It Takes a Pillage: An Epic Tale of Power, Deceit, and Untold Trillions

by Nomi Prins

  These trusts posted enormous profits before collapsing to nearly nothing in 1929, causing director and Goldman Sachs partner Waddill Catchings (coauthor of the New Era apologist book The Road to Plenty) to resign in June 1930.33

  In 1932, comedian Eddie Cantor, the Jay Leno of the time, was one of forty two thousand investors who lost a fortune in the Goldman Sachs Trading Corporation. He sued Goldman for $100 million and made Goldman Sachs a national joke to ease the pain: “They told me to buy the stock for my old age . . . and it worked perfectly. Within six months, I felt like a very old man!”34

  There were other eerie similarities between then and now: the Ponzi scheme-like companies that Goldman and others sponsored in the 1920s made lots of money on empty promises of perpetual asset appreciation; they were quickly overvalued, perversely reflecting the promise of future growth of American industry. In reality, they did not demonstrate solid growth of any kind but rather growth on paper from buzz.35 Similarly, the misplaced enthusiasm about home ownership demonstrated by Greenspan, Bush, and others helped stoke the Wall Street fires full of loans to burn and profit from.

  One of the longest lasting positive aspects of the Glass Steagall Act was that it established the Federal Deposit Insurance Corporation (FDIC) to permanently protect the people’s cold, hard earned cash—despite FDR’s understandable reservations about insuring commercial banks.36 After the slew of bank runs and bank failures during the Great Depression, FDR didn’t want banks to get too comfortable knowing that their deposits were backed by the U.S. government.37 He astutely feared that the same money hungry banks would be more likely to abuse the dollars entrusted to their care. In a 1932 letter written before Election Day and printed in the New York Sun, Roosevelt gave the following opinion on deposit insurance: “It would lead to laxity in bank management and carelessness on the part of both banker and depositor. I believe that it would be an impossible drain on the Federal Treasury to make good any such guarantee.”38 That lesson would be entirely forgotten during the Second Great Bank Depression.

  In spite of these concerns, FDR signed the Glass Steagall Act that created the FDIC on June 16, 1933, and its insurance went into effect on January 1, 1934.39 The FDIC became a permanent government agency with the Banking Act of 1935. Initially, all consumer accounts were guaranteed up to the amount of $2,500, but the same year that the insurance went into effect, in July 1934, the cap was raised to $5,000.40 That meant 45 percent of all deposits in the banking system were covered.41

  The only reason that the FDIC made sense, then, was that it coincided with the Glass Steagall Act, which separated the more stable consumer oriented commercial banks from the riskier speculative investment banks. The FDIC was only supposed to provide backing for the less risky ones. Sure, certain consumer oriented commercial banks knew the government had their backs, but equally important was that speculative banks, which created and traded risky securities—and which, by virtue of the fees they took in for their services, were prone to advise on corporate mergers and acquisitions whether they were for the public good or not—knew that they did not have the backing of the U.S. government. (Investment banks would, however, have FDIC backing during the Second Great Bank Depression.)

  Over the years, the FDIC raised the level of insurance on consumer deposits to adjust for inflation. The Depository Institutions Deregulation and Monetary Control Act of 1980 raised it to $100,000.42 The Federal Deposit Insurance Reform Act of 2005 increased the FDIC’s insurance of certain consumer retirement deposits to $250,000.43 As panic was setting into the U.S. economy in late 2008, Congress passed the Emergency Economic Stabilization Act of 2008 that until December 31, 2009, would raise the insurance limit on any other consumer deposits from $100,000 up to $250,000. On May 19, 2009, it was extended by Congress through December 31, 2013.44 Raising the cap was one of the only smart responses to the economic crisis.

  Who Killed Glass-Steagall?

  The Great Depression fallout that brought Wall Street’s leveraged bets to bear onto the general economy replayed itself during the election of 2008, but with one major difference: Barack Obama did not have a decisive plan to dissect the banking industry into manageable parts. That didn’t change once he got into office, either.

  The Glass-Steagall Act of 1933 was one of the main legislative pillars of the New Deal. The other four were the Emergency Banking Act of 1933, which legalized the bank holiday and allowed federal regulators to inspect banks to make sure they were financially sound before reopening (in contrast to the early 2009 bank stress tests, which allowed banks to provide their own results regarding their health); an executive order that made it illegal to hoard gold, gold bullion, or gold certificates; the Home Owners Loan Act of 1933, which established the Home Owners’ Loan Corporation to provide mortgage money to people at risk of foreclosure; and the Social Security Act, which established the Social Security Board.45

  As I’ve mentioned, Glass Steagall separated financial institutions into two categories: commercial banks, which dealt with public deposits and loans; and investment banks, which dealt with speculative trading activities and corporate mergers and acquisitions. It was the perfect solution: beautiful in its simplicity and powerful in its effectiveness. Under the terms of the act, commercial banks would receive more government backing, which was only fair after years of nationwide economic depression. Investment banks would not, which was also only fair after the speculation by investment banks that had caused years of economic depression.

