The Glass-Steagall Act Kept Banks in Order Until 1990

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For about ten years, Simon Jenkins and I were both writing columns for the London Times. Simon is still writing a column for The Sunday Times, but has shifted his weekly column to The Guardian. However, he has written something in The Sunday Times which has provoked a very interesting reply from a reader, a copy of which has been sent to me. The reader’s letter comes from a Mr. D.P. Marchessini. I suspect that Mr. Marchessini is correct and the present credit crisis is the natural consequence of high leverage, the repeal of the Glass-Steagall Act and the creation of excessive and complex derivatives. The letter traces the sequences of events:

“In 1933, the United States passed the Glass-Steagall Act, which prohibited commercial banks from dealing in investments, and prohibited investment banks from doing commercial banking activities. This was a very sensible measure, and kept the banks in reasonable order until 1990. Unfortunately, in 1990, this Act was repealed – for reasons best known to the psychiatrists of the legislators. The result was that all the big Wall Street brokers became banks, as well as brokers, and the big banks started trading and speculating. This was combined with an enormous increase in “leverage” – borrowed money – by all the banks. Leverage is the ratio of a bank’s capital to its total assets. This used to be between five and seven times, pre-1990. But post-1990, it immediately started ballooning and, although the banks tried to keep it quiet, it was known that Merrill Lynch was more than 40 times. Goldman Sachs was 28 times, and Lehman Brothers was 30 times when it failed. Regardless what one thinks of such hair-raising tactics, the one thing that is clear is that they only work when the market is going up. Apart from their Balance Sheet, all the banks also had an enormous amount of “derivatives”, which were kept off the Balance Sheet. Derivatives are an enormous cocktail of very exotic Options, on almost anything. In 1995, I was talking to someone at a dinner party, who was rich and supposedly very well connected in the financial world. I asked him what he thought the total amount of nominal value in derivatives were at that time. He said he thought perhaps $100 billion. In fact, at that time, they were $1 trillion. Today, they are $1.3 quadrillion – all off the Balance Sheet. They are also not included in any bankruptcy. Of course, this is the nominal value, and the actual amount at risk is much less. But five percent of $1.3 quadrillion is $65 trillion – still a tidy sum.”

I do not understand derivatives, certainly not at a level of $1.3 quadrillion. I am not even sure what a quadrillion is, though I assume it is 1,000 trillion. I do not feel ashamed of my inability to understand the global derivatives market, since the sage of Omaha, Warren Buffett, himself has said that he does not understand them. What is clear is that they have been created in very large numbers. If Mr. Marchessini’s figures are correct, the gross value of derivatives is far in excess of the capacity of all the world’s governments to bail them out. Even a net value of $65 trillion is beyond the bail-out potential of the major powers.

The Secretary for the Treasury, Hank Paulson, has asked Congress to authorise $700 billion as a bail-out for those banks which have invested in sub-prime mortgages and other toxic assets. This is a sum one can reasonably understand. In London there are a large number of houses worth £1,000,000 or more. A thousand such houses are worth £1 billion. That is a solid reality. The $700 billion, which Secretary Paulson is asking for, is worth about £400 billion. It is therefore equivalent to about 400,000 good town houses in London.

Plainly that would be a valuable estate, but it is conceivable. I can imagine the suburbs of London rolling out to Heathrow and the West. If one started at Canary Wharf and went on to Heathrow one could easily identify 400,000 houses worth £1 million each. If the U.S. Government chose to pledge itself for 400,000 such houses that seems reasonable. This may involve very large figures, but so does the Federal Budget.

It is the trillions that cease to be meaningful. I know several billionaires; I have certainly never met a trillionaire, let alone a quadrillionaire. If these derivatives hang over the whole banking system, then they should presumably be wound down and, over time paid off. They represent potential liabilities f the banking system, even if they are off the banks’ balance sheets. They cannot simply be consigned to a bad bank or simply be allowed to go into default. Even if Mr. Paulson gets his $700 billion, what will that do to settle the problems of quadrillions of derivatives?

