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TGIF: The Housing-Financial Meltdown Revisited

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Five years after the housing and financial meltdown, self-styled progressives are still peddling their pseudoexplanation: that it was largely the fault of the 1999 repeal of a provision of the New Deal–era Glass-Steagall Act, which mandated the separation of commercial and investment banking. This tale is favored by Sen. Elizabeth Warren and others of her ilk, who hold the rather absurd view that the United States had free banking between the 1980s and the passage of Dodd-Frank in 2010. (See this video in which Warren attributes the growth of the American middle class to Glass-Steagall and the middle class’s decline to the repeal. Not everyone agrees, however.) For more on Warren, click here.)

One wonders if Warren et al. ever bother to look at the facts, particularly the passage of Glass-Steagall and what, if any, role the repeal actually played in the crisis. Since they never say anything specific, it’s hard to know if this is anything more than an incantation designed to blame the “free [sic] market” and to bolster their case for bureaucratic management of our lives (which they call “the economy”). It takes Herculean ignorance or dishonesty to claim that America had free banking before 2010. Hence, this is a classic confirmation of my observation that no matter how much the government controls the economic system, any problem will be blamed on whatever small zone of freedom remains.

According to folklore, Glass-Steagall was passed because of rampant conflict of interest and abuse among banks that both served savers and borrowers (commercial banking) and underwrote and sold securities (investment banking). But this is a case of the victors writing the history.

In “The Rise and Fall of Glass-Steagall” (2010), economists Jeffrey Rogers Hummel and Warren Gibson explain that Sen. Carter Glass realized his long-held goal of separating these two banking functions only after the 1933–34 so-called Pecora hearings in the U.S. Senate. (Ferdinand Pecora was chief counsel of the Senate Banking and Currency Committee.) “Revelations of supposed abuses by National City Bank (NCB) of New York and its president, disclosed in the Pecora hearings, provided the spark to ignite the issue and give Glass his victory,” Hummel and Gibson write. But the revelations revealed nothing terribly substantial against NCB or its subsidiary, National City Company (NCC).

Among the more serious charges, executives allegedly profited from the firm’s own securities underwritings. For example, National City bought a large block of stock in the new Boeing Corporation. Rather than sell this stock to the public, Pecora charged that NCC “retained a large block for itself and allotted the remainder to Mr. Mitchell and a select list of officers, directors, key men, and special friends.” But an internal NCC memorandum concerning this stock says,  “[O]n account of the fact this industry is still somewhat unseasoned, even though we regard this particular company as sound and having a very bright future, we were not quite ready to make a general offering to our customers. It would have been next to impossible to avoid taking orders from the type of investor who should not buy this stock. Therefore, our own family and certain officers and employees of the Boeing Co. and affiliations have taken the entire issue.”

On which Hummel and Gibson comment, “Not only does this not sound improper, but in fact it sounds like just the sort of prudent regard for customers’ best interests that was supposed to be lacking in combined firms such as NCB/NCC.” It certainly was not a case of a bank peddling dubious securities to gullible customers.

However, they continue,

The committee produced a Mr. Brown, a witness who claimed to have lost $100,000 as a result of an NCC salesman’s bad advice. Bankrupt and in ill health, Mr. Brown was an ideally sympathetic witness, but it turned out that he had been a successful businessman and not a novice. NCB was forbidden to call rebuttal witnesses.

Economist George Bentson looked into the complaints against NCB and Chase Bank in his The Separation of Investment and Commercial Banking (1990) and concluded that they had no sound basis. Bentson “added a thorough critique of the supposed theoretical problems of universal banks such as conflicts of interest,” Hummel and Gibson write, continuing,

But what about conflict of interest? It is certainly possible that a banker in a combined firm might steer customers into ill-suited investments or insurance products. This is a hazard we face whenever we deal with professionals, such as physicians who advise treatments and also provide them, or lawyers who advise lawsuits and offer to file them. Such hazards are manageable: We can always get a second opinion or consult a fee-based financial planner or simply rely on the professional’s incentive to maintain a reputation for ethical service.

A few anecdotes and the potential for a conflict of interest were hardly good reasons for the government to arbitrarily separate financial functions, depriving customers of the benefits of integrated services. Hummel and Gibson write,

Financial institutions have widened their offerings considerably in recent years without any apparent problems. At the website of Wells Fargo Bank, for example, one finds not only traditional deposit and savings accounts and loans of all sorts, but also stock brokerage, mutual funds, automobile insurance, homeowner’s insurance, and even pet insurance. (But the Wells Fargo branch in a nearby Safeway store didn’t catch on and was closed.) Similarly, Charles Schwab, which began as a discount broker, now offers a full range of investment products and advice as well as banking services through its affiliated bank. Customers enjoy expanded services and lower prices as a result of the widening of competition among traditionally distinct firms. There is no sign of significant or widespread problems arising from conflicts of interest in such firms.

