In 1930, Senator Carter Glass proposed several versions of a bill which aimed at the separation of investment and commercial banking. It was the beginning of the great depression – a period right after the “roaring twenties”, a time when ‘there was so much alpha in the markets, you had to be an idiot not to invest’. Glass believed that speculative investment activities by commercial banks were the primary cause for the Wall Street crash of 1929. After much debate and several disagreements between Glass and Representative Henry B. Steagall, the “Banking Act”, also known as the “Glass-Steagall Act”, was finally passed in 1933. Although being controversial in its making, it ended up being widely accepted as a good piece of legislature.
That was until 1999, when Bill Clinton gave in to pressure from the banking sector and loosened up the structural reforms that were set in place for very good reasons 66 years earlier. He would publicly announce that “the Glass–Steagall law is no longer appropriate.” Times had changed.
What politicians sadly didn’t consider was that, even though times change, people don’t. There seems to be no such thing as a collective memory when it comes to financial screw ups. The only collective memory that we have, is passed on to the next generation in the form of laws, such as legal restrictions for the financial sector in order to avoid repeating disasters. Nevertheless, laws alone will never be enough without a public understanding of why we have and need them. Laws can be easily overthrown, such as the Glass-Steagall act in 1999.
The relaxation of the financial system after Glass-Steagall spurred an explosion of new financial products: CDSs CDOs, forwards, options, etc., in summary also called Derivatives – investments that derive their value from movements in underlying assets. Why would anybody need derivatives? The long answer is that they can be used for a wide variety of purposes: from hedging away risk caused by commodity fluctuations that are not part of your core business, all the way to massively leveraging up your position in a stock, which you believe will spike, because you are brilliant and know the market. The short answer is, that when they were brand new in the ‘80s and ‘90s, they allowed the ones who actually knew what they were doing to achieve real alpha. With derivatives you can synthesize securities in a million different ways. If one of the ways you find is cheaper to produce than another one, you make money. Today, these opportunities are pretty much exhausted and alpha is a comforting story that a fund manager will tell you right before you sign. Therefore, it didn’t take long for Warren Buffet to famously call them “financial weapons of mass destruction”.
After the removal of Glass-Steagall in 1999, Goldman-Sachs became a bank, Morgan Stanley became a bank and many other great companies – but not banks – became banks. This is exactly what Glass-Steagall would have stopped from happening. In the years to follow “banks” went nuts and decided it would be a brilliant idea to be over-lending. There was so much alpha in the markets, you had to be an idiot not to invest. When the mortgage market collapsed in 2007, the political failures of a decade ago would catch up with the illusion that every house would only ever rise in price, irrespective of natural market mechanics such as supply and demand. What followed was a global financial contagion, recession and whole new avalanche of legislation.
In 2016 we are effectively still stuck in a cycle, which really started in 1999. Just like in 1936, when the developed world was still stuck in a cycle that really started in the 1920s. The political spectrum is shifting towards the outer ends, just like then. The only difference between now and then is, that now we know what happened then and this time it could all have been avoided. Nevertheless, the upside of history repeating itself is that we can be twice as certain about the lessons learnt.