The merger that hurt

Why the demise of Glass-Steagall helped trigger the 2008 financial meltdown that cost millions of Americans their jobs, homes and savings

This month is the eighth anniversary of the all-enveloping 2008 financial crisis. Wall Street apologists and many of their Washington, D.C., acolytes argue there is zero evidence that the takedown of the Glass-Steagall Act had anything to do with the meltdown, but the assertion ignores the role the rule of unintended consequences played in the crisis.

Glass-Steagall was enacted during the Great Depression to separate Main Street from Wall Street, creating a firewall between consumer-oriented commercial banks and riskier, more speculative investment banks. During the six-plus decades the law was in effect, there were few large bank failures and no financial panics comparable to what happened in 2008.

In the 1980s, Sandy Weil, one of the godfathers of modem finance, began acquiring control of various banks, insurance companies, brokerage firms and similar financial institutions. These were cobbled together into a conglomerate under the umbrella of a publicly traded insurance company known as Travelers Group.

In 1998 Weil proposed a $70 billion merger with Citicorp, America’s second-largest commercial bank. It would be the biggest corporate merger in American history and create the world’s largest one-stop financial services institution.

Touting the need to remain competitive in a globalized industry and customers’ desire for a “one-stop shop” (a supermarket bank), both companies lobbied hard for regulatory approval of the merger. Advocates argued that customers preferred to do all their business -life insurance, credit cards, mortgages, retail brokerage, retirement planning, checking accounts, commercial banking, and securities underwriting and trading -with one financial institution.

But the merger’s one-stop-shopping approach would make a mockery of the Glass-Steagall firewall. The proposed transaction violated its prohibition of combining a depository institution, such as a bank holding company, with other financial companies, such as investment banks and brokerage houses.

Citigroup successfully obtained a temporary waiver for the violation, then intensified decades-old efforts to eliminate the last vestige of depression-era financial market regulation so it could complete themerger. A Republican Congress passed the Financial Services Modernization Act and President Clinton signed it in November 1999. It permitted insurance companies, investment banks, and commercial banks to combine and compete across products and markets, hammering the final nail into the coffin of Glass­ Steagall.

Now liberated, the banking industry embarked upon a decade of concentrating financial power in fewer and fewer hands. Acquisitions of investment banks by commercial banks, such as FleetBoston buying Robertson Stephens and Bank of America buying Montgomery Securities, became commonplace.

Traditional investment banks suddenly faced competition from publicly traded commercial banks with huge reserves of federally insured deposits. The investment banks faced pressure to deliver returns on equity comparable to those of the new financial supermarkets, which also put competitive pressure on traditional investment banking businesses such as mergers and acquisitions, underwriting, and sales and trading.

In response, the investment banks sought to raise their leverage limits so they could borrow more money to engage in proprietary, speculative trading activities. In 2005 they convinced the Securities Exchange Commission to abolish the “net capital” rule that restricted the amount of debt these firms could take from 12-1 to 30-1, meaning the banks could borrow 30 dollars for every dollar of equity they held.

By 2008, increased leverage and speculation on toxic assets would ravage investment banking, leading to the collapse, merger, or restructuring of all five major Wall Street investment banks. During a six­ month period, Bear Stearns collapsed into the arms of JP Morgan, Lehman Brothers filed for bankruptcy protection, Merrill Lynch merged into Bank of America, and Goldman Sachs and Morgan Stanley converted to bank holding companies, giving them access to precious short-term funds from the Federal Reserve’s discount window.

The demise of Glass-Steagall may not have been at the heart of the 2008 financial crisis but it certainly contributed to the lunacy of financial deregulation. Had the law not been neutered, it would have lessened the depth and breath of the crisis that cost millions of Americans their jobs, homes and savings.

Originally Published: Sep 3, 2016

The repeal of a Depression-era banking law and the economic crash of 2008

The causes of the 2008 financial crisis are multiple and complicated. Minor deities of finance and even presidential candidates such as Bernie Sanders argue over whether the repeal of the longstanding Glass­ Steagall Act laid the groundwork for the financial meltdown. Those who don’t think it did overlook one major unintended consequence of repealing Glass Steagall: the excessive use of leverage.

After the 1929 stock market crash and the onset of the Great Depression, Congress passed the iconic Glass-Steagall Act in 1933 to help ensure safer banking practices and restore faith in the financial system. Before the Great Depression, banks had engaged in imprudent stock speculation. In addition to their traditional staid banking services such as taking in deposits and making loans, they also used depositor’s funds to engage in high-stakes gambling on Wall Street.

The act was passed to halt a wave of bank failures and rein in the excesses that contributed to the 1929 Crash. Among other things, Glass-Steagall separated the more stable consumer-oriented commercial banking from riskier investment banking and set up the bank deposit insurance system to protect small savers against bank failures. The business of accepting deposits and making loans was to be kept separate from underwriting and peddling stocks, bonds, and other securities.

The movement to deregulate the American economy began in the 1970s. It spread to air travel, railroads, electric power, telephone service and other industries, including banking. The sustained bull market of the 1990s supported arguments that financial markets could regulate themselves, and bankers lobbied Congress to further emancipate the financial sector.

Citigroup forced Congress’s hand in 1998 when the firm announced it would join forces with the Traveler’s Group in a corporate merger. The $70 billion deal would bring together America’s second largest commercial bank with a sprawling financial conglomerate that offered banking, insurance, and brokerage services. The proposed transaction violated portions of the Glass-Steagall Act, but Citigroup obtained a temporary waiver, completed the merger, and then intensified the decades-old effort to repeal Glass-Steagall.

Just a year earlier, Travelers had become the country’s third largest brokerage house with its acquisition of the investment banking firm Salomon Brothers. Touting the pressures of technological change, diversification, globalization of the banking industry, and both individual and corporate customers’ desire for a “one-stop shop” -a financial supermarket- both firms lobbied hard for approval of the merger.

In 1999 a Republican Congress passed and a Democratic President signed the Gramm-Leach-Bliley Act, essentially repealing Glass-Steagall and removing regulatory barriers between commercial banks, investment banks, and insurers.

Advocates of the universal bank model argued that customers preferred to do all their business – life insurance, retail brokerage, retirement planning, checking accounts, mergers and acquisition advisory, underwriting, and commercial banking lending -with one financial institution.

The universal bank created an uphill battle for the major investment banks like Lehman Brothers and Bear Steams. For example, it was believed that the investment banking arms of universal banks would move into the lucrative securities underwriting business, using loans as bait to get the inside track on underwriting engagements, essentially using depositors’ money to drive investment banking fees.

As public companies, these investment banking firms faced pressure to deliver returns on equity comparable to that of the universal banks. To stay competitive,  they resorted to excessive leverage or borrowing to juice their returns.

In 2004 they received approval from the Securities Exchange Commission to increase their leverage from 12-1 to better than 30-1. The numbers were indeed worrisome. For instance, Bear Steams was leveraged 33 to 1 and before crashing in September 2008 Lehman Brothers had a 35 to 1 leverage ratio, meaning they borrowed 35 dollars for every dollar of capital.

By the winter of 2008, excessive leverage would ravage the investment banking industry, leading to the downfall, merger, or restructuring of all major investment bank firms and unleashing a global recession. And the American taxpayer would learn that free markets are not free.

Originally published: April 30, 2016