  You may get tired of my beating this dead horse, but you have to believe me: the horse totally deserves it. I cannot overstate the value of Glass Steagall. If it had not been repealed a decade ago, our current banking system meltdown would not have occurred. Deposits and loans would not have been used as collateral for an upside down pyramid of risky securities. The competitive corporate drive to become bigger combined with unconstrained financial players wouldn’t have spawned a tornado of toxic assets and mega leverage. And bank execs wouldn’t have scooped up immense rewards before the economy became a total mess.

  Senator Byron Dorgan Predicts We’ll Rue the Day

  Glass Steagall’s demise is not surprising when we see the array of forces lined up against it. One of the men heading the charge, with a private sector mentality from the pulpit of public office, was none other than Robert Rubin, a former Goldman Sachs cochairman and President Bill Clinton’s treasury secretary.46

  He began to lobby for the repeal of Glass Steagall in May 1995 when he testified before the House Committee on Banking and Financial Services. “The banking industry is fundamentally different from what it was two decades ago, let alone in 1933,” Rubin said. He stressed how global banking had become, arguing that raising capital on the back of diverse new products had become an international game. He stoked an already illusory fear that if the U.S. banking industry didn’t have the same opportunities and structure as existed abroad, banks would move their most profitable businesses across the ocean.

  Rubin was downright hostile to the core concepts of Glass-Steagall, which he considered a cost and-efficiency roadblock to bank profits. He declared that the act could “conceivably impede safety and soundness by limiting revenue diversification.”47 And who’d ever want to be an impediment to safety?

  Hell bent on removing barriers to banking activities, Rubin testified again on February 24, 1999, imploring that the United States was missing an important boat that had already set sail, while implying that without the repeal of Glass Steagall, the industry and its customers would suffer. And the world as we know it would cease to exist. (Okay, he didn’t exactly say that, but his point was pretty clear.) This time, Rubin made his case before the Senate Banking Committee:

  Financial modernization is occurring already in the marketplace through innovation and technological advances. With the lessening of regulatory barriers, financial services firms are offering customers a wide range of financial products. Banks and securities firms have been merging; banks are selling i
nsurance products; and insurance companies are offering products that serve many of the same purposes as banking products—all of which increases competition and thus benefits consumers.48

  To be sure, there were critics of repeal back then. Notably, Senator Byron Dorgan (D ND) warned in 1999 that a “financial swamp” would result from the casino-like prospect of merging banking with the speculative activity of real estate and securities.49

  Another critic was the late Paul Wellstone (D-MN), who stressed, “We seem determined to unlearn the lessons of history. Scores of banks failed in the Great Depression as a result of unsound banking practices, and their failure only deepened the crisis. Glass Steagall was intended to protect our financial system by insulating commercial banking from other forms of risk. It was designed to prevent a handful of powerful financial conglomerates from holding the rest of the economy hostage. Glass Steagall was one of several stabilizers designed to keep that from ever happening again, and until very recently it was very successful.”50

  Nonetheless, President Bill Clinton signed the Gramm Leach-Bliley Act (also called the Financial Modernization Act) into law on November 12, 1999.51 During the signing ceremony at the Eisenhower Executive Office Building, there was no show of partisanship. The Democrats and the GOP were in sync. Republican Senate Banking Committee leader Phil Gramm said, “We are here today to repeal Glass Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.”52

  Rubin’s protégé Lawrence H. Summers, who had taken over as Clinton’s treasury secretary while Rubin took a plum job at Citigroup and carried his mentor’s deregulation mantle, remarked, “Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the twenty first century. This historic legislation will better enable American companies to compete in the new economy.”53

  A decade later, Clinton renounced any blame for the Second Great Bank Depression. He claimed that killing off Glass Steagall had nothing to do with the crisis. “There are some people who believe that that bill enabled them to somehow participate in some of the riskier housing investments,” Clinton said. “I disagree with that. That bill primarily enabled them to, like the Bank of America, to buy Merrill Lynch here without a hitch. And I think that helped to stabilize the situation.” 54 Now, as you can imagine, I strongly disagree with Clinton on this issue. And I would hope you do, too. Buying Merrill Lynch, with its $70 billion worth of collateralized debt obligation positions, was risky. The government pumping Bank of America with almost $220 billion of capital injections and guarantees to keep it alive following its merger with Merill Lynch did not go off without a hitch.55 Earth to Clinton. Repealing Glass Steagall was financially destructive to the general economy. Big mergers create big problems.

  Far from being on the defensive, Clinton was brimming with money-making glee when he signed Gramm Leach-Bliley: “Financial services firms will be authorized to conduct a wide range of financial activities, allowing them freedom to innovate in the new economy. The Act repeals provisions of the Glass Steagall Act that, since the Great Depression, have restricted affiliations between banks and securities firms. It also amends the Bank Holding Company Act to remove restrictions on affiliations between banks and insurance companies. It grants banks significant new authority to conduct most newly authorized activities through financial subsidiaries.”56 Bank holding companies, previously regulated by the Bank Holding Company Act, were allowed to mutate into the giants that trashed the world economy.

