When Former Treasury Secretary Larry Summers and former Senator Phil Gramm (R-Texas), among others, pushed through the repeal of the Glass-Steagall Act in 1999, they didn’t give proper thought to the dangers of institutions funding a bankers/traders casino with guaranteed customer deposits. When Bill Clinton signed the new law into effect repealing Glass-Steagall in November 1999, it sowed the seeds for the economic crisis. I don’t believe Clinton in his heart of hearts wanted this law to be repealed; it was just that everyone else in his cabinet did. Robert Rubin, Larry Summers, and other Wall Street heavy’s had this one law that was in the books since 1934 in their cross hairs. Wall Street’s crony capitalism regime for years had been funding political campaigns. That is why crisis after crisis rules and regulations were never enacted. From the S&L’s, Junk Bonds, LTCM, 1994 CMO Implosion amongst others were conveniently dismissed as temporary hiccups. But the one law that had been a noose around the necks of bankers and institutions since the 1930’s needed to be repealed. This law needed to go so that bankers and traders would be free to gamble with insured deposits. Most Wall Street institutions were not partnerships; they were now publicly traded companies. Before Goldman Sachs was a publicly traded company they were a partnership. In a partnership, whatever money that is traded is the partner’s money, so you better be careful in your investing and trading. So you can bet that gambles and leverage was in total control, as you had to justify the risks to the bosses whose money you were taking risks with. But when GS converted to a publicly traded company, the partnership was converted to actual shareholders whose interest no longer depended on taking bets per say, but by how high the stock traded on the exchange on any given day. If you can control the risk and show steady profits, your stock went higher, enriching the former partners. This was the way GS was run. I am sure the timing of the repeal of Glass-Steagall and Goldman’s debut on the exchange was not a coincidence. Goldman went public earlier in 1999. Goldman knew that once they became a publicly traded company they had to open themselves up to everything. Before they were run like a tightly knit group of partners. Who cares if Glass-Steagall is there or not? We are a private partnership, that doesn’t affect us. Once they were a publically traded entity GS needed to expand their horizons. I understand that Goldman didn’t have a commercial bank back in 1999 or took in deposits, but once Glass-Steagall was repealed, the whole idea of Too Big To Fail was born. Before if investment houses gambled with their own money and lost, they would be left to either go bankrupt or find capital from other investment houses. They would have to raise capital from private sources, so they controlled their risk accordingly. They knew they would be ruined if they screwed up. The public would not bail them out and politically there was no will for bailouts in a Glass Steagall world. Remember LTCM was bailed out by other Wall Street Investment Firms with help of course from the Fed. Now with the combination of commercial banks and investment houses, the risks would be too large for the economy to let these entities go bust. They were free to trade and take absurd and out sized risks. This was their line of thinking even back in 1999. The bankers were already setting the stage for what was to come. I personally know this for a fact as I noticed after Glass-Steagall was repealed that risky propositions and trades that used to be frowned on were now green lighted. I have worked for major Wall Street institutions before and after the repeal of Glass-Steagall. The entire mindset and attitudes surrounding risk did a complete 180 degree turn. Wall Street didn’t overnight start to gamble with insured deposits, but the foundation for future government bailouts was planned out. The incentives to take risk were plenty. The math geeks and quants were building more and more complex models that no one understood except the math geeks. Who am I to argue with a PHD from MIT? After all, these guys had Nobel Prizes. LTCM only blew up not because the models were bad, we were told. Of course not! Stuff happens; it was a 10 standard deviation event that occurred. This kind of stuff never happens, this time we have it all figured out. Just believe and trust the math. Math is never wrong. This was the attitude that was forced on us by upper management. They were following theories that had been drilled into other academics minds since the early 70’s. If you didn’t listen to the models and put in your own trades, you better be careful. Don’t lose money on your own. Listen to the geeks. They were never wrong. If the bankers were back in the world of partnerships they would have never let the quant’s take over Wall Street.
What was lost on everyone was that models can’t predict human behavior, no matter how great they are. No matter how complicated they get, this is a universal truth. Humans do stupid things; they are irrational creatures when confronted with the unordinary.
