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