  The repeal of Glass Steagall was not accompanied by legislation to strengthen regulatory oversight for newly consolidated supermarket financial firms amalgamated from broker dealers, commercial banks, and insurance companies. Yet that didn’t seem to matter as Clinton promised, “This historic legislation will modernize our financial services laws, stimulating greater innovation and competition in the financial services industry. America’s consumers, our communities, and the economy will reap the benefits of this Act.”57

  The scene was set for disaster. History had already shown that if commercial banks speculate or borrow too heavily against their customers’ assets, the system self-destructs. It was only a matter of time after the Glass Steagall repeal that history would repeat itself. Without a reinstatement of Glass Steagall, which is not even near the table in Congress, it will again.

  When Congress approved the bill on November 5, 1999, Dorgan said, “I think we will look back in ten years’ time and say we should not have done this but we did because we forgot the lessons of the past, and that that which is true in the 1930s is true in 2010. We have now decided in the name of modernization to forget the lessons of the past, of safety and of soundness.”58 Sadly, he was right.

  But levelheadedness was lost in the blur of a reckless desire to deregulate, or destroy legislation that had already taken its share of knocks but had still proved effective for nearly seven decades in preventing a widespread banking meltdown. The act was repealed without any serious public consideration of the potential consequences. It was a one sided hatchet job that led to spectacular financial devastation, and a completely unlevel playing field controlled by the bigger banks.

  To this day, none of the architects or the advocates of Glass Steagall’s destruction have taken their rightful blame for their role in destabilizing the system. Yet, bringing back Glass Steagall would be the single most effective way to reconstruct the financial industry in a way that wouldn’t require public support for the losses caused by the unbridled risk taking of the banks that hold our money.

  “An Awfully Big Mess”

  As part of the rush to deregulate, Congress watered down the SEC rules that were put in place to protect the public from reckless corporate behavior. As we’ll see, after Glass Steagall was repealed, many banks went shopping to buy investment banks and insurance companies. Some investment banks, however, preferred to remain insulated from commercial banks. But the problem was that investment banks couldn’t compete with the money and leverage of the “supermarket” commercial banks, which had access to their customers’ deposits as collateral. The solution for the investment only banks was to raise their own leverage limits, so they could borrow more money for speculative activities, without having to post as much collateral or capital. To raise leverage limits, investment banks had to pick apart the net capital rule that the SEC had set in 1975. It had required broker dealers to cap their debt to net capital ratio at twelve to one.59 In other words, they couldn’t borrow more than twelve dollars’ worth of debt for every one dollar of real capital, or equity, that they held. Changing the net capital rule was referred to in the business as “low hanging fruit,” or something easy to deal with. It was just a matter of time and tactical influence.

  Shortly after the Glass Steagall repeal, there was one firm that sprinted out of the box to raise leverage in order to maintain its edge. On February 29, 2000, Goldman Sachs CEO Henry Paulson testified at the Senate Banking Committee hearing on the “Financial Marketplace of the Future.” He pressured for lifting the seemingly innocuous 1975 net capital rule. In his testimony, he stated, “We and other global firms have, for many years, urged the SEC to reform its net capital rule to allow for more efficient use of capital. This is the single most important factor in driving significant parts of our business offshore; so that our firms can remain competitive with our foreign competitors, risk based capital standards must become the norm.”60

  In short, Paulson was pushing for investment banks to take on more risk in order to stay competitive with the new supermarket banks and their larger balance sheets. In late April 2004, the five members of the SEC met in a basement hearing room to consider lifting the net capital rule. There were few dissenting voices out there at the time. One, from a risk management consultant from Indiana, warned that the decision was a “gr
ave mistake,” as paraphrased in the New York Times. Another, Harvey J. Goldschmid, then an SEC commissioner, expressed a prophetic truth about the ramifications of tripling leverage for the most powerful investment banks: “If anything goes wrong, it’s going to be an awfully big mess.” Regardless, after less than an hour of discussion—fifty-five minutes to be exact—a vote was taken.61 It took four years from the time of Paulson’s Senate plea, but on April 28, 2004, the biggest investment banks—those with more than $5 billion in assets, such as Lehman Brothers, Bear Stearns, Merrill Lynch, and Goldman Sachs—got approval from the SEC to increase their official leverage from twelve to one to thirty to one.

  The damage potential was even greater than it initially seemed after the SEC hearing. According to the New York Sun, “Using computerized models, the SEC . . . allowed the broker dealers to increase their debt to net capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1.”62

  Leverage gluttony had prevailed with the SEC’s blessing. Before crashing on September 21, 2008, Lehman had a thirty to-one leverage ratio, or thirty borrowed dollars per one dollar of real capital. Morgan Stanley had thirty to one and Goldman Sachs was at twenty-two to one. Of the major supermarket banks, Bank of America had a leverage ratio of about eleven to one, JPMorgan Chase had about thirteen to one, and Citigroup had fifteen to one—but that only counts the leverage we knew about.63 Most likely, if the supermarket banks’ off-balance sheet deals—which included leverage of items in structured investment vehicles (SIVs)—had been included, their ratios would have been even wider.64