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Glass-Steagall : RIP
Posted by: Lance on Sunday, September 21, 2008

(cross posted at A Second Hand Conjecture)

Continuing the discussion on tonight's podcast, one of the recurring themes of much of the commentary on our current financial crisis is that the cause is too much deregulation. Possibly there is some truth to this, though the evidence is rather vague. The most disturbing figure in all this is Barney Frank.

"We need stricter standards on loans."


Except, the problem here wasn't lack of regulation, but that the regulations were not enforced, or fraud, by lenders, brokers and their clients. More laws doesn't help. This was also a failure of long standing, not new. I would suggest simplifying and increased enforcement would be a better option.

"Restrict leverage"


Harder to say than do. Besides, the main institutions which took too much leverage were regulated (no matter how much Barney Frank and others try and obscure that fact.) Banks operate with leverage in the low double digits, but I have heard of no calls to restrict them to lower levels. So who does that leave? Well, in 2004 the SEC exempted five investment banks from the required 12-1 capital ratios, and no one else. Which five?

Goldman Sachs
Morgan Stanley
Merrill Lynch
Lehman Brothers
Bear Stearns

Two have ceased to exist, one has been merged into Bank of America, and the last two have have just become bank holding companies. Yep, it was just announced, Morgan and Goldman have become banks.

Back to that in a moment, first lets look at the relaxation of the net capital rule:

Show/Hide
So what prompted this rule change?


Show/HideSo much for the idea this issue is an American, unregulated, laissez faire model that has blown up and we should follow Europe's lead. In fact, I recommend this link highly:

Show/HidePart of the reason AIG was so important was because its insurance was being used to hide the true leverage of European banks which are far more leveraged than US banks, but used AIG's guarantees as assets which masked that effect. Go ahead, read the whole thing.

This is not brain surgery. This is not an area where more regulation is needed, we just need to impose existing regulations across the board like we used to do, and pray that Europe doesn't drag us down as they cannot deleverage without tanking their system.

The other area where ridiculous levels of leverage existed were, with the active and almost fanatical support of Barney Frank, the cases of Fannie and Freddie, which were leveraged 40-1 or more. Once again, there is no need for more regulation here, there was a need to shrink these monstrosities and remove their implicit government backing.

"Regulate hedge funds"


Uhh, hedge funds have done rather well in this environment. It isn't hedge funds which have brought the financial system to its knees through their failure, it has been investment banks (Lehman, Bear) commercial banks (IndyMac, Washington Mutual)and Government Sponsored Entities (Fannie, Freddie being the largest.)

I chuckle every time I hear the activities of these groups being compared to "giant hedge funds." What an insult to hedge funds, the majority of which use little to no leverage. Barney Frank keeps claiming that it is the unregulated sector which has gotten us in trouble, but it has been the least regulated which have done the best. Hedge funds don't expect to be bailed out, and losses far smaller than a typical mutual fund has suffered (or heaven forbid, bank stocks) leads to massive redemptions by investors. The press sensationalizes that by calling it a "hedge fund blowup" but in fact it is the discipline and risk of sudden, uncompensated failure which keeps their leverage in check. Lose 15% in the hedge fund world and not only is your income cut drastically as performance fees disappear, but your assets flee. Lose 85% or more in the regulated world, like Washington Mutual, and the government is pulling out the stops to save you, and especially your creditors. Both hedge fund managers, and especially hedge fund investors, know the score. Lose money and you are on your own. This has led to losses on a far smaller scale than elsewhere, and in many cases out and out profits.

Bring Back Glass Steagall!

The most inane attack on financial deregulation is the constant drumbeat about the repeal of Glass-Steagall, which has the added appeal of being something you can pin on Phill Gramm. Unfortunately that simple rule change doesn't help. It isn't the large diversified commercial banks which have failed most spectacularly, it has been investment banks which lack the stability of banking deposits and banks too concentrated in particular lending markets. Exactly what has Glass Steagall's supposed demise (and it really hasn't changed that much anyway) contributed to this?

I can think of no way in which it is implicated at all, despite Kuttner, Krugman and Barney Frank's heated, but unsupported claims, to the contrary. In fact, Glass-Steagall is now defacto dead anyway. The changes to Glass Steagall make it possible for Merrill to have merged with Bank of America and Bear Stearns to be acquired by JP Morgan. Barclays Bank now owns Lehman's brokerage and Morgan Stanley and Goldman Sachs have just decided to turn themselves into bank holding companies:

Show/HideActually, this is pretty sharp, and the kind of market based solution I far prefer to what the government is planning. They both need actual banking operations, and this opens up an opportunity:

Show/HideBuying up failed banks? I certainly like that better than we taxpayers. Glass Steagall is dead, and this crisis has shown that we should be glad it is.
 
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Previous Comments to this Post 

Comments
Isn’t letting the investment banks become merged with retail banking another way to prop up bad behavior?

I believed you called the securitization of mortgages, the secondary market. Didn’t that market allow the Fanny Mae situation to become as big as it did? And ultimately that was all underwritten by the Government, so people looked the other way.

Now we will have that behavior underwritten by FDIC insurance. What kind of liability does the government have if the investment branch mushrooms with all that retail capital and then the investment branch stumbles again and puts ma and pa’s life savings at risk?

Seems like we are looking at all the lessons learned from the Great Depression as quaint and ignoring them completely. I mean, what’s left? And adding social engineering to the mix.

