Explaining the U.S./Global Financial Meltdown,
Introduction by Arn Specter and article by Robert Weissman and James Donahue
I'd like to share an article with you all explaining the U.S. financial collapse in some ways that, perhaps, would shed more light on the causes and , thus, the remedies of this complex situation touching so many nations worldwide now.
The last week or so I looked into some articles pertaining to the financial collapse in the United States and the other major industrial countries of the world, which came to a head about a month ago, producing a "Financial Meltdown"; banking, security and insurance companies failing; an increase in unemployment, the drying up of loan monies and the loss of housing due to unfair foreclosures, etc.
On April 2, 2009 the G20 meeting was held in London attempting to remedy the collapse of the global financial system.
After reading just Part 1 of the following article by Weissman and Donahue it seemed to me that the U.S. and other countries at the G20 meeting in London, by mostly relying on an increase in funding for the IMF, failed to address the key factors behind the collapse. This article seems to do just that. Failing to take up and offer remedies of the core issues may well bring banking, security firms and insurance companies into much difficulty again, if they practice the same or similar policies. It is in this regard that I recommend this impressive article, an analysis of those factors (and history) of finances in America which have led to this economic collapse.
It is my hope that we find some remedies through regulations and adjustments in our economic/banking policies. Those of you, as membersd of the G20 nations, receiving this communique are in a position to have an impact on fostering such dialogue and change in the future.
Our economic and social survival may depend on establishing new laws and procedures in the U.S. Europe and other Nations.
Even the making of International Finance Law may be prudent and even necessary if the changes implemented by the G20 are found falling short of stablelizing and revitalizing the global financial system to the satisfaction of dozens of countries hit hard by the recession, shortage of funds for lending and the substantial loss of jobs worldwide with all the difficulties increased unemployment brings to nations who normally rely on one another for the smooth running of markets, trade, finance and employment.
This article, Wall Street’s Best Investment: Ten Deregulatory Steps to Financial Meltdown, by Robert Weissman and James Donahue, explains, in great detail, what has happened, over the years, in language we can mostly understand. As a lay person without any background in economics ( I'm an activist, researcher and writer) I normally shy away from economic theory and detailed activity...yet, because the writing is clear and orderly I was able to follow most of their thought and ideas.
The article is very well researched and written. Actually this is just part 1 of 10 parts, and contains ideas for the regulation of the financial institutions, especially banks, security firms and insurance companies - now able to be owned and operated by a single company, which has led to breakdowns in the global financial system.
It points out 10 deregulatory policies which have led us into deep trouble in the financial markets.
Too, it began recently with the housing foreclosures due to policies regarding mortgage selling and the bust on high housing values. The remaining 9 parts can be found on the site: multinationalmonitor.org.
It seems the response of our government and the G-20 meeting in London on April 2 failed in reestablishing controls and regulations, absent over recent years in the banking system, in addition to increasing funding for the IMF for loans and development of the emerging nations.
It would seem that what is needed are other measures; such as regulating the mortgage/banking industry so that people do not face foreclosure due to unsavory business practices as were demonstrated in recent years; allowing corporations to fail without public bailouts; and relying on the courts to evaluate and judge possible wrongdoings of current financial regulations and law.
Also nothing was said about the incredible high credit card interest rates, which are out of control and need regulation.
This article speaks of those in the government and banking who stood up for de-regulation at every opportunity for slowing or stopping the breakdown of failing financial dealings...leading us further into a recession and a breakdown in the U.S. and Global Financial System.
Arn Specter, Phila. --------------------------------------------------------------------------
MultinationalMonitor.Org , JAN/FEB 2009, VOL 30 No. 1
Wall Street’s Best Investment: Ten Deregulatory Steps to Financial Meltdown
By Robert Weissman and James Donahue
Wall Street has no one but itself to blame for the current financial crisis.
Investment banks, hedge funds and commercial banks made reckless bets using borrowed money. They created and trafficked in exotic investment vehicles that even top Wall Street executives — not to mention firm directors — did not understand. They hid risky investments in off-balance-sheet vehicles or capitalized on their legal status to cloak investments altogether.
They engaged in unconscionable predatory lending that offered huge profits for a time, but led to dire consequences when the loans proved unpayable. And they created, maintained and justified a housing bubble, the popping of which has thrown the United States and the world into a deep recession, resulted in a foreclosure epidemic ripping apart communities across the country, and caused the financial crisis itself.
But while Wall Street may not have anyone else to blame, and is culpable for the financial crisis and global recession, others do share responsibility.
