Would Glass-Steagall Have Helped?

Would Glass-Steagall Have Helped?
Last Update: 18-Sep-08 12:26 ET

[BRIEFING.COM - Robert V. Green] We are at a crossroads with respect to banking policy. The crisis in the financial sector will eventually be examined through the perspective of the Glass-Steagall Act and its repeal. There will be arguments on both sides of this issue, but the debate is almost assured and the resolution will be the primary determinant of the future for capital markets.
The Glass-Steagall Act

The Glass-Steagall Act (or more accurately, the "Banking Act of 1933" authored by Glass and Steagall) had these primary effects on the financial industry:

* Forced a financial institution to be either a "commercial lender" or an "investment bank," but not both.
* Investment banks could underwrite securities (issue stock or bonds backed by corporate or other income streams), but were not allowed to accept demand deposits (such as checking accounts).
* Commercial lenders could take demand deposits, but were restricted to issuing loans to commercial ventures with assets as collateral, not income streams.
* Commercial lenders were prohibited from packaging their loans into securities for resell, but investment banks faced no such restriction.

The principles behind this legislation were simple. The concept was to align the nature of liabilities with the nature of assets. For example:

* Commercial banks would have short-term liabilities such as demand deposits (checking accounts). The offsetting assets, such as loans outstanding, would have short-term payment schedules and be backed by hard assets in the event of default.
* Investment banks were able to have long-term liabilities of any kind, but could also own assets with long-term reward characteristics. Thus, a temporary decline in an asset would not create -- theoretically -- an immediate negative impact on liabilities.

To enforce the short-term nature of commercial banking activities, the regulation set interest rates payable on demand deposits by the Federal Reserve, not the market. This provision would eventually lead to the undoing of the entire Glass-Steagall Act.
The Erosion of Glass-Steagall Provisions

Certain provisions of the Banking Act of 1933 began to be repealed in 1987. The first of these was the provision regulating the maximum interest rate that banks could pay on a demand deposit account (checking and savings accounts).

Investment banks and other "non-commercial lenders," such as mutual funds, began to offer what amounted to "demand deposits." These "money market funds" were classified as investment securities and therefore prohibited for sale by commercial lenders (banks).

At the time, banks were prohibited from offering "money market accounts," because money market accounts were securities based upon a package of commercial paper. While commercial paper was still "short-term" by current definitions (three-to-six month maturities), the face-discount nature of their interest made them out of line with the daily potential withdrawal demand of account holders.

When interest rates soared to levels above 10% in the early 1980s, mutual fund companies began to offer money market funds with fixed net asset values (NAVs) equal to $1.00. This made money market funds appear to function exactly like checking accounts or savings accounts.

However, since banks were prohibited from offering interest rates above 4.0% on passbook savings accounts, money market funds had no difficulty in attracting deposits. Savings flowed from bank accounts to money market funds in astonishing amounts.

The result was tremendous pressure from the banking lobby for relief from the regulated rates on savings and checking accounts. That relief was eventually granted.

The issue is that a "money market fund" is essentially a packaged securities consisting of a pool of commercial paper issued by corporations. What this type of "package" does is create a short-term liability (daily interest payments or accruals) from a package of longer term assets. (Commercial paper is typically sold at a discount to face value, with the "interest" being paid only when the paper certificate becomes payable in full.)

It is this nature of "misaligned risk-reward" that the Glass-Steagall Act was designed to prevent.

Ironically, it is this type of misalignment of timing of short and long term risk that is at the root of today's financial crisis.
How Derivatives Create Risk

Financial institutions become insolvent, typically, when their short-term liabilities become greater than their ability to convert long-term assets into short-term assets.

This is roughly the same as a homeowner with a mortgage who loses their job and can now neither make the mortgage payments nor sell the house.

It is precisely this same type of situation that has created the financial crisis at Lehman Brothers, AIG, Merrill-Lynch, and other investment firms. These firms all have unique problems, but a common thread in all of the firm's problems is that their assets, almost all of which were securities of some sort, became either non-income producing or unsalable.

At some firms, such as Lehman, the short-term liability was as simple as making payroll. At others, such as AIG, the short-term liability was created by obligations on securities the company had packaged together.

No financial institution deliberately creates a situation where its liabilities are greater than assets. However, by creating securities with short-term liabilities (interest payments), but backed by long-term assets (other packaged securities or derivatives), the firms run into problems when the assets either become unsalable or stop producing income. Making the short-term liability payments then require refinancing or default.

This short-term/long-term misalignment of liabilities and assets is at the core of the financial problems of AIG and Lehman Brothers.
A Fear Realized

Ironically, the very situation we are viewing today was predicted by some when the slow erosion of the Glass-Steagall Act began in the mid-1980s.

In early 1987, the Federal Reserve Board voted 3-2 to allow banks to begin to package securities of certain "shorter term securities" such as commercial paper, municipal revenue bonds, and mortgage-backed securities. The motivation at the time was the market imbalance created by money market funds drawing savings out of commercial lending banks and into investment banks. Banks demanded the ability to compete.

Federal Reserve Chairman Paul Volker was strongly against the Federal Reserve motion to permit this type of security underwriting by banks. His argument at the time included the following points:

* Lenders will "recklessly lower loan standards in pursuit of lucrative securities offerings, and"
* "Market bad loans to the public"1

An argument against this view was made by Citigroup Vice-Chairman Thomas Theobald who argued that reckless corporate behavior would be prevented by:

* "An effective SEC"
* "Knowledgeable investors"
* "Very sophisticated" ratings agencies 1

It is truly ironic that all three of Mr. Theobald's "preventive" points can be pointed at as crucial contributors to today's financial crisis, but in reverse. Much of today's problems can be directly blamed on investors, even -- and perhaps especially -- professional investors, who were unaware of or ignored inherent risks in derivative securities.

The lack of awareness might be blamed directly upon ratings agencies. Securities issued by AIG, for example, were downgraded by ratings agencies sharply after it became clear that the firm would default on structured payments due on some of the securities sold.

It seems ironic that a rating agency would rate any security at a level above its potential risk level, but then lower the rating when the potential risk becomes real. Yet this is precisely what happened with the AIG securities, triggering the collapse of the company.

In fact, the rating policies now seem somewhat similar to the old joke about the man who has jumped out of a 20-story window and is asked on the way down how things are going. "So far, so good!" is the usual punch line.

The joke loses some of its humor, however, when you realize that this is precisely what happened with the ratings on numerous AIG securities that went into default.
More To Come

At the moment, the financial crisis is not being examined from the point of view of "would the old Glass-Steagall restrictions have prevented today's crisis?"

We think it is just a matter of time before those questions start to be asked, however.

We will continue to examine this issue as this financial crisis continues to unfold.

(Note -- part II of the argument for Verizon Communications will be published in the very near future. We have delayed that column due to the nature of the current market.)
Comments may be e-mailed to the author, Robert V. Green, at rvgreen@briefing.com

1 Frontline, PBS "The Wall Street Fix"