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By Brandon Holt

Breaking the Glass-Steagal Ceiling, An argumentative essay

Capitalism, love it, hate it; no matter how one might feel about the system, it runs the western world. However, when provoked by an outside source, it can fail in destructive ways. That is what happened to America in 2008. There was the collapse of the housing market. Millions of jobs were lost; there were hundreds of thousands of defaulted mortgages; basically, there was global economic devastation. Favorite arguments as to what caused the destruction of 2008 include corrupt bankers and deceptive loaning practices. Because banks gave mortgage loans to people who could not afford them and sold the risky loans on the stock market to unsuspecting prey, the buyers of the loans then lost everything when the mortgages could not be paid. These are the direct causes of the collapse, but none of it could have been possible without the illogical blunder of both Republican and Democrat lawmakers. The roots of 2008 trace back to 1999 and the repeal of the Glass-Steagal act by our Congress and President Bill Clinton.

When discussing the causes of the housing market collapse, answers are often buried and diluted by mystifying Wall Street rhetoric meant to intimidate a nation of people looking for those answers. Without comprehension of these terms, it is impossible to understand why the market crashed in 2008. The most critical of the terms is "subprime," which is used to classify people who would not have been able to afford a mortgage loan before the deregulation of banking in 1999; these people are high risk to not pay (default) their mortgages. Adding to their risk of defaulting are adjustable rate mortgages (ARMs), which were more popular among subprime borrowers than the traditional fixed rate. ARMs' prices rose and fell with the market and had very low-interest rates for the first few years. To make money on the mortgages, banks pooled them together in what is called a security. These securities can be bought and sold by investors in the stock market. There are two types of securities: mortgaged backed (MBS) and collateralized debt obligations (CDO). The CDO is directly a mortgage security made up of pooled mortgages, but it is more of a promise to pay by the banks based on the seniority of the actual CDO. The latter is a riskier but higher payoff. The final term needed to understand the 2008 collapse is what the MBS and CDOs split into: tranches. They are judged on the safety of an investment with a credit rating system, the highest or safest being a triple A rated (AAA) tranche and the lowest just a single B. There is more explanation, more comprehensively complicated terms and how they relate to the collapse, but one fact remains: these words would mean nothing if not for the repeal of the Glass-Steagal act.

First enacted in 1933 and then finalized in 1935, the Glass-Steagal act came in the wake of the Great Depression to prevent a similar event of economic devastation from happening again. To summarize, the law separated Commercial Banking (What your savings account is in) from investment banking, (which is more like gambling but instead of pony or dog racing, you bet on stocks). When repealed in 1999, the two types of banks were then allowed to merge and become too big to fail (Zarroli). Being too big to fail means that in the event of bankruptcy, the government will issue a bailout to save the bank. Without the risk of failing, banks started issuing mortgage loans to the subprime borrowers; then they packaged them together in MBSs and CDOs to be "bet" on in the stock market. By being pooled together, the mortgage securities were seen as safe investments because if only one or two people defaulted in the package, the complete security would not fail. That sense of safety led to people investing full pensions and retirement funds into the real estate market, making the crash even more devastating for America. However, if preventing banks' mergers were the only provision of the Act, the market collapse would not have been near as severe as it turned out to be.

The other provision of Glass-Steagal that perhaps holds the same amount of importance prohibited bankers from packaging credit securities (CDOs) and reselling them to investors. What packaging did was put CDOs that were too risky to sell into a larger CDO known as a CDO-squared until it was considered safe enough. Then it would be sold for a wholesale price. This could be repeated an infinite amount of times (Juhas 121), so it made even the riskiest of mortgage bonds "safe" enough for people to invest pension funds and retirement savings into the securities, or so the bankers thought. Repackaging was once again made legal with the repeal of Glass-Steagal in 1999 (Rickards). Although bankers took advantage of the deregulated market caused by repealing Glass-Steagal, if investors were not misled by the "safeness" of a security, perhaps millions would have been saved from the atrocious acts of greed by the banks and the catastrophic mistake of our lawmakers.

The misleading of investors was a byproduct of MBS and CDOs. Both types of securities had different levels of risk, known as tranches. They were risk rated by a credit rating system; the system was paid for by the banks selling the tranches which led to raters giving overly generous safety assessments (Economist). For example, a CDO has 1000 mortgages in it, and 700 are subprime loans; the assessors would still give it a triple A rating. So buyers were investing in the safest rated security that should have been the lowest rated because of the risk of subprime borrowers failing to pay their mortgages. However, if subprime mortgages were so prone to failure, what was a subprime borrower's incentive to get a loan in the first place?

To answer the previous question requires two explanations. The first is the adjustable rate mortgage (ARMs) offered to subprime borrowers in place of the traditional fixed rate. ARMs rise and fall with the market and had an interest rate of 1-2%. In pre-2008, the market was trending upward; in other words, the mortgages were going up in price and becoming more valuable. This increase in value would cause people to sell their homes or properties for profit. For example, X borrower buys a house for $100,000, and in a year of upward trends, the house is now worth $200,000. Then borrower X sells for a profit of a little less than $100,000 if you count the low interest paid by X in the past year. Those numbers are, of course, exaggerated, but the concept remains the same. However, these buying and selling practices ended in 2007 when the interest rates on mortgages rose to 10-20% (Juhas 118), and the market started trending downward. People were no longer willing to buy homes that were depreciating, which caused the current subprime owners to be stuck with the outrageous interest rates on homes they could not afford. Pajarskas and Jociene report,"As interest rose, house prices flattened…and refinancing options were not feasible." Rising interest rates eventually led to people defaulting on their mortgages, causing the securities they were packaged into to fail, and the investors in those securities to lose everything. This is a direct result of the deregulation caused by the Glass-Steagall repeal.

