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Friday, September 19, 2008

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.


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.


Anonymous said...

Proposed solution:
Stop unjustifiable loans by rounding up a bunch of these loan officers, their bosses, and any financial consultants who passeds along a bundle of such loans; strip them of their money, and put their heads on a stick as a warning to anyone who might consider committing fraud in the morgage loan business. If decapitation sounds a little severe, long prison terms would be the second best alternative.

mike volpe said...

I have been saying for a long time that the systemic fraud was merely overlooked. That's why I suggest that Justice be alerted of every loan in foreclosure for a serious examination. Of course, you didn't include the borrower in your list of culprits. That's nonsense. The borrowers are just as responsible as the profession. Often times, they are even more responsible.

Unknown said...

I sold Real Estate for 13 years and am now retired. Mike and others have claimed the borrower are to blame. Any information given by the borrower must be verified by loan officer and lender. Sometimes lenders will re-verified prior to closing. Some loans and closing have be cancelled because a borrower went out and bought a new car. The fraud is controled by lender and loan officer.

mike volpe said...

I never blamed the borrower. I said the borrower shared in blame along with the industry. My point was never that it was only the borrower's fault. It was that the borrower was just as at fault as the rest of the industry.

Anonymous said...

I truly appreciate your article. I have been obsessed with this topic over the weekend and I have come to several conclusions that appear to be mirrored by you. All I did was take the individual proposed pieces of the bailout plan and responded to them openly and honestly. For example, Congress wants to buy up 'toxic' assets of firms to prevent them from collapse. They also seem bent on providing some sort of relief to the 'poor home-buyers' who were 'victims' of these loans. BULL! In a free market society, the potential for failure and financial ruin is supposed to keep individuals and businesses inside the white lines of common sense and good business practices. A bailout seems just as objectionable in a free market economy as government regulation. I have had a business fail. I have also had a house repossessed. The former because my wife became disabled and lost her job without any benefits. Her income was sufficient to support the household budget. In its absence, the business seed money had to go to the family welfare. No problem, I lose a business I would have rather kept. The latter, due to our purchase of our home prior to the effective date of the Illinois Full Disclosure Act. There was a major foundation crack that was hidden by the former owner and not discovered until I remodeled the garage for my new business start. We lose. Again, no problem. We are adult enough to accept that even bad luck isn't somebody else's problem. It took nearly ten years for us to recover from these losses. Now, we are expected to ante up for the greedy behavior of others. Buyers got a truth in lending statement which they obviously thought they could figure a way around. Lenders lowered their eligibility requirements to book more business despite the knowledge of the mathematical probabilities of default. They enjoyed the profits for a few years. Now we're supposed to make up for their stupidity/greed. I think the rest of us should go on strike and tell Congress, "Bail me out too!"
This said, I have an observation about the three paragraphs that follow your introductory statement. I had done a google search on bank deregulation. The first link in that search was to an article on the World Socialist Web Site. Its first three paragraphs are word-for-word the same as yours. Not saying that's where you got it, or that they were the originators. But, aren't there supposed to be footnotes that refer back to the source? Didn't want anyone to get into any sticky situations.
Again, though, nice article. It's too easy for partisans to screw things up that should have never been a part of their 'game' to begin with. I think that is one of the other pieces of this problem.

Tim Barry

mike volpe said...

I didn't realize I was quoting a socialist web site, however the article is sourced. There is a link provided and the quote is indicatd by indentation.

Anonymous said...

It appears to me that the 1999 act undid controls put in place in the 1930s to prevent uncontrolled speculation and leverage buying which lead to the crash in 1929. OK, you say the solution isn't to limit institutions ability to enter markets in which they have no experience, only to increase government oversight. Sorry, government oversight doesn't work well, and these laws from the 1930s need to be reinstated.

mike volpe said...

It appears to me that you have no idea what you are talking about but rather you hope that if you use enough important sounding words, no one will notice.

While your words are important sounding, I have no idea what you mean. What sorts of capitalization rates were set in 1933 and what were they set to? You don't know because everything you just said is nonsense.

Anonymous said...

There are absolutely plenty of borrowers to blame. While I am sure there were plenty of cases where lenders completely lied about elements in the loans... most of the cases there were years of "nod, nod, wink, wink" going on between lenders and borrowers. The ongoing increasing prices for real estate covered these types of actions and simply pushed the next year's actions to be ever more nonchalant. At some point borrowers even thought of themselves as needing to exaggerate as real estate prices outstripped salaries.

It is the lender's job to protect their companies against people who cannot pay the loan back (which they obviously failed to do), and the borrower's job to make the loan payments they agreed to make.

What really is aggravating is that I was one of those border cases that could have bought something back in 2002-2003. I would have rolled the dice and looking around today I would have been ok as the appreciation in our area has still left most people in our area in the black if you look back that far.

So not only was I renting because it was the responsible thing to do, I will now also get to pay for my neighbors who were irresponsible in the form of higher taxes.

c'est la vie.

Anonymous said...

Deregulation made the scrutiny of the SEC voluntary. Investment bankers are no longer responsible to make certain that the product they were selling is legit. They were buying subprime mortgages and mix them in with a AAA bond and sold them as such --- AAA. And you talk about FRAUD? What could be more dishonest than that?

mike volpe said...

I don't speak gibberish. The last anonymous poster needs to explain themselves a lot better. The fraud I speak of is the lies and misstatements made in securing the loan in the mortgages that are the underlying asset of these bonds.

Anonymous said...

Who is to blame for the lies and deceit on loan applications? To get to the bottom of this, you would have to go through every loan case by case. I was shocked earlier this year when applying for a refinance of a loan that I did not qualify. I had the loan officer we were working with pull the file from 2 years ago and he told me that the application had my husband making 4 times his salary. Our application had been taken by phone. Apparently we signed it when we signed all of our loan docs and closing paperwork.

Anonymous said...

Haven't hear a lot about this or Phil Gramm and his huge hand in this.

Anonymous said...

When you write an article, you are obligated to place in quotes, and give credit to other authors work. To do otherwise is called plagiarism and is illegal. A good deal of your article is plagiarized from written & published By Martin McLaughlin on 1 November 1999

mike volpe said...

Yes, on the internet giving credit is done by linking to said article. On blogspot, that which is centered is in quotation marks. I did both for the article you referenced.

Anonymous said...

To claim that we don't really need regulation, but at the same time the crisis was caused by lack of action on the part of government? There's only one word to describe that: Hypocrisy

mike volpe said...

There's a difference between a lack of regulations and a lack of enforcements of the regulations already in place.

Anonymous said...

Greed, Greed and Greed! Does that sum it up? Financial institutions are not are friends but the consumer needs them. A necessary evil!!

Anonymous said...

Are both republicans and democrats competing to show us who is more corrupt? AND WHY ARE AMERICANS SCARED SHITLESS TO SPEAK UP?

Republicans Defend Obama's Trade Pact While Pressing To Deregulate Banks:



Will it take a military coup to purge Congress and get this country back on track? The ballot box is not doing it fast enough.