For the last three decades, financial regulators, Congress and the executive branch have steadily pulled back the regulatory system that restrained the financial sector from acting on its own worst tendencies. The post-Depression regulatory system aimed to force disclosure of publicly relevant financial information; established limits on the use of leverage; drew bright lines between different kinds of financial activity and protected regulated commercial banking from investment bank-style risk taking; enforced meaningful limits on economic concentration, especially in the banking sector; provided meaningful consumer protections (including restrictions on usurious interest rates); and contained the financial sector so that it remained subordinate to the real economy.
his hodge podge regulatory system was, of course, highly imperfect, including because it too often failed to deliver on its promises.
But it was not its imperfections that led to the erosion and collapse of that regulatory system. It was a concerted effort by Wall Street, steadily gaining momentum until it reached fever pitch in the late 1990s and continued right through the first half of 2008. Even now, Wall Street continues to defend many of its worst practices. Though it bows
to the political reality that new regulation is coming, it aims to reduce the scope and importance of that regulation and, if possible, use the guise of regulation to further remove public controls over its operations.
This article documents 10 specific deregulatory steps (including failures to regulate and failures to enforce existing regulations) that enabled Wall Street to crash the financial system. Wall Street didn’t obtain these regulatory abeyances based on the force of its arguments. At every step, critics warned of the dangers of further deregulation.
Their evidence-based claims could not offset the political and economic muscle of Wall Street. The financial sector showered campaign contributions on politicians from both parties, invested heavily in a legion of lobbyists [see “By the Numbers” on page 12],paid academics and think tanks to justify their preferred policy positions, and cultivated a pliant media — especially a cheerleading business media complex.
1. The Repeal of Glass-Steagall and the Rise of the Culture of Recklessness
Perhaps the signature deregulatory move of the last quarter century was the repeal of the 1933 Glass-Steagall Act and related legislation. The repeal removed the legal prohibition on combinations between commercial banks on the one hand, and investment banks and other financial services companies on the other. Glass-Steagall’s strict rules originated in the U.S. government’s response to the Depression and reflected the learned experience of the severe dangers to consumers and the overall financial system of permitting giant financial institutions to combine commercial banking with other financial operations.
Glass-Steagall protected depositors and prevented the banking system from taking on too much risk by defining industry structure: Commercial banks could not maintain investment banking or insurance affiliates (nor affiliates in non-financial commercial activity).
As banks eyed the higher profits in higher risk activity, however, they began to breach the regulatory walls between commercial banking and other financial services. Starting in the 1980s, responding to a steady drumbeat of requests, regulators began to weaken the strict prohibition on cross-ownership. In 1999, after a long industry campaign, Congress tore down the legal walls altogether. The Gramm-Leach-Bliley Act removed the remaining legal restrictions on combined banking and financial services, and ushered in the current hyper-deregulated era.
But the overwhelming direct damage inflicted by the Glass-Steagall repeal was the infusion of an investment bank culture into commercial banking. Commercial banks sought high returns in risky ventures and exotic financial instruments, with disastrous results.
The Pecora Hearings
Banking involves the collection of funds from depositors with the promise that the funds will be available when the depositor wishes to withdraw them. Banks do not simply keep deposits in their vaults, however. Rather, they keep only a specified fraction. They lend the rest out to borrowers or invest the deposits to generate more cash. Depositors depend on the bank’s stability, and communities and businesses depend on banks to provide credit on reasonable terms. The persistent lure of higher returns from riskier investments has required government regulation to protect the safety of depositors’ money and the well being of the banking system.
In the 19th and early 20th centuries, the Supreme Court prohibited commercial banks from engaging directly in securities activities, but bank affiliates — subsidiaries of a holding company that also owns banks — were not subject to the prohibition.
As a result, commercial bank affiliates regularly traded customer deposits in the stock market, often investing in highly speculative activities and dubious companies and derivatives.
The 1932-1934 Pecora Hearings, held by the Senate Banking and Currency Committee and named after its chief counsel Ferdinand Pecora, investigated the causes of the 1929 stock market crash. The committee uncovered blatant conflicts of interest and self-dealing by commercial banks and their investment affiliates. For example, commercial banks had misrepresented to their depositors the quality of securities that their investment banks were underwriting and promoting, leading the depositors to be overly confident in the banks’ stability. First National City Bank (now Citigroup) and its securities affiliate, the National City Company, had 2,000 brokers selling securities.
Those brokers had repackaged the bank’s Latin American loans and sold them to investors as new securities (today, this is known as “securitization”) without disclosing to customers the bank’s confidential findings that the loans posed an adverse risk.
Peruvian government bonds were sold even though the bank’s staff had confidentially warned that “no further national loan can be safely made” to Peru. The Senate committee found conflicts when commercial banks were able to garner confidential insider information about their corporate customers’ deposits and use it to benefit the bank’s investment affiliates.
In addition, commercial banks would routinely purchase the stock of firms that were customers of the bank, as opposed to firms that were most financially stable.
The Pecora Hearings concluded that common ownership of commercial banks and investment banks jeopardized depositors by investing their funds in the stock market, and undermined the public’s confidence in the banks, which led to panic withdrawals.
