The global financial system worked rather well, meaning no major meltdowns, from 1933 up until 1999. After the 1929 financial sector collapse caused an economy-wide (world-wide) depression, the rules of the game were changed and more strictly enforced. Those 1933 changes have prevented another such meltdown for 75 years. But, starting in 1970's, the rules started peeling off with the biggest and final straw happening in 1999.
The rules of the game, like in baseball, were simple, just, and transparent: Everybody understood the rules and umpires were permitted enforced the rules. Complications created to specify and clarify the rules actually weakened the rules.
Complicated rules are designed to address each and every possible situation. That's unnecessary, impossible, and harmful to everyone in the marketplace -- the financial services industry, investors, and issuers.
In reality ... in effect .. rule complications are created to build technicalities that exempt profitable, yet harmful, financial products.
It's been said that the devil is in the details. Certainly, bad stuff seems to abound.
How do you feel when you hear that a scandal monger "gets off on a technicality"?
People are creative and ingenious. Many of us will figure out new situations for better investing and some will figure out how to design new situations specifically to evade detailed, complicated rules.
Like Grisham's Law says: "The bad drive out the good". Shaving the truth is as bad as shaving the gold off coins. The shaved coins become nearly the only coins used in commerce because no one wants to be stuck with them and everyone passes them along while keeping the good coins.
Perhaps, we should go back to basics when the standard of whether an activity or instrument breaks the rules was clearly evident, especially to a judge and jury -- the umpires of our economy.
Listen to your grandmother: "You know the difference between wrong and right. Do the right thing."
Glass Steagall Act and Regulatory Agencies: In 1933, Congress separated financial services sector into its 3 component industries: Banking, Brokerage, and Insurance -- no cross-over permitted. Also, reflecting the 3 different types and levels of risk, each of them was required to maintain 3 levels of reserves.
Commercial banks, which serve business credit and transaction financial needs, were only allowed to be commercial banks. Insurers were insurers and only insurers. Brokerage Houses (also called Investment Banks) were only Brokerage Houses.
Additionally, Savings & Loans were created to prevent a crash in the housing market from also taking down the business credit market ... and visa-versa. Savings Banks were created with deposits (up to a limit per account) insured a government-run public-private Federal Deposit Insurance Company "FDIC" and the Savings Banks paid a percentage of their total collective deposits in premiums.
You see, during the 1920's, we experienced nearly the same speculation with savers and insureds money and that led to the 1930's Great Depression. President Franklin Roosevelt and (predominantly Democrats in) Congress tightened regulations to prevent another economy-wide, depression-causing financial sector collapse. And, until now, for 75 years there were not any more.
LEARNING FROM 1929 WALL STREET CRASH
In response, the US governments passed the Investment act of 1933, popularly known as the Glass-Steagall Act, which clearly, legally separated commercial banking, insurance, and investment banks, allowing companies to do only one of the three.
President Roosevelt and Congress also formed the regulatory agencies: Security Exchange Commission (SEC) plus others targeted at commercial banks, savings banks, savings & loans, and insurers.
The Glass-Steagall Act was repealed in 1999.
Stacy Mitchell, reporter for the Institute for Local Self-Reliance, makes a solid argument for bringing back Glass-Steagall.
The primary problem with merging banks with insurers with brokerages mainly lies with the different levels of risk appropriate to each and the counterbalances of each type of risk were different: Government insures bank savings; government requires 100% reserves on insurance policies; and partnership ownership restrained brokerage extremes.
Brokerage, or investment banking, appropriately takes a lot of risk with the bank's money -- sometimes very risky.
Banks sell safety, the safest possible investments.
Insurance, well insurance sells the antidote to risk.
Let's separate the 3 very different financial services businesses.
Let's bring back Glass-Steagall.
FORM OF OWNERSHIP: The Brokerage Houses were owned by partnerships of the licensed securities dealers -- the members of the firm. That means that (a) these businesses can only be formed as partnership or sole proprietorship -- not corporation -- and (b) these businesses can only be owned by the professionals licensed to practice the services at the core of these businesses -- licensed securities dealers.
Banks were owned either by individual families, partnerships, or depositors.
The Brokerage House's form of ownership and owner restrictions reflected that of only physicians owning medical practices and only lawyers owning legal practices.
LETTING THE PARTNERS OFF THE HOOK
Until 1970, the dominant New York Stock Exchange prohibited investment banks from going public (offering stock) when they repealed that rule. Goldman Sachs was the first Brokerage House to make an initial public offering ... IPO ... going public. Soon nearly all of the Brokerage Houses, Banks, and Insurers went public.
Allowing brokerage houses (investment banks) and other banks to go public was the first major mistake, the first removal of the armor protecting our economy from another financial sector collapse -- the armor put on in response to the 1929 Wall Street Crash and consequent Great Depression.
As a public equity stock, brokerages are very different from nearly any other kind of business because their value, the value of a share of stock, varies by 100+%. The trades, essentially, are funded often by many short-term loans -- some lasting minutes, hours, and days as well as weeks or months.
Even worse, when Brokerage Houses were owned by partners, the made sure that their floor traders were "more careful" with the partners' money. When they went public, the Brokerage Houses were not longer risking the partners' money; they were risking stockholders' money.
Brokerages started taking higher risks, more often ... until it became so routine that senior management didn't even know what was being traded, except approving new financial products and approving actions over a policy-determined maximum risk level.
Commercial Banks also had this possibility of wide instant variations in stock value. When they no longer had to answer to the partners and had the option of issuing more stock whenever they needed massive infusions, they took bigger loan risks ... routinely.
Do you remember South American loan crisis faced by American Commercial Banks? More recently, do you remember the Mexican and then South Asian nation's credit crises in the 1990's?
