Bank Deregulation and the Financial Meltdown

In the coming weeks and months, you will likely hear an awful lot about a bank deregulation bill that became law in 1999.

An agreement between the Clinton administration and congressional Republicans, reached during all-night negotiations which concluded in the early hours of October 22, sets the stage for passage of the most sweeping banking deregulation bill in American history, lifting virtually all restraints on the operation of the giant monopolies which dominate the financial system.

The proposed Financial Services Modernization Act of 1999 would do away with restrictions on the integration of banking, insurance and stock trading imposed by the Glass-Steagall Act of 1933, one of the central pillars of Roosevelt's New Deal. Under the old law, banks, brokerages and insurance companies were effectively barred from entering each others' industries, and investment banking and commercial banking were separated.

The certain result of repeal of Glass-Steagall will be a wave of mergers surpassing even the colossal combinations of the past several years. The Wall Street Journal wrote, "With the stroke of the president's pen, investment firms like Merrill Lynch & Co. and banks like Bank of America Corp., are expected to be on the prowl for acquisitions." The financial press predicted that the most likely mergers would come from big banks acquiring insurance companies, with John Hancock, Prudential and The Hartford all expected to be targeted.

There has long been a strain of liberal thought that blamed this bill for the mortgage crisis itself. Some have pointed to this law as an example of deregulation gone wild that created the mortgage crisis. I have already countered this point.

Now, let's examine the nuts and bolts of this law and see what role it played in the current dynamic. First, it is nonsense to say that this bill played any role in creating or perpetuating the mortgage crisis. That said, this bill did find its way into th middle of turning the mortgage crisis into a financial crisis. It is extremely important that the financial community do a thorough analysis of how this crisis spread from being a mortgage crisis to a financial services crisis. Keep in mind that Lehman Brothers and Merrill Lynch are both primary investment companies. AIG is primarily an insurance company. Something in this dynamic caused the mortgage crisis to infiltrated these companies and turn the mortgage crisis into a financial services crisis.

Now then, let's first examine the nuts and bolts of this law. What this law did was break the figurative wall between banks, brokers, insurance companies and other financial services companies. The Glass Steagall Act, among many things, separated all sorts of financial services and placed careful limits on what sorts of financial services anyone company can perform.

The Glass-Steagall Act of 1933 established the Federal Deposit Insurance Corporation (FDIC) in the United States and included banking reforms, some of which were designed to control speculation.[citation needed] Some provisions such as Regulation Q that allowed the Federal Reserve to regulate interest rates in savings accounts were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999

As you can see, that wall was broken down with this act. (keep in mind that what was and wasn't allowed is very sophisticated and technical. Certain things were allowed prior to law, but what you should keep in mind is that this law allowed a lot more cross financial services selling) Now, a financial services company could also offer checking accounts and get into banking. In other words, your local bank need not be your local bank but rather your local financial services instution. There was plenty of possibilities with these new provisions. It allowed your financial services company to offer checking accounts, and folks like Charles Schwab and Etrade have done exactly that. It also allowed banks to spread their holdings into all sorts of new financial tools. This isn't a bad thing but a good thing, and in my opinion, if this act is repealed that would be a massive mistake.

Now then, how did this act contribute to turning this mortgage crisis into a financial services crisis? If you were paying attention to my description of the act that answer should be obvious. Now, all sorts of financial institutions were free to take a position in mortgages, sub prime mortgages specifically. Merrill Lynch, for instance, bought up 4 sub prime mortgage companies in 2006. These sorts of mergers would have never been allowed prior to the act. The tragic flaw of this bill is that it exposed financial institutions everywhere to financial vehicles which they had no experience with. It wasn't merely that financial services companies were jumping into the hot market, sub prime, but that they were jumping into this hot market with little prior experience in the market.

Many analysts, in my opinion, mistakenly claim that the Merrill Lynch's of the world were buying mortgages they knew the underlying borrower couldn't pay. I don't think that's true at all. The Merrill Lynch's of the world were buying mortgages in which the underlying borrower couldn't pay the mortgage back, but since they had little experience with mortgages themselves, they didn't know it either. As a result, what would have been isolated to a mortgage and bank crisis, spread to being a financial services crisis.

Now, in my opinion, the problem is not merely the regulation itself. I think it is dishonest partisanship of the highest order to proclaim that a company like Merrill Lynch can't also attempt to get into the business of mortgages. I think it is a mistake to call for putting this wall back up. First, if you did, you would create a mass sell off all over Wall Street as financial services firms would need sell of divisions to meet the new law. Second, you would create even more illiquidity at a time when liquidity is the order of the day. By putting the wall back up, the very institutions that you need to get back in the market would be forbidden.

The real villain here is not the deregulation matter itself, but the government's failure to figure out a new oversight framework to deal with the deregulation. Government watchdogs like the SEC, FDIC, Office of Banks and Real Estate, among dozens of government agencies were now responsible for all sorts of new institutions. Clearly, the federal government did nothing in re organizing the oversight responsibilities even though they created a law that revolutionized the financial services industry. That, to me, is the biggest failing of the federal government in this manner. The regulatory agencies stayed stagnant while the financial market evolved overnight.

In fact, to me, the problem with this crisis was never one of a lack of regulations. There were already regulations in place that should have prevented the crisis. Most of the bad loans that created this crisis were done fraudulently. These so called stated loans had large numbers of FRAUDULENT income and asset disclosures. FRAUD is now, was then, and always was ILLEGAL. The regulation was there to deal with the problem, but the regulation wasn't enforced. The problem is that this fraud went on four years, en masse, and little or nothing was done about it. Even though this fraud fell under the jurisdiction of a plethora of new regulatory agencies, rather than having tougher enforcement, there was confusion and little action.

That's why it would be a mistake to try and create all sorts of new regulations in response to the crisis. What everyone should realize as a result is that this crisis resulted from a lack of enforcement not a lack of regulations themselves. If the banking deregulation act of 1999 is repealed, we will be attacking the wrong culprit. What we need is a re organization of the regulatory agencies to better oversee the new financial world.

Epilogue:

I often hate when others offer platitudes about fixing things. When they use vague worlds re organization, better oversight, restructuring, and other words that have a loose meaning and hold no specific plan. You may have noticed that I did the same thing here. As such, if you want to see how I would attack future mortgage fraud please go here. That is a specific and detailed plan for getting the feds to act more aggressively to spot and prosecute mortgage fraud. As far as re organization and restructuring, all the agencies must be made aware of fraud. If someone lied on their mortgage application, the committed tax fraud because they lied about how much they made on their taxes. Once mortgage fraud is discovered, the IRS must be warned. If they lied about how much they had in the bank, they must be reported to the FDIC because that is also bank fraud.

One of the things I saw in the mortgage crisis is that fraud carried no punishment. Fraud was almost always committed because borrowers wouldn't qualify without it. Even if the fraud was caught, the result was almost always nothing more than a denial of the loan. That meant it was the same punishment as not committing fraud. Fraud was rarely prosecuted. Yet, with the innovation of the financial services market, that fraud spread throughout the financial world. A fraudulent loan wasn't merely a fraudulent loan, but part of a fraudulent mortgage bond, insured under fraudulent terms by credit derivatives, and a major part of the portfolio of an investment company. The feds failed to realize this possibility and didn't adjust their oversight structure and that's what lead to spreading this crisis into financial services, not the law itself.

This deregulation act is a small piece in the overall puzzle of this crisi. For a summary of how we got to where we are now please take a look at this link.