Hummel and Gibson add that success is not guaranteed for such companies, and they discuss some notable failed attempts by large firms to offer assorted financial services.

While the relevant part of Glass-Steagall was repealed in 1999, Hummel and Gibson point out that it was “becoming a dead letter” well before then. The repeal mostly codified reality.

“Incidentally,” they write, “no other developed country has ever seen fit to separate commercial banking from investment banking. Banks in Germany and Switzerland have always been free to engage in underwriting and securities holding to no obvious harm.” Aren’t we often told that Europe is much more enlightened in such matters?

This is hardly to suggest that all was well with banking before Dodd-Frank. Not by a long shot. The industry was a corporatist monstrosity, a cartelized  affair that included government deposit insurance, which protects banks from conscientious depositors who would otherwise scrutinize their lending practices. But the 1999 repeal of one section of Glass-Steagall was not among the problems. (Then-Rep. Ron Paul, an advocate of free banking, voted against the repeal because no related privileges were abolished. I respect that argument, but that is different from blaming the meltdown on the repeal, which Paul does not do.)

If the repeal of Glass-Steagall is acquitted in causing the 2008 meltdown, what did cause it? Hummel and Gibson respond,

The crisis began with the housing collapse, a result of government encouragement of unsound lending practices. Financial firms took too much risk with mortgage-backed securities, in part because of moral hazard engendered by government guarantees and partly because bond rating firms were not as independent as was once thought. The limited liability that the investment banks gained when they became corporations may also have amplified moral hazard. There is no good reason to believe that Glass-Steagall, had it remained in effect, would have prevented any of these problems.

Peter Wallison of the American Enterprise Institute fills in the picture when he writes,

In 1992, Congress adopted the ironically named Federal Housing Enterprises Financial Safety and Soundness Act, also known as the GSE Act, giving HUD the authority to administer the legislation’s affordable housing goals. The law required Fannie Mae and Freddie Mac, when they acquired mortgages from lenders, to meet a quota of loans to borrowers who were at or below the median income where they lived. At first, the quota was 30%, but HUD was authorized to raise the quota and over time it did, eventually requiring a quota of 56%. [Emphasis added.]

The result of this and related policies? “At the time of Lehman’s failure [in 2008],” Wallison writes, “half of all mortgages in the U.S. — 28 million loans — were subprime or otherwise risky and low-quality. Of these, 74% were on the books of government agencies, principally the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.”

On their face, these numbers suggest that the government’s housing policy had created the demand for these mortgages, and thus had something to do with Lehman’s failure and the financial crisis. But in recent days nearly all articles have focused on the 26% of mortgages that were the responsibility of the private sector. It is as though the vast majority of the subprime mortgages that the government bought didn’t exist.

For more on HUD’s role see my “Clinton’s Legacy: The Financial and Housing Meltdown.”

Many people are determined not to see the government’s central culpability in the crisis that produced and continues to produce so much hardship. They rather believe that deregulation and greed were the culprits. But the fact remains: Wall Street couldn’t have done it alone.

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    Sheldon Richman is vice president of The Future of Freedom Foundation and editor of FFF's monthly journal, Future of Freedom. For 15 years he was editor of The Freeman, published by the Foundation for Economic Education in Irvington, New York. He is the author of FFF's award-winning book Separating School & State: How to Liberate America's Families; Your Money or Your Life: Why We Must Abolish the Income Tax; and Tethered Citizens: Time to Repeal the Welfare State. Calling for the abolition, not the reform, of public schooling. Separating School & State has become a landmark book in both libertarian and educational circles. In his column in the Financial Times, Michael Prowse wrote: "I recommend a subversive tract, Separating School & State by Sheldon Richman of the Cato Institute, a Washington think tank... . I also think that Mr. Richman is right to fear that state education undermines personal responsibility..." Sheldon's articles on economic policy, education, civil liberties, American history, foreign policy, and the Middle East have appeared in the Washington Post, Wall Street Journal, American Scholar, Chicago Tribune, USA Today, Washington Times, The American Conservative, Insight, Cato Policy Report, Journal of Economic Development, The Freeman, The World & I, Reason, Washington Report on Middle East Affairs, Middle East Policy, Liberty magazine, and other publications. He is a contributor to the The Concise Encyclopedia of Economics. A former newspaper reporter and senior editor at the Cato Institute and the Institute for Humane Studies, Sheldon is a graduate of Temple University in Philadelphia. He blogs at Free Association. Send him e-mail.