The hearings paved the way for passage of the Glass-Steagall Act.
Congress Acts
The Glass-Steagall Act addressed the conflicts of interest that the Congress concluded had helped trigger the 1929 crash by prohibiting commercial banks from owning or engaging in investment banking activity.
While the financial industry was cowed by the Depression, it almost immediately sought to maneuver around Glass-Steagall. A legal construct known as a “bank holding company” was not subject to the Glass-Steagall restrictions. Despite the prohibitions in Glass-Steagall, a single company could own both commercial and investment banking interests if those interests were held under a bank holding company. Bank holding companies became a popular way for financial institutions and other corporations to subvert the Glass-Steagall wall separating commercial and investment banking.
In response, Congress enacted the Bank Holding Company Act of 1956 (BHCA) to prohibit bank holding companies from acquiring “non-banks” or engaging in “activities that are not closely related to banking.” Depository institutions were considered “banks” while investment banks (e.g., those that trade stock on Wall Street) were deemed “non-banks” under the law. As with Glass-Steagall, Congress expressed its intent to keep customer deposits in banks, which would avoid risky investments in securities or non-bank activities that might endanger deposits. The law also required bank holding companies to divest all their holdings in non-banking assets and forbade acquisition of banks across state lines.
But the BHCA contained a loophole sought by the financial industry. It allowed bank holding companies to acquire non-banks if the Fed determined that the non-bank activities were “closely related to banking.” The Fed was given wide latitude under the BHCA to approve or deny such requests. In the decades that followed passage of the BHCA, the Federal Reserve frequently invoked its broad authority to approve bank holding companies’ acquisitions of investment banking firms, thereby weakening the wall separating customer deposits from riskier trading activities.
Deference to Regulators
In furtherance of the Fed’s authority under BHCA, the Supreme Court in 1971 ruled that courts should defer to regulatory decisions that approved bank holding company acquisitions of non-bank entities. As long as a Federal Reserve Board interpretation of the BHCA is “reasonable” and “expressly articulated,” judges should not intervene, the court held. The ruling was a victory for opponents of Glass-Steagall, substantially freeing bank regulators to authorize bank holding companies to conduct new non-banking activities without judicial interference. As a result, banks whose primary business was managing customer deposits and making loans began using their bank holding companies to buy securities firms. In a series of decisions over the next two decades, the Fed progressively enlarged the scope of commercial bank ability to enter into investment banking activities.
The Financial Services Modernization Act
While the Fed had been progressively undermining Glass-Steagall through deregulatory interpretations of existing laws, the financial industry was simultaneously lobbying Congress to repeal Glass-Steagall altogether. Members of Congress introduced major deregulation legislation in 1982, 1988, 1991, 1995 and 1998.
Big banks, securities firms and insurance companies spent lavishly in support of the legislation in the late 1990s. During the 1997-1998 Congress, the three industries spent more than $85 million in campaign contributions, including soft money donations to the Democratic and Republican parties. But the Glass-Steagall rollback stalled. The Clinton administration was winding down, and the finance industries were becoming increasingly nervous that the legislation would not pass.
In the next congressional session, the industry redoubled its efforts, including by upping campaign contributions to more than $150 million, in considerable part to support a Glass-Steagall repeal, now marketed under a new and deceptive name, “Financial Modernization.”
During the Clinton Administration, Treasury Secretary Robert Rubin, who had run Goldman Sachs, enthusiastically promoted the legislation. In a 1995 testimony before the House Banking Committee, for example, Rubin argued that “the banking industry is fundamentally different from what it was two decades ago, let alone in 1933. … U.S. banks generally engage in a broader range of securities activities abroad than is permitted domestically. Even domestically, the separation of investment banking and commercial banking envisioned by Glass-Steagall has eroded significantly.” Remarkably, he claimed that Glass-Steagall could “conceivably impede safety and soundness by limiting revenue diversification.”
At times, the Clinton administration even toyed with the idea of allowing a total blurring of the lines between banking and commerce (meaning non-financial businesses), but was forced to back away from such a radical move after criticism from former Federal Reserve Chair Paul Volcker and key Members of Congress. Rubin played a key role in obtaining approval of legislation to repeal Glass-Steagall, as both Treasury Secretary and in his subsequent private sector role.
A handful of other personalities were instrumental in the effort. Senator Phil Gramm, R-Texas, the truest of true believers in deregulation, was chair of the Senate Banking Committee and drove the legislation. He was assisted by Federal Reserve Chair Alan Greenspan, an avid proponent of deregulation who was also eager to support provisions of the proposed Financial Services Modernization Act that gave the Fed enhanced jurisdictional authority at the expense of other federal banking regulatory agencies.
