By now most everyone knows that the Glass-Steagall Act was enacted during the Great Depression to separate investment banks from commercial banks in an attempt to cut down on speculation by (the then newly) Federally backed institutions. The last of the act was repealed in 1998 with the blessing of Clinton and active lobbying by several key players in Obama’s economic team. At the time several financial historians and regulators warned that it could lead banks to take major risks, lead to huge asset bubbles and eventually catastrophic collapse. Needless to say, they were proven accurate; I won’t say prescient because that implies unusual foresight and all they had to do was point out repeated mistakes of the past when commercial banks got into speculation.
So here we are, after the government has more or less fully backstopped all the major financial players, and Wall Street is going to receive record bonuses. Bank of America and Citigroup finished paying off their TARP not because they have recovered, but because they don’t want their bonuses hindered. In fact, there is near unanimous agreement that those banks are once again severely undercapitalized and never should have been allowed to pay it off. It has been suggested that the government allowed the pay back because it wanted good PR and also to act as a back door stimulus package that they couldn’t get through Congress. Considering that there are still another $2 trillion of losses in the system, banks will almost surely be back for more “emergency” funding in the next year or two, and are really just getting away with highway robbery.
The current situation is extremely ridiculous: banks have a completely free hand to make money however they see fit; all monetary and most fiscal policy is aimed at making it as easy for them to make money as possible; if they screw up then losses will go back to the taxpayers; and there is little political will to impose strict caps on compensation in interest of the “free market.” Pravda couldn’t do a better job.
However, Yves Smith recently pointed to an article talking about how the top brass at failed firms profited handsomely and had a tidbit that surprised me:
Prior to 1970, all NYSE members had to be partnerships (and in those days, stock brokerage provided the bulk of industry earnings). That meant partners had their wealth tied up in the firm. The line at Goldman was that partners lived poor and died rich. When someone (back in the early 1980s, when comp levels were much lower than today) a top performing non-partner might make $600,000 to $700,000 a year. When he made partner, his take-home pay dropped precipitously to perhaps $100,000-$150,000 a year. New partners were under pressure to increase their ownership stake (by becoming even more productive) so they could get increase the cash potion of their comp. Moreover, if a firm went bankrupt, as Lehman did, the partners were personally liable. The creditors could seize their personal wealth.
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And those pay based incentives DID matter. Goldman was incredibly risk averse, both from a legal standpoint and in how it was cautious about deploying its capital (that does not mean it was not greedy, please, but was greedy in ways that had low odds of hurting its franchise). The firm as a public company bears little resemblance to what it was as a partnership.
In short, the commercial banks that did have government backing were disallowed from high risk activities and the firms that were allowed to deploy capital as they saw fit were on the hook if they messed up. These days banks give out more in “bonuses” than they technically earn in profit (which should be impossible but financial firms get tax breaks for paying bonuses and it doesn’t count as part of profit) and when they mess up first the stockholders take the hit, then eventually the tax payers. Rinse and repeat. It’s no wonder that we are in such dire straits and the rip off is getting bigger and bigger. Various government entities have now absorbed trillions of dollars of largely toxic assets and there is a fear that the second they stop buying the system will collapse; of course if they don’t stop buying then taxpayers will just be on the hook for more more and more while Wall Street gets all the gains.
Both liberals and conservatives should be strongly for reinstating Glass-Steagall and requiring investment banks to go back to being partnerships. That will limit public risk, reduce the need for government intervention and force the financial complex to make real long term investments instead of lazy statistical games that eventually blow up.
Update: OK from an article linked in the comments, this is prescient:
The opponents of the measure gloomily predicted that by unshackling banks and enabling them to move more freely into new kinds of financial activities, the new law could lead to an economic crisis down the road when the marketplace is no longer growing briskly.
”I think we will look back in 10 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 1930’s is true in 2010,” said Senator Byron L. Dorgan, Democrat of North Dakota. ”I wasn’t around during the 1930’s or the debate over Glass-Steagall. But I was here in the early 1980’s when it was decided to allow the expansion of savings and loans. We have now decided in the name of modernization to forget the lessons of the past, of safety and of soundness.”