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The Answer to the Ulti­mate Question?

What caused the 2008 world­wide eco­nomic col­lapse? I don’t really know, and I don’t think any­one has The Ulti­mate Answer. We’ve all heard bits and pieces, we’ve all heard argu­ments, and there have been pun­dits and politi­cians who have made claims of per­fect knowl­edge. Let’s have a dis­cus­sion about what we know and what we think.

Here’s some­thing I recently learned. The $1.7 tril­lion in sub-​​prime mort­gage loans is often held up as one (per­haps the major) con­tribut­ing fac­tor. It pales into insignif­i­cance beside the unreg­u­lated $600 tril­lion deriv­a­tives mar­ket, of which those mort­gages amounted to less than three tenths of one percent.

Okay, your eyes are about to glaze over. I can see it from here. Hang in there.

In the wake of the dis­as­trous col­lapse of 1929, Con­gress enacted a sweep­ing reform of the finan­cial sys­tem, the Bank­ing Act of 1933, oth­er­wise known as the Glass–Steagall Act, named after its leg­isla­tive spon­sors, Sen­a­tor Carter Glass (D-​​VA) and Rep­re­sen­ta­tive Henry B. Stea­gall (D-​​AL3). One of the most dev­as­tat­ing results of the 1929 cri­sis was the effect it had on mil­lions of Amer­i­cans whose life sav­ings were wiped out when the banks col­lapsed. Glass-​​Steagall addressed the issue in at least three impor­tant ways.

First, this Act estab­lished the Fed­eral Deposit Insur­ance Cor­po­ra­tion (FDIC), which insures the deposits of Amer­i­cans up to $100,000. If you put your money in a bank, and that bank goes bank­rupt, your first $100,000 is safe. (If you have more than the limit to save, and divide it among sev­eral banks such that no bank is hold­ing more than the limit, then all of it is still insured. That limit was recently raised to $250,000.) Never again, it was thought, would the poor and risky deci­sions of bank man­agers and investors endan­ger the future of U.S. citizens.

Poor and risky deci­sions of bank man­agers and investors?” Where does that fit it? It has to do with the moral haz­ards Michael talked about last month. It’s the way banks and invest­ment houses work. When you put your money in a bank, it doesn’t stay in the vault in the back. The bank loans it to other peo­ple — for instance, as mort­gage loans, so peo­ple can build houses, or com­mer­cial loans, so peo­ple can cre­ate com­pa­nies and hire employ­ees. (If you haven’t seen It’s a Won­der­ful Life, go watch it, now. We’ll wait.) The bank earns money on these loans, because of the inter­est it charges. If the bor­row­ers repay those loans, and the inter­est on them, the bank stands to earn a lot of money, depend­ing on the inter­est rate the bank charges.

Banks charge higher rates for riskier loans, to cover the increased like­li­hood of default. Mak­ing too many of these high-​​risk loans puts the bank itself at risk. Glass-​​Steagall took steps to dis­cour­age banks from mak­ing such high-​​risk loans, by lim­it­ing (among other things) the inter­est rates banks are allowed to charge for loans or to pay on deposits. This pro­vi­sion was known as Reg­u­la­tion Q.

A third pro­tec­tion for aver­age cit­i­zens was the sep­a­ra­tion of con­sumer bank­ing from invest­ment bank­ing.

The for­mer refers to the sorts of things men­tioned above — sav­ings and check­ing accounts of aver­age Amer­i­cans, mort­gage loans, also auto loans, per­sonal loans, credit cards, even many forms of busi­ness loans (par­tic­u­larly for small businesses).

The lat­ter, invest­ment bank­ing, refers to more spec­u­la­tive activ­i­ties — invest­ments in the stock mar­ket, or in cur­rency fluc­tu­a­tions, pur­chas­ing the debt of for­eign coun­tries, and so on.

One of the biggest con­trib­u­tors to the 1929 col­lapse of the Amer­i­can econ­omy (and the world econ­omy) was that banks invested heav­ily in these sorts of more risky spec­u­la­tions. These invest­ments had been funded by aver­age peo­ple giv­ing their money to neigh­bor­hood banks, which then used that money to buy into some absurd invest­ment schemes in the hope of real­iz­ing high returns — the higher the poten­tial return, of course, the higher the risk. When the bot­tom fell out of the stock mar­ket, it was aver­age people’s deposits that disappeared.

By sep­a­rat­ing con­sumer bank­ing from invest­ment bank­ing, it was thought this could never hap­pen again. The high rollers, who wanted to engage in risky spec­u­la­tion, could still do so. The aver­age cit­i­zen, who had no idea what the bank was doing with the money, would be pro­tected from the riski­est invest­ments. This seemed par­tic­u­larly rea­son­able because the aver­age depos­i­tor never saw the prof­its from those invest­ments any­way. The money had all been pock­eted by the bankers, who enriched them­selves by gam­bling with other people’s money.

Note the unfair­ness of this. The depos­i­tors took the risk, by giv­ing their money into the hands of the banks. The bankers risked noth­ing, since it wasn’t their money. But the bankers prof­ited when the invest­ments paid off. There’s that moral haz­ard rear­ing its ugly head again.