Jake Lewis, formerly a professional staff member of the House Banking Committee, notes, “When the legislation became snagged on controversial provisions, Greenspan would invariably draft a letter or present testimony supporting Gramm’s position on the volatile points. It was a classic back-scratching deal that satisfied both players — Greenspan got the dominant regulatory role and Gramm used Greenspan’s wise words of support to mute opposition and to help assure a friendly press would grease passage.”
Also playing a central role were the CEOs of Citicorp and Travelers Group. In 1998, the two companies announced they were merging. Such a combination of banking and insurance companies was illegal under the Bank Holding Company Act, but was excused due to a loophole which provided a two-year review period of proposed mergers.
Travelers CEO Sandy Weill met with Greenspan prior to the announcement of the merger, and said Greenspan had a “positive response” to the audacious proposal.
Citigroup’s co-chairs Sandy Weill and John Reed, along with lead lobbyist Roger Levy, ed a swarm of industry executives and lobbyists who badgered the administration and trammeled the halls of Congress until the final details of a deal were hammered out.
The Citigroup top officials vetted drafts of the legislation before they were formally introduced. As the deal-making on the bill moved into its final phase in Fall 1999 — and with fears running high that the entire exercise would collapse — Robert Rubin stepped into the breach. Having recently stepped aside as Treasury Secretary, Rubin was at the time negotiating the terms of his next job as an executive without portfolio at Citigroup. But this was not public knowledge at the time.
Deploying the credibility built up as part of what the media had labeled “The Committee to Save the World” (Rubin, Greenspan and then-Deputy Treasury Secretary Lawrence Summers, so named for their interventions in addressing the Asian financial crisis in 1997), Rubin helped broker the final deal.
The Financial Services Modernization Act, also known as the Gramm-Leach-Bliley Act of 1999, formally repealed Glass-Steagall. The new law authorized banks, securities firms and insurance companies to combine under one corporate umbrella. A new clause was inserted into the Bank Holding Company Act allowing one entity to own a separate financial holding company that can conduct a variety of financial activities, regardless of the parent corporation’s main functions. In the congressional debate over the Financial Services Modernization Act, Senator Gramm declared, “Glass-Steagall, in the midst of the Great Depression, thought government was the answer. In this period of economic growth and prosperity, we believe freedom is the answer.” The chief economist of the Office of the Comptroller of the Currency supported the legislation because of “the increasingly persuasive evidence from academic studies of the pre-Glass-Steagall era.”
Impact of Repeal
The gradual evisceration of Glass-Steagall over 30 years, culminating in its repeal in 1999, opened the door for banks to enter the highly lucrative practice of packaging multiple home mortgage loans into securities for trade on Wall Street. The practice, known as “securitization,” had virtually disappeared after it contributed to the 1929 crash, but had made a comeback in the 1970s as Glass-Steagall was being dismantled. Author Robert Kuttner told the House Banking Committee in 2008 that trading loans on Wall Street “was the core technique that made possible the dangerous practices of the 1920s.
Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank — e.g., Morgan or Chase — as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act” that separated banks and securities trading.
Whereas bank deposits had been a centerpiece of the 1929 crash, mortgage loans — and the securities connected to them — are at the center of the present financial crisis.
There is mounting evidence that the repeal of Glass-Steagall led banks to suspend careful scrutiny of loans they originated because the banks knew that the loans would be rapidly packaged into mortgage-backed securities and sold off to third parties. Since the banks weren’t going to hold the mortgages in their own portfolios, they had little incentive to review the borrowers’ qualifications carefully. Former Treasury Secretary John Snow has proposed requiring lenders to retain a portion of the loans they sell to third parties in order to incentivize more responsible lending.
As banks lost billions on mortgage-backed securities in 2008, they stopped making new loans in order to conserve their assets. Moreover, instead of issuing new loans with hundreds of billions of dollars in taxpayer-footed bailout money given for the purpose of jump-starting the sputtering economy, the banks used the money to offset losses on their mortgage securities investments.
In addition, banks and insurance companies were saddled with billions in losses from “credit default swaps” created to insure against mortgage defaults and themselves traded as securities on Wall Street.
In short, the Depression-era conflicts and consequences that Glass-Steagall was intended to prevent re-emerged once the Act was repealed. The once staid commercial banking sector quickly evolved to emulate the risk-taking attitude and practices of investment banks, with disastrous results.
“The most important consequence of the repeal of Glass-Steagall was indirect — it lay in the way repeal changed an entire culture,” notes economist Joseph Stiglitz.
“Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively,” writes Stiglitz. “It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money — people who can take bigger risks in order to get bigger returns.
When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risktaking.”
(see the remaining 9 parts on multinationalmonitor.org)
---------------------------------------------------------------------------------------------------
Arn Specter is an Activist, Researcher and Writer residing in Phila.
P.O. Box 5857, Phila. Pa. 19128, USA
