steagall that existed prior to 1999. Today, this is an issue that has support from both sides of the aisle in the Senate, one that has been discussed by President Obama as a future solution. The reason for this is clear: the repeal of Glass-Steagall was a cause of the Great Recession. Regardless of the money spent to assure it will remain a part of our past, Glass-Steagall, in its 21^st century form, must become a part of our future.

Author

Scott Tully

Scott Tully is the son of Scott Sr and Sheila Tully of Reading, Massachusetts. He is currently pursuing a double major in finance and political science. While he works towards a career in business, and eventually politics, he is also a student athlete, enjoying his role as a left-handed pitcher on the University's baseball team. His goal for this paper was to bring light, and clarity, to the otherwise opaque world of financial regulation in a simplified, yet informative, way. He would like to thank his Writing and Rhetoric, Elizabeth Capdeville, for her assistance in all phases of the research paper.