The Glass-​​Steagall reg­u­la­tions worked, and worked well. Prior to Glass-​​Steagall, the U.S. econ­omy had suf­fered a boom-​​and-​​bust finan­cial cycle of about ten years ever since our coun­try was founded. After Glass-​​Steagall, there was not a sin­gle finan­cial col­lapse for nearly two gen­er­a­tions. (There was a mas­sive bank bailout dur­ing Reagan’s term; feel free to dis­cuss that in the comments.)

Reg­u­la­tion Q of Glass-​​Steagall was sub­stan­tially repealed by the Depos­i­tory Insti­tu­tions Dereg­u­la­tion and Mon­e­tary Con­trol Act of 1980. Banks could now pay, or charge, pretty much any inter­est rate they wished. Credit card and mort­gage rates sky­rock­eted — but these loans were sud­denly avail­able to all. Addi­tion­ally, Amer­i­cans were now encour­aged to cre­ate new “401(k)” retire­ment accounts, and pen­sion funds were allowed to invest in the stock mar­ket. This money is not insured by the FDIC. If the 401(k)‘s or pen­sions go belly up, Amer­i­cans lose that money.

The sep­a­ra­tion of com­mer­cial and invest­ment bank­ing (along with nearly all other Glass-​​Steagall reg­u­la­tions) was repealed on Novem­ber 12, 1999, by the Gramm-​​Leach-​​Bliley Act, named after its co-​​sponsors Phil Gramm (R-​​TX), Rep­re­sen­ta­tive Jim Leach (R-​​Mt. Ver­non, IA), and Rep­re­sen­ta­tive Thomas J. Bliley, Jr. (R-​​Richmond, VA). Banks can now do what­ever they want to with your money, even with every­day deposits. FDIC still insures the first $250,000 of that, but the banks pay vir­tu­ally no inter­est to FDIC-​​insured sav­ings accounts.

Prior to 1999, there were no “deriv­a­tives.” These invest­ment vehi­cles exist only due to the repeal of Glass-​​Steagall. Banks love deriv­a­tives, because of the poten­tial profit.

A “deriv­a­tive” is pretty much what it sounds like. It is an invest­ment that is worth noth­ing by itself, but derives its value (or poten­tial value) from some­thing else:

That some­thing else could be Gen­eral Motors stock or Mor­gan Stan­ley bonds or any num­ber of other items. In a credit default swap, for instance, a hedge fund that loaned $10 mil­lion to South­west Air­lines might agree to pay 1 per­cent a year, or $100,000, to an invest­ment bank. In return, the invest­ment bank agrees to pay the hedge fund the full $10 mil­lion if South­west goes bankrupt.

You can think of a “deriv­a­tive” as a high-​​stakes wager, or a trip to Las Vegas, or an insur­ance pol­icy, whichever anal­ogy best suits your tem­pera­ment. It’s a way to make money from some­one else’s money, some­one else’s invest­ment. You’re bet­ting on whether some­one else is going to make or lose money, and using some else’s money to make the bet.

Note the unfair­ness of this. The depos­i­tors take the risk, by giv­ing their money into the hands of the banks. The bankers risk noth­ing, since it isn’t their money. But the bankers profit — not the investors — when the invest­ments paid off.

Sound famil­iar? It should. It’s our old friend, moral hazard.

These deriv­a­tives would have been ille­gal under Glass-​​Steagall. But now, there is no one to con­trol it, pre­vent it, or over­see it under Gramm-​​Leach-​​Bliley.

Where do those sub­prime mort­gages fit in? Since banks could charge what­ever they wanted for a mort­gage loan, they made increas­ingly risky loans, for increas­ingly higher rates. Since no one was watch­ing what they did with those loans, they bun­dled them into nearly-​​worthess risky bunches, and sold those bunches as “deriv­a­tives” while lying about how risky they were. Other invest­ment banks bought them, then got into trou­ble when the bets went sour — as they were designed to do. Since there was no longer any­thing pre­vent­ing com­mer­cial banks from mak­ing these bets with the deposits of aver­age Amer­i­cans — for instance, retire­ment accounts — every­one suffered.

And because there was no sep­a­ra­tion between com­mer­cial and invest­ment banks, your retire­ment accounts and 401(k) accounts were now under the con­trol of peo­ple who gam­bled them in the stock mar­ket and in deriv­a­tives. Too bad for you.

In early 1999, deriv­a­tives did not exit. Today, there are more than 600 tril­lion dol­lars — that’s more than twelve times the com­bined GDP of all nations on Earth — sit­ting in wagers in deriv­a­tives mar­kets. Not all of those wagers will fail. Many of them, how­ever, are invested in places like Euro­pean debt or even riskier ideas. The peo­ple who made those bets will not suf­fer, because it’s not their money.

Unless we begin to re-​​regulate, 2008 might soon seem to be a mere blip in the decline of world civ­i­liza­tion. T. S. Eliot may have had the right of it.

This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.