Morning Report: Glass-Steagall is a solution in search of a problem 7/19/16

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Stocks are higher this morning on no real news. Bonds and MBS are up small.

Housing starts came in at 1.19 million units, the highest since February. May was revised lower. Building Permits rose to 1.15 million units. Starts seem to have found a level here at 1.2 million per year, which is still depressed.  Housing starts have historically averaged closer to 1.5 million units (even before the real estate bubble) and inventory remains tight. This is helping push up prices, but the side effect is that the first time homebuyer remains on the sidelines due to affordability issues. Given the tight inventory out there, starts should be closer to 2 million per year, and that makes a huge difference in economic growth.

Now that Brexit hasn’t caused the world to end, the Fed is back to thinking about hiking rates again. The Fed Funds futures are now pricing in a 45% chance of a rate hike this year versus a 20% chance last week. Next week’s FOMC meeting just went from being a sleeper to potentially big. It might also mean that people who are waiting for a 1.37% 10-year bond yield to refinance might be waiting a while. The big driver will be overseas rates, and if European bonds head back into negative territory, US yields will follow. Absent the overseas influence, rates would be a lot higher in the US than they are.

Note that Morgan Stanley is calling for a 1% 10-year yield by the end of the year.

The Republican platform now includes reinstating Glass-Steagall which would break up the big banks. I guess the idea is that JP Morgan would split back into JP Morgan and Chase, Citi would spin off Smith Barney, and Bank of America would spin off Merrill. FWIW, Glass-Steagall is a solution in search of a problem, and it really had nothing to do with the financial crisis.

For a quick history lesson, Glass-Steagall was instituted during the Great Depression, but the reason for it is largely forgotten. At the beginning of the Depression, investment banks were choking on failed underwritings. In an underwriting, Company XYZ comes to an investment bank and says “I want to borrow $100 million by issuing bonds.” The investment bank gives Company XYZ $100 million and takes the bonds. The investment bank now has to sell these bonds to the public in order to get their money back. In the early 30s, there were no buyers for bonds, so the investment banks were stuck with a lot of stock and bond issues they couldn’t sell. Since these investment banks also owned commercial banks and insurance companies, they basically “sold” the failed underwritings to their subsidiaries who bought them at their inflated full value, not market value. When these banks and insurance companies failed, the regulators saw that much of their assets were worthless bonds bought from the parent investment bank. Thus Glass-Steagall was born – it prohibited investment banks from using their captive commercial banks and insurance companies as a buyer of last resort for failed underwritings. All transactions had to be arm’s length after that.

Fast forward to the late 1990s. Plain vanilla derivatives like currency and interest rate swaps were a huge business as Corporate America was doing more and more business overseas. The arena for these derivatives was highly competitive, and big foreign banks like Credit Suisse, Deutsche Bank, Barclay’s and Nomura were able to offer much better rates to Corporate America than Goldman or Merrill because they had access to cheap capital: deposits. Banks like Nomura could borrow for free, while Morgan Stanley had to borrow at LIBOR. Washington saw that “Wall Street” was beginning to mean foreign banks and not US banks. The rest of the world doesn’t separate investment banking and commercial banking. Indeed, the rest of the world doesn’t even recognize a difference. Washington decided that Glass Steagall was handicapping US banks versus the international competition (and it was). And thus Glass Steagall was repealed.

It is important to realize that the financial crisis was not the result of JP Morgan selling CDO squareds to Chase. Nor was Citi selling crap paper to Travelers. The financial crisis was the result of a residential real estate bubble, which are the Hurricane Katrinas of banking. Banking systems almost never survive a nationwide real estate bust, derivatives or no derivatives. See the busts in Japan and Sweden in the early 90s, and watch what happens in other places with massive bubbles. I guess the hope is G-S can address too big to fail, however if a hedge fund nearly brought down the system (LTCM), then an investment bank failure will as well. I am sure plenty in Washington are licking their chops at further regulating the banks and using them as a policy tool for social engineering. This is the model for many European banks.

If GS gets re-instated and the big banks break up, you could see a similar effect to when the government busted up AT&T in the 80s and investors cleaned up on all the baby bells.

Anyway, re-installing Glass Steagall might be politically popular, but it is a solution in search of a problem.

20 Responses

  1. Frist! I’m fine with bringing back Glass-Steagall but would, as always, warn against those who think it’ll be a magic bullet. Now, if we can get rid of Sarbanes-Oxley!

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    • KW:

      I’m fine with bringing back Glass-Steagall but would, as always, warn against those who think it’ll be a magic bullet.

      I would, as always, warn against those who think it would do anything whatsoever to protect against the kind of crisis we had in 2008, or frankly any other kind of crisis. Promotion of Glass-Steagall is nothing but a placebo, fake medicine that provides only the appearance, and nothing more, of actually addressing a problem.

