Public Policy Analysis & Opinion
AIG and the meth labs of finance
How the GLBA came to replace Glass-Steagall, and led us astray
By Kevin P. Hennosy
I was pleased to receive and interested to read Mr. Michael Erlanger's letter to the editor, (page 10 of the August issue) concerning my column in the June 2011 edition of Rough Notes.
Mr. Erlanger offers an insightful and well-reasoned response on the commentary that I offered with regard to the failure of American International Group (AIG). In general terms, I agree with his assessment, although he is correct that I place more blame on American insurance regulators than I believe he does.
I believe that the statute known as the Gramm-Leach-Bliley Act (GLBA) should be repealed. When measured by the loss of American treasure and prestige, the Gramm-Leach-Bliley Act is arguably the single worst piece of legislation passed by the United States Congress.
The GLBA repealed the Glass-Steagall Act, which had separated the insurance, banking and securities sectors in the years between 1933 and 1999. The passage of the GLBA not only enabled or invited but ensured the financial collapse of 2007-2008, which lingers to this day. Without repeal, the GLBA threatens to do more damage.
The Glass-Steagall Act, or the Banking Act of 1933, arose from the wreckage of the American economic collapse of 1929, and the investigation of the American financial sector conducted by Ferdinand Pecora on behalf of the Senate Committee on Banking and Currency.
As Ron Chernow wrote in The House of Morgan, the Glass-Steagall Act "was meant to restore a certain sobriety to American finance." As the Pecora Committee documented, and Chernow explained, "In the 1920s, the banker had gone from a person of sober rectitude to a huckster who encouraged people to gamble on risky stocks and bonds."
In addition, the involvement of deposit-taking and loan-making commercial banks in the underwriting and sales of securities was fraught with conflicts of interest. Again, Chernow wrote: "Banks could take bad loans, repackage them as bonds, and fob them off on investors, as National City had done with Latin American loans. They could even loan the investors money to buy the bonds."
Furthermore, the management of the Federal Reserve System feared that they might have to bail out member banks based on the weakness of a non-bank financial affiliate. In 1933, the federal government had no jurisdiction over insurance and securities markets, yet "The Fed" was expected to step in to shore up a commercial bank weighed down by losses unrelated to deposits or loans.
Glass-Steagall prohibited bank holding companies from owning other kinds financial institutions, but it tended to separate banking, securities, and insurance into distinct recognizable forms. It was the absence of such distinctions that led to problems at AIG and other institutions, which I will address later.
The primary provisions of the Glass-Steagall Act divided and segregated the major activities in the financial services sector based on how each activity processed risk. A commercial bank, which accepted deposits, focused risk in terms of safety and soundness. An investment bank, which underwrote securities, sold risk to investors in a fair and transparent manner. An insurance company accepted risk from policyholders for a fee and distributed that risk across the total pool of policyholders. These risk-based categories brought sobriety to business practice and facilitated orderly regulatory oversight.
Today, opponents of reviving a Glass-Steagall-like framework often deride the approach as divisions, based on names, but the divisions were designed to foster specialization in risk management.
The Glass Steagall Act contained other provisions that addressed other forms of financial activities that tend to undermine the strength of an institution and threaten a sound economy. Through Regulation Q, the law granted jurisdiction to The Fed to regulate interest rates in savings accounts. Another provision of Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC), which created an insurance program to protect bank depositors and a regulatory framework to govern covered institutions.
It is interesting to note that according to two eminent historians, Arthur Schlesinger Jr. and Kenneth S. Davis, President Roosevelt opposed the inclusion of the FDIC provision in the Glass-Steagall Bill. Two Texans, Vice President John Nance Garner and Chairman of the Reconstruction Finance Corporation Jesse Jones, championed the FDIC proposal. The president's opposition hardened when the liberal populist from Louisiana, Senator Huey Pierce Long, managed to amend the FDIC amendment to include state bank institutions.
President Roosevelt's opposition rested in both policy and political concerns. From a policy standpoint, at a time when thousands of banks were failing, Roosevelt expressed concern that weak banks would drag down strong banks through the deposit insurance mechanism. Politically, he preferred a nationally oriented financial system supported by federal regulatory frameworks and, if extended, guarantees. Roosevelt held political disdain for the conservative parochialism of small town bankers and did not want to do them any favors.
Roosevelt quietly circulated a veto threat to the conference committee that negotiated the final legislation, but when the compromise bill that contained the Garner-Jones-Long proposals passed both houses of Congress with overwhelming majorities, President Roosevelt declared victory and signed the bill into law.
The Glass-Steagall Act passed Congress in June, 1933. In a "Fireside Chat" delivered on September 30, 1934, President Franklin D. Roosevelt described the financial crisis that Glass-Steagall sought to correct in part: "past evils in the banking system, in the sale of securities, in the deliberate encouragement of stock gambling, in the sale of unsound mortgages and in many other ways in which the public lost billions of dollars."
The president continued, "Only a very small minority of the people of this country believe in gambling as a substitute for the old philosophy of Benjamin Franklin that the way to wealth is through work."
Most often the Glass-Steagall Act was described in terms of placing firewalls between the major financial sectors. As firewalls constructed between row houses impede the spread of fire from one structure to the next, the act hindered the spread of destructive processes between and among the financial sectors.
Furthermore, and less discussed, the Glass-Steagall Act encouraged each financial sector to compete between and among each other in two ways. Banks, insurers, and securities firms competed for consumer dollars, but they also competed politically before policymakers. The inability of the financial services industry to concentrate its economic and political objectives made the institutions more responsive to consumers and more manageable to regulators.