Now, to explain the second part of the answer as to what incentive did: subprime borrowers had to take out a loan they could not afford: irrational exuberance (IE). In his academic journal, Holt explains IE as a "heightened state of speculative favor." To put the explanation in English, it can also be explained in gambling terms, like most investment banking concepts; for example, a boxer named Z is heavyweight champion of the world and has never lost a fight; his odds are at 200:1 to win the next match. IE is that Z will win his next fight, so people bet significant amounts of money for a rather small payoff, but the odds say it's everything but a sure thing, so it is a safe bet. However, against the odds, Z gets knocked out in the first round. Those people who bet on him to win, lose everything. That is the concept of irrational exuberance, but in our case, Z is the housing market and the gamblers are the subprime borrowers, security investors, and bankers.

Now to trace the direct cause of the housing market collapse to the repeal of Glass-Steagal. Repealing the act made large bank mergers lawful again; banks then had the incentive to merge so they would become too big to fail, meaning too important for the government to let them go bankrupt with no bailout. That sense of immortality by the banks gave them the freedom to grant risky subprime loans so they could make a higher profit. To sell the subprime mortgage bonds on the stock market, banks pooled the bonds together with thousands of other mortgages into MBS and CDOs. Once combined, credit rating agencies fraudulently assessed the safety ratings of those securities and misled investors; investors then lost everything when the market crashed. The second provision that was made lawful again turned what would have been a moderate crash into a national economic disaster: repackaging CDOs that did not sell until they were repackaged to the point they were considered safe enough. When the repackaged subprime CDOs failed en masse, people lost pensions, retirement funds, and lifetime savings. Any banker or mortgage broker who issued a repackaged CDO knowing the contents should have been indicted for fraud. Regardless, the fraudulent system would not have been possible if not for the repeal of Glass-Steagal, which kept loaning practices honest for just under seventy years.
However, dissenters claim that Glass-Steagal had little to no role in the crash of 2008; the dissenters place the bulk of the blame on the Department of Housing and Urban Development (HUD) (Maverick). HUD required half of all the loans mortgage brokers issue be to people who would, at the time, be otherwise unable to receive a loan. This is known as the infamous subprime (Maverick). Since HUD passed their legislation in the early 1990s, and Glass-Steagall was repealed in 1999, popular belief on the issue is that the latter cannot cause the former. Though if the HUD Act existed without the latter, I agree that it would have led to a bubble, but I disagree that the bubble would have caused the devastating crash that turned out to be the reality because of the number of subprime loan applications denied after 1999 verses before. In 1997, after the HUD Act but before the Glass-Steagall repeal, loan denials were at 28%, but in the years of 2002 and 2003, just before the collapse and after the repeal, loan denials were at 14%(FFIEC). So subprime loans were only being denied at a rate of 14% after the Glass-Steagall repeal versus the 28% before. The increase in subprime loans, or rather the decrease in denials, is, in part, what caused a bubble to turn into economic turmoil.

In the case of the 2008 crash, the outside interference in our capitalist system was the act of removing a previous intervention. So when is laissez-faire or an entirely free market right? And when is it bad? The truth is, it depends. There is no set formula for amounts of regulation versus amounts of market freedom. For example, if a person wants to start a new local business, he/she should have the freedom to do that because small businesses improve local economies through the amount of money they put back into the towns where they exist. However, a bank wants to grant loans to anyone who walks through the door so they can increase their profits with the bonds; that should not be allowed because of the adverse effects fraudulent loaning practices have on the economy. Of course, those are only two examples in a market full of endless possibilities, but the concept remains the same. Every situation is different. Outside interference from the government can be good or bad. In 1933, it was good interference. Glass-Steagall was followed by thirty years of the greatest opportunities for economic mobility in this nation's history ( In 1999, with the purpose of getting banks more profits by allowing investment and commercial banks to merge once again, the repeal of Glass-Steagall worked for a short time, but eventually, it led to the worst economic disaster perhaps ever.
While lawmakers set out with positive intentions to try and get everyday people more money from the stock market, by repealing Glass-Steagall, they helped cause the worst economic disaster in modern times. The repeal further proves the notion of not fixing what is not broken, though it is unfortunate that it took an economic collapse to prove it. We should have never repealed the Glass-Steagall act. Though our Government will never use complete discretion regarding too much regulation versus not enough, all we can do as citizens is hope and vote for those we deem responsible. Without a doubt, there is a sense of economic uncertainty across the nation in the year of a new presidential administration like we are in now. I hope, as a current college student just starting my life, that the American people have chosen the right one for the job, and that, as a nation, we can educate ourselves more on every economic decision so we can prevent another 2008 from ever happening again.

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