A Brief Refresher on Glass Steagall

Last week, I referenced the Warren-McCain bill to restore Glass Steagall. Earlier this morning, we showed Senator Warren discussing the bill on CNBC.

The Squawkbox anchors revealed such a shocking ignorance of history, that we are compelled to offer a brief refresher on what Glass Steagall does and does not do. (Kudos to Senator Warren for her patience in explaining the basics to this crew of ideologues).

Our refresher: Glass Steagall is the Depression era, post-1929 crash legislation that cleaved in two the major fields of banking. Some folks have found it easy to conceptualize the split as dividing banking into “Main Street” and “Wall Street,” so for simplicity, we shall as use that divide to explain the legislation’s purpose.

Your basic, Main Street banking — depository accounts, savings, checking, loans, mortgages, etc. — is one half. These are the institutions that have FDIC insurance guaranteeing the safety of your deposits. What this means in actuality is that the taxpayer is ultimately on the hook for any bank failures that lead to depositor losses. If the FDIC insurance pool ever gets exhausted, you and I have to pony up the Do-Re-Mi. Late in 2008, it looked as if that might occur, but a 2009 increase in FDIC insurance fees — and of course the bailouts — prevented that.

On the other side of the banking street is the more speculative kind of financial engineering that Wall Street does: Trading, Underwriting, M&A, Investing, Syndication, Asset Management, IPOs, etc. These all involve pools of capital (other people’s money), greatly increased risk, higher potential returns, and the possibility of losses. As we saw in 2008-09, the possibility of catastrophic loss that can wipe out entire companies also exists.

The reason for Glass Steagall was to create a firebreak between the two forms of banking.

Why was a firebreak needed? The spillover effect from the Wall Street crash on to Main Street was brutal. Recall back in the 1920s, home mortgages were 3-5 year interest-only forms of credit, with a balloon payment at the end. Home owners and Farmers either rolled their mortgages over, or sold the property and paid them off. What happened post-1929 crash was that many Main Street banks had lost most of their access to capital, courtesy of the collapse of Wall Street banks. Most linbes of Credit dried up. The Great Crash of 1929 led directly to a massive foreclosure surge in the 1930s, far worse than anything we experienced after the 2006 housing peak. Some estimates for NYC RE were a failure rate of 60% or worse. The rest of the country similarly suffered from the loss of ordinary, regular credit, the lifeblood of any modern economy.

It went far beyond mortgages. Operating capital for business dried up, industrial production collapsed, unemployment skyrocketed. All of these effects were DIRECTLY attributable to the conflagration having nothing standing between the Wall Street caused market collapse and the freezing of credit on MainStreet.

Hence, the firebreak. As I described in the Washington Post last year (Repeal of Glass-Steagall: Not a cause, but a multiplier) the shortage of lifeboats on the Titanic did not cause it to sink, but it sure as hell raised the body count. The repeal of Glass Steagall had a similar effect. It did not cause the crisis, but lack of a firebreak allowed it to jump easily form Wall Street to Main Street.

In prior discussions, we have discussed the many causative factors that led to the crisis. The repeal of Glass Steagall was not one of the factors that was a direct underlying causative element. There is no doubt that its repeal allowed the credit crisis to expand faster, wider and have a greater impact than if that firebreak still existed. That is why the list of supporters for bringing back Glass Steagall includes more than just Senators McCain and Warren — former FDIC chair Sheila Bair and current FDIC Vice chair Thomas Hoenig, former Federal Reserve Chair Paul Volcker, even former Citigroup CEO John Reed.

See also:
• A Brief History Lesson: How We Ended Glass Steagall (May 17th, 2012)

• Glass Steagall Repeal Made Crisis Worse (July 30th, 2012)

• Repeal of Glass-Steagall: Not a cause, but a multiplier (July 5, 2012)

• Senators Introduce Bill to Separate Trading Activities From Big Banks  (NYT, July 11, 2013)