Repeal of Glass-Steagall: Not a cause, but a multiplier

Barry Ritholtz
Columnist August 4, 2012

When the Titanic set sail from Southampton on April 10, 1912, bound for New York, it was called “unsinkable.” This was before that chance encounter in the North Atlantic with a large iceberg. You know how that movie ended.

Many people died, of course, because there were too few lifeboats. But even if the luxury liner had four times as many, the Titanic still would have ended up on the bottom of the ocean, done in by a captain more concerned with speed than safety — and that iceberg.

Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. View Archive

This simple reality, however, obscures a broader truth.

Before it sank, more than 700 passengers loaded onto the 20 lifeboats on board and escaped with their lives. More than 1,500 others died. The Titanic had the capacity for 64 lifeboats, which could each hold 65 people. Fully loaded, they could have carried more than 4,000 to safety — or every man, woman and child aboard. Thus, many more could have survived.

While the shortage of lifeboats didn’t cause the sinking, this insufficiency after the crash was a factor in the 1,502 deaths.

I was reminded of this recently after reading articles that argued over the role the repeal of the Glass-Steagall Act played in the financial crisis. The Depression-era regulation that separated Main Street banks from Wall Street investment firms had a huge impact on the finance sector.

The repeal of Glass-Steagall may not have caused the crisis — but its repeal was a factor that made it much worse. And it was a continuum of the radical deregulation movement. This philosophy incorrectly held that banks could regulate themselves, that government had no place in overseeing finance and that the free market works best when left alone. This belief system manifested itself in damaging ways, including eliminating regulation and oversight on derivatives, allowing exemptions for excess leverage rules for a handful of players and creating dangerous legislation.

As the events of 2007 to 2009 have revealed, this erroneous belief system was a major factor leading to the credit boom and bust, as well as the financial collapse.

I have been unable to find any evidence that the Gramm-Leach-Bliley Act — the legislation that repealed Glass-Steagall — was a primary cause of the financial crisis. Imagine a “but for” scenario where Glass-Steagall had not been overturned but the rest of the deregulatory actions had still taken place. Would the crisis have occurred? Without a doubt, yes.

The Fed still would have taken rates down to unprecedented low levels. This would have led to a global spiral in asset prices. The nonbank, lend-to-sell-to-securitizer mortgage originators were still going to make subprime-mortgage loans to unqualified borrowers. Bear Stearns and Lehman Brothers would still have overwhelmingly increased exposure to subprime mortgages. AIG would still have written trillions of dollars in credit-default swaps and other derivatives with zero reserves set against them. The largest security firms and deposit banks would still have charged headlong into the subprime securitization business. And Fannie Mae and Freddie Mac would still have belatedly chased these banks into the same subprime market, just at the peak of the housing boom.

Lastly, housing prices would still have run up to absurd levels and then collapsed.

So no, the repeal of Glass-Steagall was not a proximate cause of the crisis. But its impact was both nuanced and complex. Consider the context in which it occurred:

● The repeal of Glass-Steagall in 1999 was part of a broad deregulatory push, championed by the likes of Fed chief Alan Greenspan, Sen. Phil Gramm (R-Tex.) and Treasury Secretary Robert Rubin, that eliminated much of the oversight on Wall Street. Freed from onerous regulation, the banks could “innovate” and grow.

● After the repeal, banks merged into more complex and more leveraged institutions.

● These banks, which were customers of nonbank firms such as AIG, Bear Stearns and Lehman Brothers, in turn contributed to these firms bulking up their subprime holdings as well. This turned out to be speculative and dangerous.

So we can say that Glass-Steagall’s repeal allowed the credit bubble to inflate much larger. It allowed banks to be more complex and difficult to manage. When it all came down, the crisis was broader, deeper and more dangerous than it would have been otherwise.

Glass-Steagall’s repeal, after 25 years and $300 million worth of lobbying efforts, culminated decades of deregulation.

Newfangled derivatives? No oversight, reporting or reserves necessary, courtesy of the Commodities Futures Modernization Act of 2000. Subprime-lend-to-sell-to-securitizers business model? Those are the financial innovators! At least, that is what Greenspan called them, and why he refused to oversee them as Fed chairman. Rules on SEC leverage? Let’s create a special exemption from the law for just five investment banks.

Of course “reputational risk” would serve as a deterrent to poor decision making! No bank would ever behave so recklessly as to put their own hard-won status on the line — or its very existence.

How’d that idea work out?

With Glass-Steagall, there would not, could not, have been a Citi/Travelers merger, and competitors would not, could not have bulked up the way they did. Major money center banks most likely would have been smaller, more manageable, more easily wound down. Arguably, too big to fail might not have been the rule, and bailouts might not have been necessary. This is, of course, mere supposition.

What we should be discussing is the corrupting influence of crony capitalism and radical deregulation. Instead, we find ourselves forced to defend capitalism and free markets. We should be finding ways to definancialize the U.S. economy and reduce bankers’ influence.

There are lots of thing we can do about this, but I have a modest suggestion that would be a good start: No more Wall Street bankers as Treasury secretaries. It would be much better for the nation to find someone from industry who understands finance rather than finding someone from finance who understands industry.

Consider where we would be today if we put Citi and Bank of America into prepackaged bankruptcy (as was done with GM). It would have been much more painful, but ultimately, much healthier.

The past 50 years have seen a dramatic financialization of the American economy. Wall Street has morphed from serving industry to a Titanic leaving a damaged economy in its wake.

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Twitter: @Ritholtz

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