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Striving to be an informed citizen, I am researching the financial meltdown. I’m going to give you my understanding of how the GLB act and the credit-default-swap contributed to the crisis, and I’d like you to tell me if it is accurate and, if not, critique it.

Here’s the way I see it. Before GLB and under Glass-Steagall, before the repeal of Glass-Steagall, your mortgage was between two entities, you and your bank. If you defaulted, your bank took the hit. GLB connected your bank to Wall Street and allowed it to sell your mortgage to investors and financial institutions. These investors in turn sold the mortgages to more investors, often in complicated bundles and using exotic financial tools like the credit-default-swap, something I still don’t understand. After passing through layers of investors, many of whom were respectable banks like Morgan Stanley, Lehman Brothers, etc. (since these institutions were “responsible,” rating agencies gave these mortgages AAA safety ratings), bundles of subprime mortgages were being marketed as sound investments. The entire chain became overleveraged, and once you, the buyer, couldn’t pay your mortgage, the defaults had a cascading effect throughout the entire financial system. Whereas before GLB, the default would have been limited to you and your bank.

So that’s my understanding of the whole matter, as simple as I can put it. My question is: is it true that before GLB, banks could not resell your mortgage to Wall St. using tools like a credit default swap? Did the Glass-Stegall regulation, repealed by GLB, prevent them from playing both the deposit/loan side of the game and the investing side?

Please don’t turn this discussion into a blame game. Provide an answer that is related to the GLB act. Thanks!
mishkin, your answer was very informative, I appreciate it. My question remains though: were the banks prohibited, before GLB, from reselling their mortgages to investors? You mentioned Freddie and Fannie. Before GLB, did banks sell their mortgages to them and did Fannie and Freddie in turn sell them to investors and investment companies? Or were those banks and/or freddie and fannie prohibited from that doing that due to the separations of depository institutions and investment banking of the Glass Steagall Act?

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4 Thoughts on Did the Gramm-Leach-Bliley Act open up the risky market of credit-default-swaps?
  1. Reply
    mishkin
    May 18, 2011 at 12:25 am

    Hmm to be honest with you I think you are confusing a bit CDS with MBO’s/MBS’. In CDS the underling risk lies with a BOND of a corporation, where with MBO’s the risk lies with a LOAN (mortgage) of an individual. Thus, you basic risks models go like these: CDS = risk of a bank/corporation defaulting on a bond vs MBO = risk of a person not being able to pay the mortgage. CDS are business to business contracts, ratings get checked and etc. there is no Fannie Mae and Freddie Mac encouraging lending without consequences, so CDS are much more stable instruments, whereas you have MBO’s – where the original bank could underwrite a horrible loan and did not matter because they never got to carry the risk – as Freddie and Fannie bought the loans and took the risk onto themselves (that is until they packaged the loans into MBO pools and sold them on the market). Historically, MBO’s were fairly safe – but a few years before the crush the banks got super greedy and underwrote loans which they knew people could not pay (because they had bad credit scores, no income and etc.), but it did not matter because they got their commission, sold them to Freddie/Fannie and at the end of the day Meryll Lynch, Lehman Brothers, AIG and others bought those MBO’s for investments purposes. Once people started defaulting on their mortgages the MBO’s (carried on the books as assets) became worthless and had to be wirtten off (asset removed and expense recorded) thus destroying liquidity and capital of the financial instutitions and in turn of the market.

  2. Reply
    eternal student
    May 18, 2011 at 12:39 am

    In your description, you have stated that securitization itself was the problem. Any good thing can be misused, and that is what happened here. The originators of loans who are responsible for checking credit failed to do so. Also, you mention that ratings agencies gave these mortgage backed securities AAA ratings because these institutions were “responsible.” That is not the basis on which they are supposed to give ratings. They are supposed to evaluate the quality of the underlying loans, estimate the probability of default, using mathematical models to give their MBS ratings. Their models were flawed and there were severe conflicts of interest because the ratings agencies were helping design the very securities they were rating in exchange for lucrative consulting fees. The originators of loans were non-banking institutions and were not under the purview of Federal regulators. There were many other areas of weakness and cracks in the system and the problem is more complicated than you have described.

    Coming to your question on GLB. The GLB allowed regulated depository banks to merge with investment banks. Though this created conflicts of interest and systemic risk that caused regulators to deem some banks to be too large to fail, the GLB did not directly cause the crisis. As result of GLB, regulated banks started taking more risks in order to compete with investment banks by taking excessive leverage and hiding some risks using off-balance sheet vehicles like SIVs. This certainly was a big problem. But, you imply in your question that the GLB caused securitization. That assumption is not correct. Securitization was going on even before the GLB. Secondly, the GLB did not explicitly address the issue of securitization as implied by your question. Banks could easily sell their loans to other institutions rather than keeping it on their books even before the GLB act.

