This is all Bill Clinton’s fault.   Although Senator Phil Gramm (R-TX) introduced the legislation in 1999, ultimately the burden of blame for the U.S.’s current economic crisis rests with the President who let the Gramm-Leach-Bliley Act pass.  This is the bill that overturned the part of the Banking Act of 1933, also known as the Glass-Steagall Act, that said commercial banks, those that accept deposits from customers and lend that money to borrowers, could not engage in the practice of underwriting securities.

The banking industry had been pushing extremely hard for the repeal of this part of the Banking Act of 1933.  Their argument was that more corporations were turning to investment banks because of lower costs due to less regulation.  Commercial banks were losing customers and therefore revenue to both investment banks and foreign banks, many of whom did not have the same regulations that split the activities of deposit acceptance from securities underwriting.

The Banking Act of 1933 was put into place during the Great Depression for very good reason.  The practice of underwriting securities is inherently riskier than traditional loans because credit standards are less of a concern due to the nature of the transaction.  An investment bank essentially borrows money from a commercial bank to give to a corporation in return for either stock or bond agreements that the investment bank then sells to private investors via the stock exchanges and bond markets.

The investment bank, whose repayment depends upon their ability to sell the securities to investors, care very little about the future financial stability of the entity they gave money to in exchange for the securities because the investors who purchase the securities from the investment bank are taking all of the financial risk assumed with giving money to that entity. The risk to the firm underwriting the security is in the nature of the agreement and the current market dynamics.  One of the types of securities causing our current problems is mortgage-backed securities (MBS).

Traditionally, mortgage backed securities were considered very low-risk investment instruments because most people paid their mortgages with a very predictable default rate.  People were riding the internet stock wave of the late nineteen nineties and did not predict that the stock prices were grossly over-valued and therefore must stabilize.  Coupled with the unforeseen tragedy of 9/11 and the subsequent financial market crash, the Federal Reserve systematically lowered interest rates to historic lows to combat the financial crisis at the time.

The resulting low interest rates on mortgages led to an enormous amount of people purchasing homes.  Basic economics tells us that if demand increases at a rate greater than supply, then prices increase.  Home prices began to skyrocket due to the lowering of interest rates. Increasing home prices starting reaching a point that many people could not meet the requirements for traditional mortgages based on the inflated property values.  To respond to this, banks began offering new loan instruments, such as the interest-only mortgage, that bypassed typical credit standards and down payment requirements.

The Federal Reserve always walks an interest rate tight rope, trying to maintain balance between setting rates too low, which leads to inflation (so they say), or being too high, which stifles economic growth through making borrowing money cost-prohibitive.  While these historically low interest rates were causing economic growth through real estate profits, all good things must come to an end and the Federal Reserve began to raise interest rates by quadrupling them over an eighteen-month period from 2005 into 2006.  This caused variable rate mortgages to suddenly become much more expensive on a monthly basis to the borrower.  People then began to default on these mortgages in record numbers.

Back to basic economics again: if a large population of borrowers are opting to take the credit hit of defaulting on a mortgage, this leads to a large population of people who can no longer qualify for a mortgage thereby decreasing the demand for homes.  Decreasing demand with an ever-increasing supply indefinitely leads to lower prices.  Now, commercial banks are financially burdened with a property that is lower in value than the money they lent to someone to buy it, thus accepting the loss.

Investment banks are being hurt in this situation because of the mortgage-backed securities (MBS).  When borrowers stopped paying their mortgages, investment banks had to devalue their MBS and take a loss.  So, since commercial banks were now allowed to own investment banking firms, ultimately the cash flow of the commercial banks were hurt.  This is how commercial banks are now taking huge losses on two fronts; all a result of the Gramm-Leach-Bliley Act of 1999.

Another part in this history is the formation of the Federal Deposit Insurance Company (FDIC), also a product of the Banking Act of 1933 meant to bring an end to the Great Depression.  Since the FDIC will have to pay banks’ depositors enormous sums of money for claims should the bank go bankrupt, the government usually attempts other means to avert the need to pay out on deposit insurance for a bank failure.  These other means have manifested both directly and indirectly impacted many of the financial crises during 2008: Bear Stearns’ near bankruptcy led to the government relaxation of traditional FTC waiting periods in order to allow JP Morgan Chase to acquire Stearns before it had to liquidate the firm’s assets, the Federal Government takeover of Fannie Mae and Freddie Mac, the Bank of America acquisition of Merrill Lynch through relaxed FTC regulations, the temporary ban on short selling certain financial sector stocks, the Lehman Brother’s deal, and inexorably to the $700 billion Federal Government bail-out that is still not finalized.  These events will be the subject matter for part 2 of the U.S. Economy in Crisis Explained series.