It was the roaring twenties, and the United States economy was booming. Following WW1, American manufacturing was in full swing, and many had jobs. Corporate profits were skyrocketing and wages were growing exponentially. But, while many women and minorities were working alongside men, the richest one percent of Americans owned over a third of all American assets. This much wealth focused in one group slowed economic growth, as it was not liquid. Many of these savings were tied up in savings accounts, rather than circulating through the economy and allowing for growth.
Highly desired technological advances such as the automobile and household appliances were purchased by the middle class on installment plans (debt), stretching debt capacities. At the time banks were operating unregulated, and due to this they did not offer guarantees and gave out riskier and riskier loans. These loans were often used by reckless stock speculators to invest in the rapidly growing stock market, on the thought that they could make large returns quickly This new tool was called buying on margin. Margin was a loan, given by the banks for speculators to buy stock. If these investors were right, they paid the bank back the initial investment and took all of the profits. However, if investors were wrong they had to pay the banks back all of the losses.
Margin allowed investors to buy $100 of stock with only $10 (as low as 10% down), and these speculators placed huge orders. These orders added to the hyperinflation of stock market values, and if (and when) the market went down in value, many speculators were numerically unable to payback their loans/loses. These loans were unregulated, and because banks made money for every person who bought on margin, these loans were extremely easy to obtain. While the market was experiencing some legitimate growth, these speculators and overall optimism pushed into a bubble, that was just waiting to burst. Many major companies were highly overvalued compared to their revenues and growth, and were investing these newfound funds in rapid expansion without any real demand for their product.
As the roaring twenties were drawing to a close, investors were beginning to worry about a bubble, and were prone to panic on any bad news. So, when the DJIA opened 8 points lower than the previous trading session, investors sold in a panic. Changes in the market were not reflected instantly, like today, but instead over hours so investors had no idea how much money they were losing. This added to the panic of investors unloading all their shares. This rapid sale resulted in the stock prices collapsing, as there was no demand. Panicked, large banks tried to purchase large amounts of stock in the market to stop losses and restore investor confidence, but their efforts were futile.
This event was the first of many in the domino chain that is called the great recession today. As stock prices collapsed due to panic and the realization that these companies were only worth half of what they were trading for, investors posted major losses. Speculators trading on margin suddenly were unable to pay back the losses to major banks. Many losses were unpayable back to the banks, as the individual’s net worth was not large enough to liquidate and repay the loan.
The Great Depression worsened as banks limited cash on hand, and could not fulfill withdrawal orders. Investors turned to commodities such as gold, causing its value to spike upwards. The US, at the time, still had a gold standard, where each dollar’s value was backed by gold. As commodities spiked, the Fed had to honor this standard and did so by trying to increase the value of the dollar by raising interest rates. This did raise the value of the dollar, but also made it harder for large companies to secure funds to grow. Because of this, the companies tried to cut costs and did so by laying off their workforce (by as much as 50%). This, and a number of other factors added into this stew of economic depression, such as a major drought.
While the country did get out of this depression with the help of the government and a world war, Americans vowed to never go into depression again. Congress, and a number of other newly formed agencies like the FDIC studied the causes of the depression, and found that a major cause of this economic collapse was due to traditional banks using their customers money to give out margin loans to stock speculators. This was due to the fact that regular, consumer banking (savings/loans) was mixed with investment banking (margin/brokerages/stocks). After discovering this unsettling fact, and with huge public support, congress began creating legislation to prevent another depression, by separating consumer and investment banks. They did so by passing the U.S. Banking Act of 1933, which prevented securities firms and investment banks from taking deposits, and commercial banks from giving out risky loans and distributing non-governmental securities. The Glass-Steagall legislation was included in the U.S. Banking Act.
Following is 1933 passing, the legislation kept commercial and investment banks apart for almost 70 years. No massive recessions happened due to banks giving out risky loans up until the 80’s, mainly due to FDR’s new deal, and wartime economy. The U.S. economy grew at a steady pace, with no bubbles, following the great depression due to regulation. However in the 80’s the government began rolling back regulation, and the dollar value began inflating. Congress passed two acts allowing for banks to offer a wider range of savings loans while reducing regulatory oversight from the SEC and other agencies. At the same time, the Fed was raising interest rates to try to combat the rapid inflation of the dollar making it harder for loans to be paid back. The deregulation caused banks to give out loans with rates that were doomed to fail, as they were either unpayable after time or would experience problems when the Fed inevitably rose rates. A combination of these lead to a mini-recession known as the savings and loan crisis, where the Federal Savings and Loan Insurance Corporation had to dissolve or close almost 300 lending entities.