In 1950, the FDIC amendments were removed from the statute and reinstated as a stand-alone law, which probably saved its long-term viability.
Nearly as soon as Glass-Steagall became law, financial interests tried to repeal the bill or challenge its provisions in federal court. Until the 1980s, the courts proved more open to undermining the framework than the Congress. As the courts chipped away at the clarity of the law's definitions, factions of Congress became more receptive to repeal.
In 1980, the Depository Institutions Deregulation and Monetary Control Act repealed The Fed's authority over savings account interest rates. The coordinated lobbying effort aimed at the repeal of state usury laws followed. Beginning in 1981, a major theme of the "Reagan Revolution" was deregulation of business.
In 1982, the Garn-St. Germain Bill set the tone for financial deregulation by removing rules governing the savings and loan sector, and establishing the Adjustable Rate Mortgage (ARM). The first action led to the collapse of the savings and loan sector, which necessitated a massive taxpayer bailout to battle a complete collapse of the real estate sector and related erosion of the value of the dollar. The latter, coupled with a slashing of federal funding for low-income housing, provided the raw material for the sub-prime mortgage bubble.
It was as if the policymakers had decided to remove teachers and playground equipment from schoolyards and invited crystal methamphetamine dealers in to keep the kids busy.
For at least 30 years, a cottage business in lobbying arose around repealing Glass-Steagall. These lobbyists worked hard to keep hope of repeal alive, but had little incentive to see passage for repeal, which would signal the end of the gravy train.
Still, in the late 1990s the repeal efforts grew in influence. Groups like the Independent Insurance Agents and Brokers of America (IIABA) remained cool to repeal for fear of the threat of banks entering insurance sales in a big way. The IIABA argued for the maintenance of a strong state regulatory system over insurance and prohibitions on bank sales of insurance through anti-tying and other consumer protection statutes.
The National Association of Insurance Commissioners (NAIC) was not as strong an advocate of state insurance regulation as the IIABA.
Then Wisconsin Insurance Commissioner Josephine Musser did the greatest damage to the NAIC's defense of state insurance regulation by taking deep quaffs from the cup of deregulation. Musser seemed enamored with junk-science analysis contained in books such as Reinventing Government, which argued for privatization of public assets and services unfettered by complex concepts like democracy. Behind Musser's leadership, the NAIC lost time and effort as she attracted political tips from financial lobbyists.
When it finally became clear that Musser did not have the best interests of the association or the state regulatory framework at heart, Kentucky Insurance Commissioner George Nichols received the NAIC's lobbying portfolio on Glass-Steagall repeal. Where Musser flirted with the concept of federally chartered and unregulated super-insurers, Nichols embraced the concept of "functional regulation," which has proven to be dysfunctional.
Functional regulation maintained for the continued application of regulatory frameworks to financial service activities based on the nature of the function, rather than the type of institution.
With regard to the insurance function, the repeal legislation established that "the McCarran-Ferguson Act remains the law of the land" without regard to the type of financial institution engaged in the insurance function.
Just as a parent is not likely to let a teenage daughter take a boyfriend and a supply of beer into her bedroom and close the door, just because she calls the room her "Study Hall" or claims to "just be studying," financial regulators were supposed to affirmatively act to determine when firms engaged in certain functions no matter what they called themselves or the function.
The repeal of Glass-Steagall invited name games to avoid oversight. The lack of clear definition and active regulation invited the financial crash from which we are still trying to rebuild.
According to one former NAIC lobbyist, Jack Chesson, Congress might not have passed the GLBA to repeal Glass-Steagall if it were not for former President Bill Clinton's affair with Monica Lewinsky, which led to his impeachment. After the Senate refused to convict the president, Capital Hill and White House leaders looked around for a major piece of legislation that would give the impression that they were all "grown-ups." At a Kansas Insurance Day Seminar conducted in 2000, Chesson recounted this story and called the GLBA, "Monica's Law."
The passage of GLBA led to a frenzy of deregulation by the states as state officials tried to entice support away from optional federal charter legislation. It was a kabuki drama where the regulators tried to demonstrate that they could be less intellectually curious and not as physically active as phantom federal charter-masters.
That is where I believe insurance regulation failed with regard to AIG, which was able to consolidate so much economic and political power that it could never be regulated. AIG became the meth dealer in the schoolyard as well as the boyfriend with the beer in the bedroom.
The concentrated economic and political power concentrated in the financial services industry through the repeal of Glass-Steagall provided the power to inflate the debt-inflated bubbles of the past decade. The Sub-Prime Bubble could have never inflated without poorly designed insurance products that insurance regulators ignored: Credit Default Swaps insuring Collateralized Debt Obligations.
AIG sold insurance on bond defaults without calling it insurance from a subsidiary that was not called an insurance company—but AIG sold insurance on bonds. Under functional regulation, the state insurance regulatory system had jurisdiction and responsibility to regulate AIG in all of its manifestations. I respectfully disagree with Mr. Erlanger over whether the regulators fulfilled their role.
State insurance regulators had to want to regulate but they feared the power of companies like AIG, so they didn't. Which brings to mind another quote from President Roosevelt:
"The liberty of a democracy is not safe if the people tolerate the growth of private power to a point where it becomes stronger than their democratic state itself. That, in its essence, is fascism—ownership of government by an individual, by a group."
Repeal of Glass-Steagall was a mistake, which should be remedied through new legislation.