    As for your question regarding CDS being unregulated, in the late nineties the CFTC floated the idea of regulating these contracts between counter parties. The overall mood at the time (late nineties) was one of euphoria and deregulation. So, the Treasury, the Fed and the Congress rejected the idea of regulating these contracts and Congress passed a bill preventing the CFTC from regulating CDS and other similar OTC contracts. This issue was not directly addressed by the GLB as implied by your question.

    Regarding your question on the link you between GLB and the current financial crisis, I would just say two things. GLB was not at the root of this crisis, and repealing GLB will not solve the problem as your question seems to suggest. Beyond that I would just say that this topic is much more complex than you have described. The whole issue of “shadow banking system” and the role they have come to play, the need for new regulatory structure, etc. is much more complicated than the way you have framed the issue.

  3. Reply
    Kevin R
    May 18, 2011 at 12:50 am

    Your research is accurate however your conclusion is flawed. Wall Street never should have accepted the risk they naively (or greedily) underwrote. When the subprime mortgage exposure was discovered, and enormous fees received, cost to cash, to return on equity, and interest rate swaps, became the en vogue hedge to income Nirvana.

    Wall Street believed as interest rates fell, mortgages, like bonds, would steadily increase in value. Forgetting each bundle of mortgages represents several hundred mortgages usually from the same banking issuer, and geographic location. As one particular metro area implodes, Wall Street must tap dance to replace (or hedge) that income stream. Unable to let go of them at ‘marked-to-market’ losses, they held, and swapped (for a price), underwriting through derivatives.

    With Glass-Steagal repealed, investment banks stepped into much longer than 13 week round turn on money. Any immediate profits at an investment bank are invested the same way they were derived. The gov even sees higher revenue through corporate profits, and lending banks are safer. Every body wins.

    So, to answer your question simply, yes, GLB removed the banks inability to invest in equity. No, GLB didn’t open the door to investment banks’ Real Estate lending. It allowed them to ‘co-mingle’ funds. I think the initial purpose was to educate John Q Public, and allow Social Security to be invested in stocks.

    Nobody saw it coming. $ 140 oil, hit the economy like a baseball bat. I thought we went to the MIDDLE EAST to preserve peace (and cheap gas). Fixed income plays (now no income) couldn’t overcome the cost increases (inflation) involved in new construction outlays. The RE bubble burst.

    Big Three auto is in eerily same position.

  4. Reply
    Michael T
    May 18, 2011 at 1:21 am

    Prior to GLB, credit default swaps (insurance on credit securities) were allowed but were regulated. In 1999, credit default swaps became unregulated allowing insurers to issue the swaps without any reserves causing the market to balloon from about $ 900 billion to between $ 50-$ 70 trillion within 7 years. Credit default swaps did not directly cause the current problems but instead exasperated the problem once defaults started to occur.Credit default swaps were issued by insurance companies, hedge funds, private equity companies, and occasionally banks.

    Although derivatives such as mortgage backed securities (primarily CDOs – Collateralized Debt Obligations) were allowed prior to GLB, they were not heavily used due to their complexity. The theory behind their use was that risk would be reduced since loses would be spread amoung many mortgages and investors. Also it was assumed that a market could be made for the CDOs allowing them to be traded much like bonds therefore spreading the risk among many investors. Each investment bank would would become a market maker for the CDOs that they issued selling and repurchasing the CDOs to create the market. In theory this may have worked well if the CDOs were basically created equal (same ratio of prime, ARM, alt, and sub-prime loans and mortgages acquired from around the country). However, when some CDOs with large number of sub-prime loans from California, Flordia, or Nevada started to default heavily, investors quit purchasing all CDOs.

    A third problem was that in 2004 the SEC lifted the regulation on investment banks to keep the leverage at 12:1. This allowed the investment banks to invest more of their money raising profits which attracted more investors to make loans to the banks increasing profits further. The banks in turn started bundling CDOs with more and more sub-prime loans.

    Example:

    Lehman Brothers borrowed a large amount of money which became heavily leveraged in CDOs which contained a large amount of sub-prime loans. When the CDO market collapsed, Lehman Brothers was holding the bag with CDOs that they held for their own investment as well as repurchased CDOs to try to keep the market liquid. With mounting loses and an ever shrinking CDO portfolio, Lehman Brothers filed for bankruptcy.

    Although the bankruptcy of Lehman Brothers would be considered severe, the problems did not end there since there was a large amount of credit default swaps (estimated at $ 360 billion) against Lehman Brothers securities which were now due to holders of the credit default swaps. Since most of the credit default swaps were held by private investors and the insurers were financial instutions, the cost of the bankruptcy to financial instutions may have been double or even triple due to the credit default swaps causing terror in the financial instutions.

    With unregulated credit default swaps, it is very difficult to determine the effect of a bankruptcy on the economy. Bank regulators will know which bad loans (corporate bonds) will go into default but will probably not know if those corporate bonds had credit default swaps issued against them. Since the credit default swaps are not regulated, there may be 2 or 3 times the insurance issued against the value of the bond. In the case of a bankruptcy, regulators may assume that the cost to financial instutions would be about $ 200 billion but instead the real total could possibly be $ 600 billion due to credit default swaps.

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