William Rees-Mogg
for The Daily Reckoning Australia

William Rees-Mogg
Leading political editor William Rees-Mogg is former editor-in-chief for The Times and a member of the House of Lords. He has been credited with accurately forecasting glasnost and the fall of the Berlin Wall – as well as the 1987 crash. His political commentary appears in The Times every Monday. His financial insights can only be found in the Fleet Street Letter, the UK's longest-running investment newsletter.
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Comments

  1. …”the present credit crisis is the natural consequence of high leverage, the repeal of the Glass-Steagall Act and the creation of excessive and complex derivatives.” On one level, this is certainly correct – these are proximate causal events in a long chain of cause and effect, but is this the true root of the problem?
    In fact, this state of “high leverage”, known as astronomical, mind-boggling debt to the layperson, is an inevitable outcome of a debt based monetary system. In certain circles, including those who write for and read the Daily Reckoning, it is taken as a self evident truth that any currency which is not backed by a finite, tangible asset such as gold…. will, given human nature, have a powerful tendency towards monetary inflation, an excess of supply which will eventually cause the currency to fail.
    This observation gets us even closer to the root of the problem, but even so we aren’t quite there yet. We don’t need to try to wrap our brains around the mind numbing complexities of derivatives, we need only ask WHY do fiat currencies have this tendency towards excessive supply? The answer is pretty simple: BECAUSE THIS MONEY IS ACTUALLY CREATED BY DEBT… and because there is never enough money in existence at any given point to repay the aggregate of the principal and interest that is owed on the debt that exists at that time, due to the nature of compound interest. THIS MEANS THAT THE MONEY SUPPLY MUST CONTINUALLY EXPAND AT AN EXPONENTIAL RATE IN ORDER TO REPAY THE DEBT THAT IS ITSELF EXPANDING AT AN EXPONENTIAL RATE! Can anyone dream up a better definition of mass insanity?
    The cycle of an ever expanding monetary supply, inextricably linked to an ever expanding debt load, is the essential structural flaw that is part and parcel of the central banker’s long running scam, the debt based monetary system. The crisis we are faced with now is the implosion that has been inevitable all along.

    Stuart Davies
    September 26, 2008
    Reply
  2. Stuart, I mostly agree with you accept one point.

    Debt itself does not create inflation. In a world without excess money supply, growth of debt is restricted because debt tends to be secured by tangible assets or future cash flows. You actually have to have real economic growth to support the money being borrowed. Now, if you introduce excess money supply into the system, you throw that restriction out the window because the money supply is growing faster than the economy, providing excess credit and resultantly excess debt.

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  3. You are missing the point here John. Do you understand where money comes from in our current system? It comes into existence through the creation of new debt. since that “loan” only creates the principle, but not the compound interest required to repay it, the only mechanism to supply the means to repay THAT interest is the further expansion of the money supply through the issuance of yet more debt. In other words, both the money supply and the debt load are locked in an ever expanding feedback loop, the epitome of a vicious circle. Because the interest on debt is compounded, the rate of expansion of the money supply, and hence the issuance of NEW debt, MUST BE EXPONENTIAL.
    The end result is not just an oversupply of money, but an unbearable burden of debt. On the one hand, it is accurate to say that an excess of money leads to an excess of credit/debt, which is the point of view that you and many others fix upon. However, my point is that in a fiat currency system like ours, money is created by debt in the first place, the two are essentially different aspects of the same thing. What I’m getting at that the oversupply of money is not an independent causal factor which leads to an excess of credit/debt, but that an excess of BOTH is the inevitable end stage result of a debt based monetary system. The money supply MUST expand or the system fails. The credit/debt load MUST expand in order to create more money…. ad infinitum, until it implodes. Get it?

    Stuart Davies
    September 27, 2008
    Reply
  4. So, John, debt only creates inflation if loans are not secured by tangible assets or future cash flows? Isn’t what is happening right now and recently, a lot of debt being secured NOMINALLY by “future tax flows” –that would be the debt incurred by the American government, but since they lower the taxes and raise the ceiling of the national debt, isn’t this false security? If it’s never to be repaid, how is that “secured?” The same is true for the Enron -type corporate debt. They cook the books to raise the expectations of future cash flows and create a bunch of new money (as debt) that will never be repaid, so what does it do, it goes into the economy in vast amounts and, more currency chasing the same goods, causes inflation! No?

    With a different system of finance, –one that does not reward bad loans equally as “good” loans –in other words with accountability built in, we would not be having this crisis.

    L Urban Kohler
    September 27, 2008
    Reply
  5. I actually thought that the Banking Act of 1933 (No.2) was repealed on 12th November, 1999, after bipartisan passage of the Gramm-Leach-Bailey Act of 1999, and signed into law by Clinton without power of veto.

    Silly me.

    Reply

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