Forget Glass-Steagall repeal. It’s the Securities Acts Amendments of 1975 That Really Did Us In

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Regular readers of this blog are aware that I’m extremely dubious of the argument that the 1999 repeal of the Glass-Steagall Act, which separated banks from securities firms, is to blame for today’s financial crisis. But it keeps coming up, so let me try to smack it down again.

First, I think it’s fair to say that 90% of the people who blame today’s troubles on Glass-Steagall repeal have no idea what they’re talking about. It’s just that the whole thing has a deregulatory sound to it–and deregulation is bad. That, and one of the names on the law that repealed Glass-Steagall, the Gramm-Leach-Bliley Act, belongs to John McCain’s Treasury-Secretary-in-Waiting Phil Gramm, who is not just Satanic but Texan. Nobody seems to care that another of the names on the law belongs to saintly Iowan Obama supporter Jim Leach. Or that Bill Clinton signed it. But whatever: Let’s focus on the 10% who do have some idea of what they’re talking about.


First there’s the Robert Kuttner argument–which is basically a much broader indictment of financial deregulation over the past 40 years that happens to make a big deal out of Glass-Steagall repeal because it’s convenient to make a big deal out of Glass-Steagall repeal. I find this at least a little bit perverse because many supporters of Gramm-Leach-Bliley–Leach among them–backed it because they thought it would result in more of the financial system coming under the oversight of bank regulators and the Federal Reserve. So for them it amounted to reregulation, not deregulation. But Kuttner’s critique contains some sensible points, too, so I don’t want to dump on him too much.

Then there’s the Oh-the-Poor-Investment-Banks argument, which I’ve seen a lot in the financial media lately and was just succinctly (and approvingly) summarized by John Cassidy in the New Yorker:

Commercial banks, such as Chase Manhattan, merged with investment banks, such as J. P. Morgan. The remaining Wall Street firms, grappling with new competition in their traditional businesses, increased their borrowing and made riskier bets. Last year, Bear Stearns, Lehman Brothers, and Merrill Lynch had more than thirty dollars of investments on their books for every dollar of capital. Having borrowed so heavily, the firms were hostage to a withdrawal of credit on the part of their lenders. After the sub-prime-mortgage market collapsed, that was precisely what they faced.

The first problem here is that J.P. Morgan was a commercial bank, which had been separated from its investment banking arm–Morgan Stanley–by the Glass-Steagall Act. Chase could have bought it in 1963 or 1936 if it had wanted to (and could have afforded it).

The big commercial bank/investment bank combination that everybody was really focused on in the years after Glass-Steagall repeal was Citibank/Salomon, which was created in the Citicorp-Travelers merger (which happened the year before the law was repealed, but was basically ratified by Gramm-Leach-Bliley). In the early 2000s, there was a lot of talk about how Citigroup was successfully pressuring (or tempting) its banking customers to use it for M&A and underwriting work. That was of course back when Citigroup was perceived as a juggernaut and not a bunch of jugheads, and more recently I had heard far less about it taking away business from the standalone investment banks or anybody else.

But let’s just assume that Cassidy is–once you get past his boneheaded J.P. Morgan error (I’ve made my share of boneheaded errors over the years, too)–right: The entrance of commercial banks into investment banking created more competition for investment banks, causing some of the remaining standalone investment banks to take suicidal risks. So the issue is that competition, and competitive pressures, are dangerous–at least on Wall Street. If that’s the case, though, why are we so fixated on Glass-Steagall repeal in 1999? The really important competitive shift came when Congress voted in the Securities Acts Amendments of 1975 to deregulate brokerage commissions.

From the earliest days under the Buttonwood Tree on Wall Street, brokers had all charged the same (high) commissions for buying and selling stocks. They were members of a lucrative if usually dull club. With California Rep. John Moss, a noted consumer-rights crusader, leading the way and the securities industry squealing in outrage, Congress banned that patently anti-competitive practice in 1975.

After May Day in 1975, brokerage firms had to reinvent themselves to survive. Charles Schwab famously went for the low-fee, low-service model. Merrill Lynch kept its commissions high, but compensated with all sorts of new services–like the Cash Management Account–that encroached on the territory of banks. And the firms that came to dominate Wall Street itself, like Goldman Sachs, Morgan Stanley, First Boston, and Salomon Brothers (Merrill eventually joined this group too) began in the 1970s and 1980s to aggressively pursue new lines of business: M&A, securitization and, perhaps most important, making bets with their own money.

Former Salomonite Michael Lewis addressed this nicely a while back in trying to explain how Wall Street firms had become so “shockingly opaque”:

It dates back at least to the early 1980s when one firm, Salomon Brothers, suddenly began to make more money than all the other firms combined. (Go look at the numbers: They’re incredible.)

The profits came from financial innovation–mainly in mortgage securities and interest-rate arbitrage. But its CEO, John Gutfreund, had only a vague idea what the bright young things dreaming up clever new securities were doing. Some of it was very smart, some of it was not so smart, but all of it was beyond his capacity to understand.

Lewis went on to explain that Gutfreund’s successors on Wall Street have continued to look uncomprehendingly upon the money-making activities of their bright young employees, but have seldom reined them in because to do so would mean losing their most promising charges to competitors.

And that may actually get at the competitive force probably most responsible for pressuring investment banks into overleveraging themselves in recent years. They were desperately trying to find ways to pay their best employees enough to keep them from jumping ship to hedge funds and private equity firms.

I don’t know quite how you put that back in the bottle, although the credit crunch will do the trick at least temporarily. So will the fact that there are now no longer any major standalone investment banks. Which is a state of affairs enabled, at least in part, by … the repeal of Glass-Steagall.

Update: Lack-of-originality alert! John Gapper at the FT floated the May Day argument weeks before me (thanks to The Epicurean Dealmaker for pointing this out). At least he quoted a TIME article (from 1975) to make his case.