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      • Trying to think of a case where that isn’t pretty much everything congress does, and I’m having a heard time. What about dumping Sarbanes-Oxley? You think that would be helpful?

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        • KW:

          You think that would be helpful?

          Yes. But of course I am fairly anti-regulation as a matter of principle.

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        • Even if your pro-regulation, I’m not seeing how Sarbanes-Oxley has been helpful, or accomplished its ostensible goals. But I am not an expert in the field by any stretch.

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    • NRO quotes John Berlau pointing out what Brent and I have repeatedly pointed out here re Glass-Steagall:

      http://www.nationalreview.com/corner/438047/gop-platforms-glass-steagall-recommendation-serious-mistake

      Adopted early in the New Deal, the Glass-Steagall Act separated investment and commercial banking. It prohibited commercial banks from underwriting or dealing in securities, and from affiliating with firms that engaged principally in that business. The GLBA repealed only the second of these provisions, allowing banks and securities firms to be affiliated under the same holding company. Thus J.P. Morgan Chase was able to acquire Bear Stearns, and Bank of America could acquire Merrill Lynch. Nevertheless, banks themselves were and still are prohibited from underwriting or dealing in securities. [N.B. contra the Platform’s insinuation]

      Allowing banks and securities firms to affiliate under the same holding company has had no effect on the current financial crisis. None of the investment banks that have gotten into trouble — Bear, Lehman, Merrill, Goldman or Morgan Stanley — were affiliated with commercial banks. And none of the banks that have major securities affiliates — Citibank, Bank of America, and J.P. Morgan Chase, to name a few — are among the banks that have thus far encountered serious financial problems. Indeed, the ability of these banks to diversify into nonbanking activities has been a source of their strength.

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  2. Interesting observation:

    “I asked Castellanos, “What if we had Twitter and Facebook in 1968?””

    http://www.theatlantic.com/politics/archive/2016/07/cracking-trumps-tough-facade/491816/

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  3. Brent – I changed the word “repealing” in your conclusion to “re-installing” so that the conclusion would square with the premise.

    I avoided “reinstating” in order to not repeat the use of the word from the previous paragraph.

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    • NH – What I like most about Johnson, besides his mellow personality, is that by not being a doctrinaire libertarian [that is, he was willing to compromise with a D lege to ratchet down government] he really did move the needle on tax-and-spend in NM, and made the state far more efficient than it had ever been. I have said this to folks again and again, only to hear that he cannot win, or more recently that he is a pothead who cannot win.

      If TX were in play, I had thought in 2012 that I would vote for BHO, b/c TX needs two parties again. Having one party rule is to me as dead end as it was when it was the Ds in 1968. Competition makes things better all over. But for 2016, I think I would vote L anyway, at least for POTUS.

      And he is very strong on personal liberty, as well.

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      • Mark:

        Having one party rule is to me as dead end as it was when it was the Ds in 1968.

        By what metric has Texas been a dead end?

        And how would voting for BHO for president alter local party rule in Texas?

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        • Dead end as in individually less talent gets further up the ladder – take our AG who is facing state and fed indictments for securities fraud and civil fraud charges as well, or Rick Perry. When we had two parties, the guys who ran against each other had to account better for themselves. No automatic “D” or “R” wins, regardless of calibre of the individual. There were some awful Ds who got elected in the 60s just b/c of their party affiliation.

          My constable precinct is purple, not blue. When the D Constable was caught with his hand in the cookie jar, we all voted R. That is the good thing about not having automatic winners by party.

          If TX ever went D again in a POTUS election it would revive the moribund TX D Party. But for me character counts and Johnson is a man of character, ’nuff said.

          Addendum: In the R Primary, our very conservative but extremely high character Land Commissioner ran 4th for AG b/c the rest of the field was working so hard to run to his right, as he said. It really pissed me off that when he lost the R primary [despite my active help!] my choice was limited to the guy running a scam, there not actually being a D in the race, AFAI recall.

          I think I voted for an L who wasn’t even a lawyer in the GE.

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        • The D AG for Travis county is another example of too much one party rule.

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        • Mark:

          What’s the point in promoting responsible state government if you are electing people who are going to concentrate power away from the states and into the federal government?

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  4. Queen and other groups object to the RNC/Trump using their songs as convention/campaign music.

    http://www.rollingstone.com/music/news/queen-frustrated-by-donald-trump-after-rnc-song-usage-w429857

    Question: If a baker should be forced by the law to allow his talents to be used to celebrate an event he personally objects to, why shouldn’t a musician be forced by the law to allow his talents to be used to celebrate an event he personally objects to?

    Like

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