Glass-Steagall: Be Careful What You Wish

After a Massachusetts wake-up call Obama has decided to pay more attention to Paul Volcker. Is it too little, too late to quell public anger? What will the effects be if new Glass-Steagall legislation is enacted?

Let's explore those questions starting with Obama to Propose New Rules on Proprietary Trading.

President Barack Obama tomorrow will offer proposals to limit the size and complexity of financial institutions’ proprietary trading as a way to reduce risk- taking, an administration official said.

“We’ve got a financial regulatory system that is completely inadequate to control the excessive risks and irresponsible behavior of financial players all around the world,” Obama said in an interview with ABC News broadcast tonight.

“People are angry and they’re frustrated,” Obama said in the ABC interview. “From their perspective, the only thing that happens is that we bail out the banks.”

The proposed rules could limit activities of banks like Goldman Sachs Group Inc., the most profitable investment bank in Wall Street history. Goldman reaped more than 90 percent of its pretax earnings last year from trading and so-called principal investments, which include market bets on securities and stakes in companies.

Obama to Propose Limits on Risks

The New York Times also weighs in on the issue in Obama to Propose Limits on Risks Taken by Banks.

President Obama on Thursday will publicly propose giving bank regulators the power to limit the size of the nation’s largest banks and the scope of their risk-taking activities, an administration official said late Wednesday.

He also would prohibit proprietary trading of financial securities by commercial banks, including mortgage-backed securities. Big losses in the trading of those securities precipitated the credit crisis in 2008 and the federal bailout.

Last week he proposed a new tax on some 50 of the largest banks to raise enough money to recover the losses from the financial bailout, which ultimately could cost up $117 billion.

Now, in perhaps his most daring move, he is calling for a modern-day version of the Glass-Steagall Act, which in 1933 separated commercial and investment banking. The new separation would prohibit standard commercial banks from engaging in proprietary trading using funds from their commercial division.

Only a handful of large banks would be the targets of this legislation, among them Citigroup, Bank of America, J.P. Morgan Chase and Wells Fargo. Goldman Sachs, the Wall Street trading house, became a commercial bank during this latest crisis, and it would presumably have to up that status.

Mr. Volcker has been trying for weeks to drum up support — on Wall Street and in Washington — for restrictions similar to those passed in the Glass-Steagall Act in 1933. That law separated commercial banking and investment banking, so that the investment arm could no longer use a depositor’s money to purchase stocks, sometimes drawing money from a savings account, for example, without the depositor’s knowledge.

Mr. Volcker has gradually lined up big-name support for restrictions on such trading, but the Obama administration until now had focused on regulating the activities of the existing financial institutions, not breaking them up or limiting their activities.

“When I was running Citi,” Mr. Reed said of his tenure in the 1980s and 1990s, “we simply did not trade for our own account.”

Targeting Big Banks

Either an idea is a good one or it isn't. And if it is a good one, then it should be uniform. I see no sense in targeting "a handful of large banks".

Glass-Steagall Scapegoat

Moreover, I think Glass-Steagall is a scapegoat for this crisis. I am not the only one. Please consider Volcker's Quest To Reinstate Glass-Steagall.

The loudest argument to bring back Glass-Steagall usually goes something like this: Depository institutions (commercial banks) need to be very safe and stable. If you allow investment banks to take big risks with those deposits, bad things can happen.

Now let's take a step back. What are these risky securities we're talking about? They're bonds backed by real estate -- originated by commercial banks. So really, it was the commercial banks that took the crazy risks that almost broke the economy. If there was never securitization, and the same subprime loans were made, then we'd have very, very sick depository institutions, but investment banks would have been largely unscathed.

Of course, there was securitization, and that was done by the investment banks. Where might Glass-Steagall have helped here? Well, it wouldn't have. Securitization existed before the Act was repealed, and it would exist if it's brought back. Commercial banks can still sell mortgages into giant pools for investment banks to make securities out of, with or without the mortgage originators and bankers living under the same umbrella. Commercial banks also still would have retained lots of their mortgage exposure, and still been quite sick. Just ask Countrywide.

Merits of Glass-Steagall

The idea that Glass-Steagall would have done much, if anything to prevent this crisis is potty. Goldman Sachs, Bear Stearns, and Lehman would all have done what they did. Wells Fargo would have kept its pool of option arms, and the rest of the banks would have followed their lend to securitize model and the regional banks would still be losing their asses on silly commercial real estate deals.

That said, I am in favor of these initiatives for the simple reason they help prevent fraud. Many of the large institutions hand out advice and trade against it. Goldman Sachs is accused of front-running trades. Their disclosure documents even allow it.

Hedge Funds And Banking

I would go one further than Obama. Goldman Sachs is best viewed as a hedge fund. It is ridiculous that such an operation can borrow money from the Fed for virtually nothing and not only trade that money, but trade against the advice they are handing out to clients, with leverage!

Thanks to the Fed, Goldman Sachs can do just that. So the first thing I would do would be to remove the bank holding company status of Goldman Sachs.

The second thing I would do would effectively require it to break up.

Soft Separations Do Not Work

Expecting trading divisions to not talk to investment advice divisions within a single company is like expecting unsupervised teenagers in a room with a keg of beer to not drink. It won't happen.

I believe it is unethical if not outright fraudulent to front run trades or to trade against advice given to clients. Units that offer advice must be physically separated, not logically separated from units that trade their own accounts. The only sure-fire way to make that happen is to physically breakup the companies.

All of this dark-pool stuff of sniffing out orders and front-running trades has to go as well.

Outside of that, I do not care what Goldman does or how much money they make or how much bonuses they hand out, as long as taxpayers are not on the hook for what they do.

Given that Goldman makes nearly all of its money trading, I think Goldman ought to go private. No one would then know or care how much they make, and taxpayers would have the side benefit of Goldman coming out of too big to fail category.

Morgan Stanley and Merrill Lynch should not be bank holding companies either. Citigroup, Wells Fargo and literally all the banks need to bring off-balance sheet garbage onto the balance sheet and mark it to market.

Banks need to get back to making loans to qualified customers and holding those loans for the term. All of this other crap adds risk to the system and puts taxpayers at risk.

What About The Free Market?

Are such proposals inconsistent with a free market? I think not. The free market is not the same as anarchy. The role of government is to protect property rights and civil rights. There are rules and regulations to prevent theft, murder, and fraud, as well there should be.

Glass Steagall would not have prevented this crisis, but the proposals would prevent front running trades and betting against advice given to clients, both of which I believe constitute fraud.

However ......

Be Careful What You Wish

Everyone is railing about banks not lending and the bonus pools at Goldman Sachs, JPMorgan, and Morgan Stanley. Well guess what?

• Reduced leverage means reduced lending and reduced profit potential.
  
• Marking loans to market would reduce lending and reported earnings.
  
• Goldman Sachs going private would reduce S&P 500 earnings.
• Bringing assets on to the balance sheets of banks would reduce S&P 500 earnings.
• Reduced earnings (in the long run) means lower share prices

Everyone wants more small business lending and less risk. Sorry folks, that is physically and logically impossible. Reducing reckless risk, especially risk born by others (taxpayers) is a good idea, but it's important to understand exactly what that will mean to earnings going forward.

Think of the affect lower share prices and reduced risk taking will have on pension plans and 401Ks. In the long run, less risk is a good thing, and I am in favor of it. I just doubt people are prepared for what it means.

The stock market is already insanely overvalued, and the regulatory actions everyone is clamoring for will make it even more so. Good luck with that.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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