Understanding The Crisis, Part Three

I hope that all of you will try your best to follow this series. I also hope that I’ll explain things in a way that you can understand them, although certain aspects can be VERY complex. I know, too, that there is some really DRY stuff here, but please try to stick with reading it, as it is all VERY important, as I’m sure Congress and members of BOTH parties will be trying to assess what has happened in recent times, and to then put in place new laws to govern banks and various investments.

During the Great Depression of the 1930s, banks failed by the thousands. In an effort to prevent, or to at least control, such things from happening again, the Glass-Steagall Act was passed and signed into law in 1933.*** First, it established the Federal Deposit Insurance Corporation (better known to most of us as the “FDIC”), which insured bank deposits (then up to a limit of $100,000, which was quite a sum for those times); that is, if you had $5000 in a bank and that bank collapsed, you still got your $5000 back. Why would this help? Okay, one of the reasons for bank failures was “a run on the banks;” that is, many people were fearful of losing their money, sometimes their life savings, from a failing bank, and they withdrew their money. Now, there’s no question that some banks were shaky for a variety of reasons, but when a few banks collapsed, it caused even “healthier” banks to fail, because depositors withdrew their money. In such situations, even rumors (whether true or false made no difference) could cause bank failures, because depositors were terrified of losing their money, and thus the fear of a bank collapsing brought about the reality of that bank collapsing. With deposits insured, and the public aware that they could get their money even if their bank failed, it was hoped that “panics,” with mass bank withdrawals, could be curtailed, or even stopped, thus preventing the collapse of “healthy“ banks.

The new law also gave more power to the Federal Reserve in regulating interest rates, but that’s another matter. Further, “Glass-Steagall” separated banks into commercial banks and investment banks, with rigid barriers against mixing the two. Part of the reason for the Depression was seen by many, but not all, as banks having gotten too involved in investments in the stock market (including “speculation“ in stocks), for one thing. In those pre-Depression times, many banks often had brokerage departments, which often issued various securities, including stocks and bonds for corporate clients, while the rest of the bank took care of the more traditional banking roles of deposits and lending. By assuming so much risk in the brokerage area, investments gone sour could pull down the whole bank, rather than just the brokerage part. So what does this mean? Well, let’s say that you have your life savings in bank XYZ. The bank also has a brokerage unit which takes a major hit during “The Crash.” The losses from the brokerage unit have to be covered by the whole bank, not just the brokerage part. Ahh...cough, cough....guess whose money is now at risk?

Further, collapsing banks, the resulting jobs losses and the financial losses to depositors fed into the “depression” mentality that kept the downward spiral going, and as mentioned above, often caused mass withdrawals from other banks, even though some of those banks might have been sound, causing these banks to either fail or teeter on the brink. So you see, there was kind of a chain reaction. When you hear, “Your money is safer under your mattress, than in a bank,” this is more or less what is meant.

I won’t get into too much more on this part of the subject, but there were additions to the Glass Steagall Act made later in the 1950s, prohibiting bank holding companies that owned two or more individual banks from buying banks in another state.+++ Further, these bank holding companies were restricted to more or less traditional banking practices and restricted banks from the insurance business .

Many bankers didn’t like the laws, and over time, there were attempts to get aspects of the laws changed or repealed, with more intense efforts beginning during the Reagan years. In 1987, the Federal Reserve Board voted to loosen restrictions on some banking activities, including the issuance of....“mortgage backed securities.” Then Fed Chairman, Paul Volcker, dissented, fearing that banks would lower the standards for loans, then market shady loans to the public, all to make money from these securities they would then sell. (See Part One, for the basic workings of the mortgage lending business) Also in 1986/1987, the Fed broke the precedent of Glass-Steagall by allowing banks to again engage in certain limited investment activity, but limited such activity to no more than 5% of their gross business. In 1989, the Fed, now under Alan Greenspan, a strong advocate of deregulation, increased the percentage to 10%, and in 1996, to 25%. Gradually the banking laws were being dismantled.

In 1999, Senator Phil Gramm (R-Texas), Rep. Jim Leach (R-Iowa) and Rep. Tom Bliley (R-Virginia) introduced a measure in Congress that would effectively repeal much of “Glass-Steagall.” It permitted banks to outright own investment firms and insurance companies. The basic bill, also known as “The Financial Services Modernization Act,” had the support of the Clinton White House and Treasury Secretary Robert Rubin.^^^ The first vote in the Senate was 54-44, with 53 Republicans and one Democrat voting for the bill, and 44 Democrats against. The House passed a somewhat different version by voice vote; that is, there was no roll call to indicate how individual members voted. The bill went to conference committee to get an agreement between the two versions and the final bill was then passed by the Senate 90-8 and by the House 362-57. Clinton signed the bill into law. The walls between various financial sectors were shattered.

To be continued...

(No "Word History" this time)

***This was actually Glass-Steagall #2, as a previous act was passed in early 1932 and was known by the same name.
+++One could certainly argue that this prevented any banks or bank holding companies from becoming “too big to fail.”
^^^Rubin was a former exec of Wall Street investment firm "Goldman-Sachs." Not long after Glass-Steagall was repealed, he went to work for one of the beneficaries of the new law, Wall Street financial conglomerate "Citigroup." Hmm, now you people don't think....there could have been some tie....oh come on!!! You folks are cynical!!! (But so am I!)