Following this bump in the road, one should assume that without regulations the economy was bound to experience recessions. The great depression definitely showed regulators/investors what would happen, and following that as well as the regulation was relatively smooth sailing. In the 80’s when congresses experiment of deregulation was conducted, and ended up in the savings and loans crisis, they should have realized that rapid deregulation is a pretty bad idea. While deregulation over time would lead to a steady growth in the economy, many economists feel, it must occur over time, and the government should still have oversight over these processes.
Following the savings and loans crisis, the 80’s and 90’s experienced a series of ups and downs with a few more ressions being caused by the fed, oil rates and a number of other factors. It is also worth noting that there was an asian financial crisis in 1997, and while some international stocks lost as much as 60% of their value, effects were dampened by intervention by the world bank and intervention by Fed Chair Greenspan, Robert Rubin and others. This group of american economists was dubbed by the media as “The Committee to Save the World”. However, as the country was nearing a new millennia, and America was coming to realize that their biggest industry had become banking, more and more pressure was on congress to repeal banking regulations, dating back to the 1930’s. Especially the Glass-Steagall act.
The pressure was multiplied by 100% when, in 1998, Citicorp and Travelers Group announced they were merging. This was in direct violation of the G-SA and Bank Holding Company Act, and would have been illegal if not for a loophole; companies received a two-year review period of proposed mergers. Though the G-SA was baring the companies from completing a merger, Citibank expected that they would be able to repeal the act before the two years, and thus announced their merger to up the pressure on congress. But, this was not enough pressure, so Sandy Weill and John Reed (co-chairs of Citibank) sent legions of activists, lobbyists and corporate executives to ‘strongly encourage’ the repeal of the Glass-Steagall Act. Weill stated at the merger’s announcement “that over that time the legislation will change…we have had enough discussions to believe this will not be a problem”.
Robert Rubin, the recently retired Treasury Secretary was also enlisted by Citibank to try to get the act repealed. He had served as vice chairman and co-chief operating officer at Goldman from 1987 to 1990 and as co-senior partner and co-chairman from 1990 to 1992, and his interests intertwined with Citi’s. While he no longer had a governmental position, he did have a good reputation and network (such as preventing a worse outcome of the asian financial crisis in ‘97). He was also looking for a new job, and while it was not public knowledge, he was discussing the possibility of an executive management position with Citi. Citi persuaded him to broker the final deal with congress on repealing the G-SA, and he did. He ended up with the position on the board of directors at Citigroup and as a senior advisor to the company until 2009. He was paid, in total, $126 million.
Because of Rubin, the Clinton administration and lobbyists from the big banks, the Glass-Steagall act was repealed in 1999 and replaced by the Gramm-Leach-Billey act, which essentially nullified the G-SA.
Citicorp and Travelers merged soon after the G-SA was repealed, at the time being the largest merger in history, creating a $140 billion firm with assets of almost $700 billion. But, while called a merger, it was more like a stock swap, with Travelers Group purchasing the entirety of Citicorp shares for $70 billion, and issuing 2.5 new Citigroup shares for each Citicorp share. Following this merger, Citi grew even more, acquiring Associates First Capital Corporation for about $31.1 billion in stock. This gave Citi the reach to the mortgage industry, and made it into exactly what the G-SA protected against, and all in one consumer and investment bank.
Around the same time, as the Clinton administration was leaving office (and worrying about impeachment), they passed the Commodity Futures Modernization Act of 2000. This made it so that over-the-counter derivatives transactions between the large banks would not be regulated as futures under the Commodity Exchange Act of 1936 (CEA) or as “securities” under the federal securities laws, and would have limited oversight and regulation by the SEC.
