Why Too Big To Fail?

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Contents

Foreword...........................................................................ixIntroduction.......................................................................xv1929 vs. 2009......................................................................3The Glass-Steagall Act.............................................................5Components of the Financial Services Industry......................................11The Federal Reserve System.........................................................16Post-Depression Recovery...........................................................19Disintermediation and the Savings and Loan Crisis..................................24Banks vs. the Federal Reserve......................................................32Citibank and J. P. Morgan: Their Role in the Fall of the GSA.......................35The Financial Modernization Act....................................................41Travelers-Citicorp Merger: The Final Push..........................................45The Current Crisis: 2008-2009......................................................55Fannie, Freddie, and Ginnie Mae....................................................59Securitization.....................................................................61Troubled Asset Relief Program (TARP)...............................................69Their Roles and the Results........................................................77Bear Stearns.......................................................................79Lehman Brothers....................................................................81American International Group (AIG).................................................83Citigroup..........................................................................88Merrill Lynch & Bank of America....................................................90Hedge Funds........................................................................93The Proposal.......................................................................99The Concerns.......................................................................106Conclusion.........................................................................113Notes..............................................................................119

Chapter One

1929 vs. 2009

On October 24, 1929, the United States stock market suffered a historic crash that has been cited as a contributing cause of the Great Depression. The economic downturn had started earlier, in the summer of 1929, and it escalated with the October stock market crash. The natural response in such a financial crisis was for consumers to stop buying. No one knew what would happen next; consumers responded by ceasing to purchase durable products. The reduction in demand led to a reduction in output-a drop in production-and, ultimately, the Great Depression. The depression did not end until around 1940.

The Depression era was a frightening period for those who lived through it. Banks failed, companies went bankrupt or downsized, unemployment was high, and people feared that they would not be able to provide for their families. Does this sound like the 2008-2009 crisis? Yes, it does. Fortunately, however, we are not experiencing failures of 40 percent of our banks and 20 percent unemployment, as was the case during the Depression era of the 1930s.

How did we climb out of the doldrums of the Great Depression? Did we put in place safeguards to prevent the possibility of widespread collapse in the future? Well, I think we did-and then we undermined our efforts!

Over the years, there have been various theories about the true cause of the Depression, but it cannot be denied that, leading up to that time, banks took serious risks with their depositors' money. Again, there are similarities today, such as the creation of, and investment in, the risky collateralized debt obligations using mortgage-backed securities. Though these particular securities did not exist in the 1930s, risky loans were made and risky investments were both offered and managed through the banks. When these loans failed, so did the banks.

The banking system has experienced many changes since that time, and yet it seems that the industry may have come back to square one. A tenet learned in basic finance courses is that the greater the risk, the higher the return. Well, that's true-but it's also true that the higher the risk, the greater the potential for significant loss. That was true in the 1930s, and it is equally true today. We are in the most severe recession since the Great Depression, and, at this crucial juncture, the way we deal with this crisis will determine our success in the future.

The Glass-Steagall Act

In an effort to fix some of the problems that caused the crisis during the Great Depression, Congress enacted the Glass-Steagall Act (GSA) of 1933. The objective of the GSA was to separate commercial and investment banking activities. Commercial banks would no longer be allowed to underwrite or trade corporate stocks or bonds. They would, however, be allowed to purchase and sell Treasury securities and general obligation municipal bonds. On the other hand, investment banks would not be allowed to perform the functions of commercial banks.

Additionally, the GSA restricted commercial banks that were members of the Federal Reserve from affiliating with companies that engaged in investment banking activities. Finally, the GSA also prohibited investment bank directors, officers, employees, or principals from serving in these respective capacities at a member commercial bank. This stipulation was put in place to guard against conflicts of interest.

The GSA also established the Federal Deposit Insurance Corporation (FDIC). The FDIC's role is to insure bank deposits in the event of bank failure. Under the GSA, all member banks of the Federal Reserve had to participate in the FDIC program. The program is similar to a regular insurance policy. The FDIC charges the banks a premium, and, in the event of failure, depositors are guaranteed the return of their money up to the sum insured. The insured value was initially set at $2,500 in 1934; by 1980, the deposit insurance coverage had risen to $100,000. The aim of deposit insurance was to reduce the likelihood of mass withdrawals by depositors, popularly referred to as "a run on the bank."

With the onset of the economic crisis of 2008, the FDIC increased the deposit coverage on interest-bearing accounts to $250,000 and made its coverage unlimited for non-interest-bearing accounts. In the atmosphere of late 2008, amid uncertainty about which bank would collapse next, this temporary measure was intended to reassure citizens that the government would protect our bank deposits. The fears were well founded-there was a run on Wachovia when it became evident that the bank was having difficulties. Wachovia has since been purchased by Wells Fargo.

The GSA also sought to eliminate competition among banks by instituting an interest-rate ceiling for deposits, under Regulation Q. It was determined that interest rate competition among banks contributed to the bank failures of the 1930s. The premise of this regulation was the assumption that, as banks paid high interest rates to attract depositors, they would in turn...