The nation's biggest banks have done a great job portraying the repealed Glass-Steagall law as "Depression era legislation." In their highly successful lobbying effort, they rewrote history, obscuring why the law, which separated commercial and investment banking, was originally passed.
To recount: Glass-Steagall was enacted in large part because a number of large banks particularly First National City, today's Citigroup had massive loans to Cuba. The country's economy was based on sugar, and in the 1920s, sugar was flying high, much like oil in the late 1970s. Suddenly, the price of sugar plummeted and Cuba wasn't able to pay its massive debts.
In response, National City got a brilliant idea. Why not set up an investment banking subsidiary and sell these worthless loans to the unit, which in turn, would package them and sell them to the public? Other large banks followed National City's lead.
The investment banking subsidiaries went out and sold the bad loans to the proverbial widows and orphans, leaving these investors holding the almost worthless paper.
And that's why Congress wrote the Glass-Steagall Act. Sneeringly calling it "Depression-era" legislation, banks have obscured the reason for the law. Now the real reasons Glass-Steagall was enacted are resurfacing, though in somewhat different forms.
A few years ago, NationsBank was fined by regulatory authorities because a unit of its investment banking arm packaged a bunch of derivatives that were under water and sold them to a trust. NationsBank's investment banking arm then sold participations in the trust to a list of NationsBank customers, all of whom were 60-years-old or older. Obviously, the trust lost money and the oldsters were left holding the bag. The Securities and Exchange Commission fined the banks, followed, rather reluctantly, by bank regulators.
Still another form of passing credit risks to others and at times to people who don't understand what they're getting into is securitization. In a page-one feature story, The Wall Street Journal recently told of how, approximately three years ago, J. P. Morgan Chase & Co. arranged an $800 million loan for Teligent, the then-high-flying telecommunications giant. Teligent sought bankruptcy protection last May. At that point, it turned out that Morgan/Chase had only $80 million, or 10%, of the loan on its books. Some $400 million was held by small investors through purchases of mutual funds that invest in bank loans.
No one's up in arms about such practices because there have been no truly disastrous losses yet. But if the economy fails to recover, there will be. And that may make "Depression-era" legislation seem not as dinosaurian as the big banks would have us believe.