Not with a Bang
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.
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.
- 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.
- Glass — Steagall Act From Wikipedia, the free encyclopedia (worldwright.wordpress.com)
- Too Big To Lend? Why Small Businesses Are Getting Denied By Big Banks (huffingtonpost.com)
- Will Rogers on Occupy Wall Street (indiancountrytodaymedianetwork.com)
- Paul Ryan: ‘I Agree’ We Need To Reinstate Glass-Steagall (thinkprogress.org)
- Nothing less than the total separation of retail and investment banks will do (telegraph.co.uk)
- There is no such thing as a safe bank (flipchartfairytales.wordpress.com)
- Richard Barrington: It’s (Still) A Wonderful Life: A Remake (huffingtonpost.com)
About dcpetterson (198 posts)
D. C. Petterson is a novelist and a software consultant in Minnesota who has been writing science fiction since the age of six. He is the author of A Melancholy Humour, Rune Song and Still Life. He lives with his wife, two dogs, two cats, and a lizard, and insists that grandchildren are the reward for having survived teenagers. When not writing stories or software, he plays guitar and piano, engages in political debate, and reads a lot of history and physics texts—for fun. Follow on Twitter @dcpetterson