I think its time to add gold to my portfolio.
 
Written By: jpm100
URL: http://
I’m enjoying the hypocrisy of the the State-shtuppers swarming the comments sections of the pro-freedom blogosphere, blaming the free market for the mess (ignoring the their beloved Daddy and Mommy State’s involvement every step of the way) and then pretending that this crises shows the need for a bigger and more powerful governemtn. You know, like they were all free-marketer before. If this crisis had never happened and the economy was going swimmingly, they’d still be advocating more Stae intervention in the market. I don’t know why they just can’t be honest (well, I guess a philosophy based on legalized plunder isn’t going to attract a lot of honest people) and say, "I love the State! I want more of it! Freedom scares me, and I also kind of get off on forcing people do to what I want." This crisis has little to do with their attraction to power and coercion, except to provide an excuse for the exapansion of the State. It’s an old story.
 
Written By: Bilwick
URL: http://
Let me quote Boortz, here.
1. Almost all of the financial problems we see today are based on bad mortgage lending. That would be lending money to people to buy homes who didn’t qualify for a loan.

2. The Democrats, under Clinton, strengthened a government-created monster called the "Community Reinvestment Act." This law was then used by "activists" and "community organizers" (like Obama?) to coerce lending institutions to make these bad loans ... millions of them.

3. Now we see what happens when political "wisdom" supplants good loan underwriting. When private financial institutions are virtually forced to make loans to people with a bad credit and job history .. this is what you get. Enjoy it.
The ’bad behavior’ was governmental in nature.
They created the damage, and forced it by means of law.

 
Written By: Bithead
URL: http://bitsblog.florack.us
The Community Reinvestment Act (CRA) may have been responsible for some portion of problem mortgages, but I really doubt that all those bad sub-prime mortgages are due to the evil CRA. The implication here that innocent and unwilling lenders were forced to issue subprime mortgages, some with dubious documentation, to low/moderate income borrowers is ludicrous. Government may have had a role in producing this mess, but it is not the only cause.
 
Written By: timactual
URL: http://
I think its time to add gold to my portfolio.


Always. A little gold for the just in case the worst happens scenario.

What kind of liability does the government have if the investment branch mushrooms with all that retail capital and then the investment branch stumbles again and puts ma and pa’s life savings at risk?
Except JP Morgan, Bank of America and the rest are already investment banks. Investment banking per se, wasn’t the issue, it was the leverage and lack of diversification. Commercial banks that are undiversified haven’t fared much better. I expect at least a thousand to go under. Small investment banks have done very well, much better than commercial banks, but they don’t carry swollen balance sheets at 30-1 leverage.

 
Written By: Lance
URL: http://asecondhandconjecture.com
Timactual,

I agree. The government is part of the problem, but markets don’t insure rational action by participants. They should insure there is a penalty for it, which is what Wall Street and much of our political class is trying to avoid.
 
Written By: Lance
URL: http://asecondhandconjecture.com
There are going to be some fortunes made from this....any tips on who is going to do well from this mess 5 years down the line?
 
Written By: Harun
URL: http://
Tips? I don’t have any tips, except I do not think this is over by any means. That kind of insight will have to wait until a lot more water is under the bridge.

I would guess the survivors will do pretty good, though they will have to operate in a less profitable (though less risky) environment. They should be able to pick up market share however. The problem is, who survives?
 
Written By: Lance
URL: http://asecondhandconjecture.com
I just have to wonder how much of the economy this activity has been stimulating, or at least how much of the economic numbers this has been stimulating. I’ve always been given the impression housing construction figures heavily in those numbers. And that has to be driven in part from housing demand.

We’ve been flirting with low GDP numbers as it is. Should be interesting what the less risky environment brings. Or if investors will find a new home for their dollars.
 
Written By: jpm100
URL: http://
The Community Reinvestment Act (CRA) may have been responsible for some portion of problem mortgages, but I really doubt that all those bad sub-prime mortgages are due to the evil CRA
Of course not all of them; there’s always bad loans out there, even assuming qualified borrowers. However the real spike in bad loans occurred when? Post CRA.
The implication here that innocent and unwilling lenders were forced to issue subprime mortgages, some with dubious documentation, to low/moderate income borrowers is ludicrous
Hardly.
You under-estimate the power of government in this. I OTOH was at a national back for about 10 years through that period. I saw it, first hand.
 
Written By: Bithead
URL: http://bitsblog.florack.us
Idk. I think flipping and the housing bubble made bad loans seem tolerable. In six months, the person would have equity and a little bit longer the person could probably sell and break even or make a profit.
 
Written By: jpm100
URL: http://
"Post CRA"

Post hoc ergo propter hoc, eh?



Allow me to clarify part of my statement by restating;

"The implication here that the entire problem was caused by innocent and unwilling lenders being forced to issue subprime mortgages, some with dubious documentation, to low/moderate income borrowers is ludicrous".

I am willing to bet that there are plenty of bad mortgages on houses bought in upscale neighborhoods.
 
Written By: timactual
URL: http://
I am willing to bet that there are plenty of bad mortgages on houses bought in upscale neighborhoods.
In fact, the majority of the exposure is to middle and upper class borrowers, whether subprime, alt-A or Prime.
 
Written By: Lance
URL: http://asecondhandconjecture.com

 
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