One by one, more and more investment banks began consolidating to cover all aspects of the financial world. J.P. Morgan & Co. had its merger with Chase Manhattan Bank in 2000, forming JPMorgan Chase. Bank Of America merged with NationsBank in 2000 as well. Bank of America possessed combined assets of $570 billion, as well as 4,800 branches in 22 states, but stunningly only had to divest from 13 branches in New Mexico in its merger. These banks, and a few others (like Morgan Stanley, Lehman Brothers, Wells Fargo) kept consolidating and acquiring other financial units, eventually owing lending, credit, and investment aspects.
Following the 2000 tech bubble, and subsequent crash, these newly formed mega banks began marketing mortgage-backed securities and sophisticated derivative products at unprecedented levels, because up until then, mortgages were considered rock solid. Everyone paid them back. They also made it really easy to get loans, and gave out many loans to recipients who may not be able to pay them back without refinancing. These loans often had teaser rates (known as adjustable rate mortgages) for the first few years, so recipients were only paying back 20-25% of the actual monthly payments. Every year or so, these lenders refinanced for a lower rate and thus, were able to make payments on time.
The recipients used these loans to purchase houses, and live above their means. Suddenly, middle class people were owing 3-4 homes each, and had loans on each of them. Many new homebuyers saw these purchases as investments because the housing market had been experiencing exponential growth since 2002. If they bought a 300,000 house in a decent area, in two years the house could sell for $500-600,000. This rapid growth is known as a bubble, because the market was growing too fast to accurately value the homes.
At the same time, investors were buying into the loans because they had high ratings of A-AAA. Larger investment banks and hedge funds also purchased CDOs, a collection of many loans bundled into one vehicle. When they bought these, they received all of the loan payments, and the bank’s (who were selling them) no longer had any responsibility. These banks marketed the CDOs as a great way for large investment institutions to receive dependable revenue into the far future. However, what they didn’t tell investors, was that while the CDOs had high ratings the loans that they consisted of had ratings of BB at a maximum. These were known as subprime loans. This meant that the people paying the loans had a higher chance of being unable to repay the loans in the future. Essentially the banks and ratings agencies were working together to make trash into a profit, and the buyers of the CDOs were going to end up with loans that weren’t going to be paid back.
In late 2006 home values were at an all time high, and banks continued giving out loans. Investment institutions kept buying the CDO’s from the banks. The banks kept making profit. However, the Adjustable Rate Mortgages offered in the early 2000’s were about to switch from their teaser rate to the higher rate and the housing bubble was about to crash. The rates ramped up in the first quarter of 2007 and as a result, millions of Americans were unable to pay back the loans. At about the same time (and partially resulting from the ARMs), the housing bubble popped, and overnight homes valued at $1 million were now valued at anywhere from $500-300,000. Americans collectively lost $6 trillion in the value of their homes in an extremely short period of time.
Because of the housing bubble popping, mortgage-backed securities and sophisticated derivative products that the banks were offering were suddenly worth pennies to the dollar. Investment insurers such as AIG who were insuring CDO losses suddenly owed more than their net worth and investment banks like Lehman Brothers went bankrupt, in a matter of weeks from the housing market bubble popping. AIG, GM and other companies who were about to go bankrupt (and in turn liquidate to post collateral) had to be bailed out by taxpayer money because they were deemed too big to fail. About $20 billion went to bailouts in 2008-9, and much of this went into the national debt.
In the following year and a half, the market lost as much as 50% of its value and economic wealth dried up. The Fed lowered interest rates nearly zero in order to promote liquid provided banks with a staggering $7.7 trillion of emergency loans, from taxpayer money.
If it were not for the Clinton administration and their reckless deregulation of the financial world, the 08’ recession probably wouldn’t have happened. Though we probably would have seen a bubble in the housing market, or another tech bubble, the ensuing recession would not have been horrible. Instead, without the Glass-Steagall act, banks consolidated into massive financial institutions and engaged in extremely risky lending practices. Ratings agencies falsely lead investors to believe that these loans were still good investments, and massive insurance agencies backed them under the impression that they would never fail. When they did, everyone lost out, except for the executives (which is another article in itself).
While the blame can be traced back to certain individuals, nobody has been prosecuted and convicted of a crime. The regulatory agencies seem to be wary of launching any major investigations, and any fraud investigations must close at maximum, two years after the fraud has happened (that opportunity has passed). We must learn from this experience and realize that smart regulations must be in place to protect the financial industry from itself. Without it, we will continuously face the cycle of bubble, recessional, bubble, with each event occurring with increasing severity.