In 1998, just prior to the 1999 repeal of Glass Steagall, Slate magazine published an interesting article: "Why investment banks go public?" Did you notice how Brokerage Houses evolved their industry into the name investment banks?
In 2004, University of Oxford (England) professors, Alan D. Morrison and William J. Wilhelm, Jr. published the research paper: "The demise of investment banking partnerships: Theory and Evidence"
In 2008, Andrew Ross Sorkin, Editor-at-Large at The New York Times, in his column DealBook, wrote "A partnership solution for investment banks?"
THE CANARY IN THE MINE
In the 1970's, we were shown what could ... or would ... happen if we removed Glass-Steagall when Congress starting to allow Savings & Loans to move beyond individual residence mortgage & home equity loans and into large-scale developer loans. Massive amounts of depositor money ... and stockholder money ... pursued big developers because the interest rates on their loans paid lots more than home loans and turned over more quickly (as the tracts of property and buildings were sold).
President Jimmy Carter expressed concern when the Savings & Loans' defaults accumulated to approximately $20-billion. He wanted to remove the looser loan changes to their regulations. His successor, President Reagan, did not want any changes.
After the deep recession of the early 1980's, we were hit in the late 1980's by the Savings & Loan Crisis. In 1989, President George H.W. Bush and Congress funded a $128-billion taxpayer bailout and enacted stricter restrictions on the Savings & Loans. They formed the Resolution Trust Corporation (RTC) to liquidate failed Savings & Loans into mergers with healthy banks.
The 1989 Savings & Loan Crisis ... and $128-billion taxpayer bailout ... was the canary in the mine. We were warned.
America ignored the warning.
LETTING THE HORSES OUT OF THE BARN
In 1999, President Clinton and Congress repealed the Glass-Steagall Act. Banks, brokerages, and insurers were free to merge or go into each other's industries.
Repealing the Glass-Steagall Act was the second, and most encompassing, removal of the armor we wore to protect our economy from another Wall Street Crash ... and consequent depression.
In 2010, Daniel Gross of Slate magazine published the MoneyBox column: "The Gang of Five and how they nearly ruined us -- The little known reason investment banks got too big, too greedy, too risky, and too powerful."
In 2011, Dylan Matthews, of the Washington Post, in his WonkBlog column "Research Desk" answers the question "Should investment banks be private?"
Perhaps, for reasons similar to why law firms must be owned by lawyers and physicians must own medical practices, we should return to only brokers owning investment banks.
Forbidding investment banks to go public -- requiring them to remain partnerships -- would ensure that investment bank executives would pay careful attention to the risks taken by their traders and others who handle the firms house account. No regulations necessary there!
WHEN IS AN INSURANCE POLICY NOT AN INSURANCE POLICY?
Call investment instruments what they really are in colloquial, transparent, and easily understood words -- especially so they follow the rules of what they really are.
Credit Default Swaps are insurance policies (on Collateralized Debt Obligations and Mortage-Backed Securities) and should be following the rules behind insurance policies to ensure they are covered bets. Insurance policies, by law, must be 100% collateralized. If the Credit Default Swaps had been classified and collateralized as insurance policies, then there would be fewer of them and they would not be toxic -- the 2008 Crash would have been less severe.
CDO's (Collateralized Debt Obligations), MBO's (Mortage Backed Securities) would have faced a different market and the investment banks would have had cleaner, more solid balance sheets if we did so.
A financial instrument is either an equity, currency, debt, option, or insurance.
PLACING A BET ON YOUR HOUSE BURNING AND YOU DYING
The Credit Default Swaps became bets ... gambling ... that specific Collateralized Debt Obligations, mainly Mortgage-Backed Securities, would default: The homeowners would default on their mortgages. CDS owners had to pay annual premiums like insurance policies. But, in every other way they were gambling that tragedy would happen to someone else ... which also gives them an interest in having that tragedy occur.
Did you know that you can take out a life insurance policy on someone else? In fact, employers often take out life insurance policies on employees.
In the insurance-business jargon, these are called "Dead Peasant Policies". Officially, they are called "Corporate-Owned Life Insurance" or "COLI" (as in e-coli). Usually, the employees don't even know that the policies exist! The employer company gets a tax-free windfall when employees die!
The business press, like The Wall Street Journal in a 2002 article, has been reporting on these for 10 years, although few people, if any, not involved with the policies are aware of them.
These "Dead Peasant Policies" are not policies taken out on senior management ... executives considered major financial losses to a company should they die ... are called "Key-Person Insurance" and usually negotiated above the table, even some are in the executive contracts. "Dead Peasant Policies" COLI are taken out on the rank and file.
Walmart and Dow Chemical have been called-out by dead employee families in law suits charging "unjust enrichment". In one case, Walmart settled with families of 73 million employees in Oklahoma and agreed to pay a total of $5.1 million to the families.
Let's take the gambling on other peoples tragedies off the table.
Summary:
So these are the 4 steps I recommend we, as nations, look at towards removing the threat of another 1929 crash and 2008 crash.
(1) Like baseball, keep the rules simple, transparent, and easily understood by everyone and empires really enforcing the rules. Nix the technicality generating complications.
(2) Separate commercial banking from investment banking from insuring, by restoring the Glass Steagall Act.
(3) Return investment banking / brokerage firms to partnership and proprietorship owned only by licensed securities dealers.
(4) Ground the fancy, complicated financial instruments in simple, easily understood wording consistent with whether they are an equity, currency, debt, option, or insurance policy ... and specifically call Credit Default Swaps insurance and require they follow insurance product regulations.
Of course, I would like to see betting on someone else's tragedy ... like house fire, death, and mortgage default ... banned. But it's not necessary for preventing another Wall Street Crash.
What do you think?
By Steven J. Reichenstein
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