Again, you can’t model human behavior with mathematics. There is no computer model that will ever tell you someone will pay their mortgage, and there never will be. This was the most maddening thing about the Gaussian Capula Function/Model. It was this model that was created by a JP Morgan quant that enabled Trillions of CDO’s to be packaged and sold. This model gave one default figure for an entire tranche of thousands of mortgages. Just think about that for a moment? How in the world can you possibly model default correlations for disparate asset classes? The nerve to think you can eliminate risk this way, but that is what happened. The entire CDO business was about spreading risk away from your firm and unto someone else’s balance sheet. Do I have to add that there was never appropriate data on subprime defaults? That the data that was used was for a given period of low defaults? In some modeling, they didn’t even model this, they just modeled the last 10 years of CDS pricing. Can you actually believe this? They sold trillions of CDO’s packed with subprime and 2nd lien mortgages to investors, paid off the ratings agencies to slap AAA on them. The ratings agencies were getting paid 600K to rate a $500MM CDO, follow the money. All for what? AAA CDO’s were only trading some 25-30BP above Treasuries! The sheer greed is infuriating! Again, all of this was made possible by the Fed keeping rates low. This enabled the dollar to get weaker relative to other foreign currencies. Export driven countries were raking it in selling their goods to over leveraged US consumers. The flow of dollars created current account surpluses for many emerging countries like China. China just recycled their dollars back into our Treasury market, pushing down long term interest rates, which in turn kept mortgage rates very low. All of these exotic and toxic mortgages were modeling low default rates because housing never goes down. Housing had never declined more than 5% since the depression. This is what the models at Lehman, AIG, Merrill, WAMU, Wachovia, and Countrywide were telling them.
There is never been a model that figures out the correlation between two asset classes. It’s never been done for a reason. It’s impossible to model and or calculate. Doing so is only trying to fool the fool. It’s pure charlatanism. The computing power today is just not powerful enough to calculate all of the cash flows and the such in these complex derivatives.
The risk will and always be there. You can’t calculate it or hedge it. Risk and reward are beyond the intellectual limits of computers. Just like the idea of God is beyond the intellectual limits of our own minds, but yet we still want a personal relationship with god. Give me a break! How egotistical to think god wants a relationship with you. Going back to the repeal of Glass-Steagall only made Wall Street more beholden to complex modeling; this is because a lot of the models needed excess leverage to work. Excess leverage needs excess cash. Enter customer deposits. Most of these huge Wall Street institutions had trillion dollar balance sheets that were levered some 25-1, if the value of your assets drop just 5%, there goes your equity. But again, housing never goes down. The models have it all covered. Many smart short sellers actually read the CDO prospectus and noticed not only subprime mortgages but 2nd lien mortgages attached to them. A lot of these CDS contracts written against CDO’s only had a 5% trip wire associated with them, meaning the seller only has to post collateral if the CDO goes down in price 5%. Guess who was selling CDS insurance? AIGFP! AIGFP was drinking its own quant cool-aid. They were using AIG’s AAA ratings to underwrite CDO insurance. These guys in a million years never though they would have to pay up for these contracts again because housing never goes down. Put it all together and it’s a low rate induced credit orgy.
The whole plan of repealing Glass Steagall was predicated on knowing that the government would come to the rescue of not only the economy but customer deposits. It was the Wild Wild West all over again. The global casino that was created after Bretton Woods had been eliminated only was further emboldened after Glass Steagall was gone. The Commodities Modernization Act was the final piece of the puzzle. The grand master plan that Wall Street had envisioned since 1929 was put into effect.
The introduction of Glass-Steagall in 1934 had been highly damaging to the economy, because it de capitalized the investment banks, killing off the capital markets for the remainder of the 1930s and playing a major role in prolonging the Great Depression. This is the excuse that the banks use today in not reappointing Glass-Steagall. This was all true. However, by 1999, the investment banks were more than adequately capitalized (provided they followed sound principles of risk management and leverage, which of course they increasingly didn’t). This was the main selling point and rational that Summers, Gramm, and others pointed to, but as we all know, the rationale for allowing commercial banking and investment banking to be combined was shaky at best. It should have caused further doubt that the trigger for killing Glass-Steagall was the acquisition of the investment bank Travelers by Citigroup, which almost went out of business in the early 90’s.
Volcker’s plan to separate prop trading is a huge first step in reigning in bank risk and size. Whoever says that prop trading didn’t cause the crisis is not living in reality. I have trillions in losses that say otherwise. The banks originated toxic loans, packaged these loans but couldn’t sell them. They had to keep those loans on their books. If this is not prop trading I was in the wrong business for 15 years.
Great post
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