Bill Clinton restarted a longtime debate this week about the role of one of his signature policies. Speaking to Inc. magazine, Clinton defended the 1999 Gramm-Leach-Bliley Act, which eliminated the firewall between investment banks and commercial ones. “Look at all the grief I got for signing the bill that ended Glass-Steagall,” Clinton said. “There's not a single, solitary example that it had anything to do with the financial crash.”
This is a familiar claim made by those who don’t want to push financial reform beyond the incremental confines of Dodd-Frank. They say that Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac and AIG, firms whose failure drove the crisis, were either pure investment banks, non-bank mortgage companies or insurers, all unaffected by the Glass-Steagall repeal. And Countrywide and Ameriquest, lenders that handed out bad mortgages like candy, weren’t banks at all.
This myopic view neglects all kinds of facts about the financial crisis. The tight coupling of financial institutions expanded the crisis from a problem of mortgage lending to something that could collapse the economy. And repealing Glass-Steagall was part of that process, allowing the investment bank mindset of excessive risk-taking to infect the whole financial system.
First of all, the supporters of Glass-Steagall repeal make a factual error. AIG was not just an insurance company. For purposes of federal regulation, it was a bank. Mimicking several other large companies of the time, AIG bought a small savings and loan in Wilton, Conn., allowing it to be regulated by the Office of Thrift Supervision, recognized as such a lenient federal banking overseer that even Dodd-Frank eliminated it.
As an insurance company, AIG could not have bought a thrift under the old Glass-Steagall rules. And Gramm-Leach-Bliley expressly prohibited the Federal Reserve from regulating insurance holding companies, which AIG was during the crisis years. So the bill that repealed Glass-Steagall did ensure that AIG could shop for the lightest-touch regulator, one that wouldn’t delve deeply into its credit default swap and securities-lending activities. Incidentally, the Volcker rule, the Dodd-Frank reform that looks the most like Glass-Steagall, caused AIG to sell its thrift.
Moreover, the litany of crisis-based firms that “had nothing to do with Glass-Steagall” always skips the one that got the biggest bailout from the federal government: Citi. “All you need for a financial crisis are excess optimism and Citibank,” goes the possibly apocryphal quote. And what we now call Citigroup is an entity that comes right out of Glass-Steagall repeal.
Citicorp’s merger with Travelers, and its investment-bank holdings like Salomon Smith Barney, was impermissible when completed in 1997, but audaciously done to force repeal through Gramm-Leach-Bliley. Other firms had chipped away the firewall between investment and commercial banks, particularly JPMorgan. (In fact, Clinton elides culpability by focusing only on Gramm-Leach-Bliley and not his regulatory forbearance in allowing the chipping away.) But Citi, under former CEO Sandy Weill, put the stake through the heart of Glass-Steagall, and got advance clearing from regulators and the Clinton administration to do so, as a forcing event.
This created a complex, difficult-to-manage firm where the philosophies of commercial and investment bankers went into open competition. And the investment bankers won. Don’t take my word for it; ask Richard Parsons, a board member and eventual chairman of Citigroup. “To some extent what we saw in the 2007-2008 crash was the result of the throwing off of Glass-Steagall,” Parsons told the Rockefeller Foundation in 2012.
Arthur Wilmarth, a law professor at George Washington University, wrote the definitive study of Citigroup in the post-Glass-Steagall era. Executives constantly loaded on risk that blew up, with over $130 billion in assets needing write-downs from 2007 through 2009. The bank embroiled itself in a series of scandals even before the financial crisis, including illegal transactions with Enron and WorldCom, dishonest research used to “spin” stock, foreign bond market manipulation and a totally fraudulent Japanese private-banking subsidiary that was shut down.
Citi also plunged into the fundamental activities of the crisis. It engaged in predatory subprime lending through CitiFinancial as early as 2000, purchasing the corrupt non-bank lender Associates First Capital. During the bubble, Citi packaged dodgy loans into mortgage-backed securities and created derivatives from them known as collateralized debt obligations (CDOs). The company actually doubled its subprime lending from 2005 to 2007, at the top of the bubble, to feed the securitization beast. These actions brought Citi to near-ruin, and they were explicitly investment bank-based, high-risk strategies that would have been out of reach under a Glass-Steagall firewall.
In fact, with Citigroup leading the way, all the large money center banks went into the mortgage business. As former Clinton Labor Secretary Robert Reich explains, big banks funded non-bank lenders through warehouse lines of credit, ensuring a steady stream of home mortgages to use in securities (Citi provided such warehouse lines to major non-bank lenders Ameriquest and New Century). They funded investment banks too, through repurchase agreements and other lines of credit.
Mega-banks issued the securities, and derivatives off those securities, that blew up and drove the crisis; without them, AIG would have had nothing to insure. At the end, every CDO issuer bought everyone else’s CDOs as raw material to convert into more CDOs. The system was desperately interconnected, all chasing the same risk and all dependent on one another, building up leverage that eventually gave out.
Glass-Steagall repeal did play a role in that, as did the deregulatory maneuvers Clinton and his economic team pursued before and after it, like the ban on derivatives regulation in the Commodity Futures Modernization Act. You can properly see Gramm-Leach-Bliley on a continuum of deregulatory actions, creating a laissez-faire system of monitoring that predictably failed.
When commercial and investment banks merged operations, the philosophy of the investment banks, and their appetite for risk, won out. The credit bubble inflated much more because there weren’t more sober sources of funding in the system to tamp it down. Those who raised concerns were ignored or fired. Barry Ritholtz calls Glass-Steagall repeal something like a force multiplier.
The unified banks didn’t fail after the subprime meltdown because the government bailed them out, precisely because they had that consumer banking component that policymakers didn’t want to let fall. The redesign after Glass-Steagall created the “too big to fail” component that led to the bailouts.
So Glass-Steagall repeal facilitated and amplified the transformation of Wall Street into a back-alley craps game. That doesn’t necessarily argue for its return: There are lots of strategies available to tame the financial industry. But separating practices, so depositor money and federal depositor insurance doesn’t get caught up in the gambling, makes sense. As for Bill Clinton, his spinning over how his signature didn’t make him culpable for the crisis is a case of the man who doth protest too much.