Minor Thoughts

In this present crisis, government is not the solution to our problem; government is the problem.

Did Deregulation Cause the Crash?

Many people are blaming the mortgage crash on the repeal of the Glass-Steagall Act — the 1999 Gramm-Leach-Biley Act. But did Gramm-Leach-Bliley cause the crash? I don’t think so.

First, Glass-Steagall created a “wall of separation” between investment banking and commercial banking. Investment banks create and sell securities in the investment markets. Commercial banks earn money by offering deposits and making loans (home, auto, business, etc). Glass-Steagall said that commercial banks couldn’t offer securities in the investment markets and investment banks couldn’t offer loans or deposit accounts.

The law had been steadily weakened before being repealed:

The 1933 Glass-Steagal Act that prohibited commercial banks from owning investment banks, and vice versa, had been steadily weakened since the 70s by an increasingly diverse and complex new financial reality. Waivers from regulators for merger became routine and the 1998 merger between Travelers and Citigroup functionally repealed the law. Gramm-Leach-Bliley only put a de jure stamp of approval on a de facto regulatory framework.

Second, how did allowing a merger between investment banks and commercial banks cause the crisis? Investment banks were primarily buying mortgages from commercial banks. Commercial banks weren’t creating the mortgage backed securities, they were selling mortgages to investment banks who then created the securities.

The rest of the previous link offers more details:

In fact, the evidence so far shows that Gramm-Leach-Bliley has helped soften the blow to taxpayers by allowing commercial banks to take over trouble investment firms. Just look at which organization’s have failed:

  • Bear Stearns was an investment bank before it was sold to JP Morgan Chase (which includes a commercial bank).
  • Fannie Mae and Freddie Mac were government sponsored entities before the government bought them.
  • Lehman Brothers was an investment bank before it want bankrupt.
  • Merrill Lynch was an investment bank befor it was sold to Bank of America (which is a commercial bank).
  • AIG is an insurance company with no commercial banking division.

Remember, Glass-Steagal was passed to protect commercial banks from failure by forbidding them from investment bank practices like trading in securities and underwriting stocks and bonds. As you can see above non of the failed institutions are commercial banks that got in trouble through risky investment banking. Instead, it is the commercial banks that are providing some stability to the system by purchasing troubled investment banks. Without Gramm-Leach-Bliley they would not even be allowed to technically do this.

Alex Tabarrok and Tyler Cowen say the same thing, but both include links to scholarly sources and papers to back up their point. Megan McArdle also dubunks this myth and includes these interesting notes:

They can’t say it more directly because it’s moronic. Even if you ignore the economic history indicating that Glass-Steagall didn’t help the crisis it was meant to solve—even if you assume, arguendo, that the repeal was a bad idea—there’s simply no logical reason to believe it had anything to do with the current mess.

Securitization was not introduced in the 1990s; it was invented in the 1970s and became popular in the 1980s, as chronicled in Liar’s Poker. (As an aside, if you haven’t read it, you really must. Especially now).

GLB had nothing to do with either lending standards at commercial banks, or leverage ratios at broker-dealers, the two most plausible candidates for regulatory failure here.

Most importantly, commercial banks are not the main problems. If Glass-Steagall’s repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk. Instead we see the exact opposite: the failures are among either commercial banks with no significant investment arm (Washington Mutual, Countrywide), or standalone investment banks. It is the diversified financial institutions that are riding to the rescue.