The recent market turmoil has produced an astonishingly predictable wave of populism. Even McCain and Palin are blaming corporate greed and abuse of the public trust. (To be fair, corporations cannot fairly abuse the public trust as they are formed for the benefit of their own shareholders, not the public. Somewhere, Ayn Rand is rolling over in her grave.)
The most idiotic line of attack, not surprisingly, is coming from the Democrats. In an effort to pin the market’s problems on Senator McCain, Obama has pointed to the 1999 Gramm Leach Bliley Act. The wholly uncontroversial act was passed by nearly unanimous vote and signed into law by Bill Clinton. Of course, as the lead sponsor, Senator Phil Gramm’s connection with Senator McCain’s campaign gives Barack Obama some Hope® to link the two to the current market problem.
Obama, having no economic experience beyond the begging for, squandering and doling out of tax dollars, is perhaps not familiar with the purpose and history of the Act. (One of the more entertaining aspects of the last several days has been watching the mental midgets at Daily Kos, the Huffington Post and elsewhere espouse their opinion on GLB. If asked before the recent market crisis, I would bet most of these people would think Gramm Leach Bliley was professor of Dark Arts at Hogwarts.)
I never thought this would come in handy, but as it turns out, I work with GLB every day, so I do know a little about it. Which is to say, a great deal more than apparently what Obama and the Democratic party know about it.
GLB overturned a depression era law known as Glass Steagall (and no, that’s not a magical transparent bird from Harry Potter). Glass Steagall prohibited retail banks (banks that make their money by holding deposits and lending money to consumers) from engaging in insurance and commercial and investment banking (like Goldman Sachs, these banks make their money mostly from investing in and lending money to corporations). The rationale was simple: during the market crash of 1929, which precipitated the Great Depression, many retail banks failed because their assets were tied up in the stock market.
Glass Steagall did two things: (i) it created the FDIC to insure deposits at retail banks up to now $100,000 and (ii) it prevented banks from exposing themselves to market risks that could again crash the entire system.
Over 60 years later, the economy and the markets had changed. The Securities Act of 1933 and the Securities Exchange Act of 1934 had developed strong, robust markets that were, for the most part, self-correcting. In addition, the Savings and Loan crisis had shown that restricting diversification was not necessarily the best way to prevent bank failures. In addition, retail banks and large investment houses wanted to be a one-stop shop and compete with one another for the savings and investment accounts of their customers. All of this lead to the repeal of the second major prong of Glass Steagall. In a sense, that is all the GLB did: it allowed your checking and savings account to be held at the same place as your insurance policy and your mutual fund.
Obama, however, is now claiming that GLB should be repealed. He’s flatly wrong. Repeal of GLB would lead to disaster. In fact, GLB is operating as the savior today. Who saved Merrill Lynch from bankruptcy? The largest bank in the world, Bank of America. Glass Steagall would have made that illegal. Who is rumored to be buying Morgan Stanley? Wachovia, another retail bank that would have been prohibited by Glass Steagall from intervening. Who is picking up the pieces of Lehman Brothers? Barclays Bank, a UK bank known primarily for retail banking and credit cards.
Obama’s claim that GLB is the cause of the problem is even more idiotic. The root cause of the current problem is over aggressive lending by mortgage banks like Fannie Mae, Freddie Mac, Countrywide and a slew of others. These banks, after being pressured by Congress and President Clinton, made loans to lower income families that everyone knew could never be repaid by their income alone. The buyers, to the extent they knew what they were doing, were thinking, “I’ll buy a $200,000 house I can’t afford. I can pay interest only for a few years, then the house will increase in value and sell it at a profit and buy a new house for more money.” The banks were thinking, “worst case scenario, we foreclose and sell the house for a profit.” In essence, the banks and the homeowners were betting that housing prices would go up. They were wrong. In fact, the fast and loose credit rules further exacerbated the problem by artificially driving up home prices. If more people can afford a home, home prices become less affordable. (Note to Dems, this is where the Law of Supply and Demand meets the Law of Unintended Consequences).
So, you may ask, but only if you’re still paying attention, how does this bring down Lehman Brothers, who doesn’t have a mortgage brokerage? Well, Fannie, Freddie and Countrywide were not content to hold these bad mortgages themselves. A mortgage is just a promise from some putz to pay over 30 years. If you’re a mortgage lender, you prefer your money up front (who doesn’t). So the banks devised a new product called mortgage or asset backed securities (ABSs). These are a bundle of thousands of mortgages, each with the same or similar terms. The bank then sells interests in each of the ABS’s to investment banks like Lehman (and Merrill and Morgan Stanley).
The problem is, the ABS’s are only as good as the aggregate credit of the underlying homeowners. If one or two in a thousand default, no problem. The losses are offset by the payments from the others. The only way this could fail is if a lot of buyers started defaulting on their home loans at the same time. Well, guess what? When you systematically extend credit to people who can’t afford it, you create systemic risk. The bottom falls out when the first person can’t sell their home. The next person to try to sell is facing a buyers market and we race to the bottom. The fact that baby boomers are all retiring and trying to sell their homes at the same time compounds the problem.
To further complicate matters, the ABS’s were further divided and picked apart and merged with other instruments (like credit default swaps and other derivatives). All of this means that even the whizkids at Lehman couldn’t figure out what their real risk was. (Like John McCain, first Lehman, and now the taxpayers don’t know how many homes we all actually own.) This led to a panic and a run on the investment bank. Shares plummeted and investors in Lehman products bailed out. In a sense, this is the exact opposite of the bank failures that lead to the Great Depression. It wasn’t market speculation that lead to a run on retail banks, but retail banks’ speculative lending that lead to a run on investment banks.
The take home point here is that Gramm Leach Bliley is not the culprit. Nanny state regulation and do-gooder intentions in the mortgage market are the culprit. The sooner we realize that altruism is not a valid economic policy, the more we can avoid these messes.