November 4, 2011
On November 4, 1999, U.S. Congress passed the Gramm-Leach-Bliley Act (GLB), which was signed into law by President Clinton eight days later on November 12.
The Act, also known as the Financial Services Modernization Act of 1999, was an expansive reform of the financial industry that banks and financial institutions actually sought.
This is because GLB deregulated a significant part of the financial industry, in that it allowed previously separated “commercial banks” and “investment banks” to be owned by a single holding firm.
GLB also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks.
These prohibitions were originally created by 1933’s Glass-Steagall Act, which was passed in reaction to the mass bank failures nationwide during the Great Depression.
Under Glass-Steagall, a “commercial bank” was defined as what we traditionally think of as a bank: an institution where deposits are made and through which loans are issued (mortgages, personal loans, credit cards, etc).
“Investment banks,” on the other hand, were firms that dealt primarily in stocks, bonds, debentures, notes, or other securities.
Glass-Steagall was created to curb speculation by bankers, which many economic historians credit as being a major contributor to the economic crisis in the 1930s.
Glass-Steagall’s prohibitions, though, represented a blockade on a substantial revenue source for financial institutions (banks in particular).
GLB was the first successful attempt (twelfth overall) to repeal those sections of Glass-Steagall’s in question.
As mentioned earlier, the repeal of those provisions opened up an entirely new revenue stream for financial institutions, not least among which are mortgage-backed securities (MBS), forms of asset-based securities (ABS).
An asset-based security is a debt instrument, such as a bond, and it is secured by assets that have been pooled and assets from that pool.
A mortgage-backed security is an ABS in which mortgages are the “asset” that is pooled.
Securities are sold to investors, and through these securities, the investor assumes the risk of the mortgage, but is also entitled to principal and interest payments from the pooled mortgages.
This “risk-sharing” aspect of MBSs actually precipitated a major change in risk-assessment by the lender.
Traditionally, the risk of default is factored into the origination of a loan by the lender.
Because of the off-balance-sheet* nature of securities, though, the risk of a bad mortgage was passed from the lender onto the owner of a MBS.
This wasn’t much of a problem in the early 21st-century when the real estate market was booming and defaults were low.
During this time, MBSs were extremely lucrative, and the demand for them was just as high.
This, in turn, led to lenders loosening their standards so that more mortgages – and thus more MBSs – could be issued.
Unfortunately, these loose standards led to an increase in mortgage default rates.
MBSs suddenly turned toxic, and the holders, which included a wide range of investors from major investment firms to individual consumers, were left with worthless securities.
This chain of events was one of the primary contributors to the 2008 financial crisis.
Does this mean that GLB is directly responsible for the current economic hardship?
That’s difficult to answer with any reasonable certainty, although if not for GLB, banks – such as Bank of America, Wells Fargo, and Citigroup (formerly Citicorp) – wouldn’t have been able to deal in MBSs at all.
We can only hope that leaders in Washington are able to objectively identify any role GLB or other laws had in the economic decline and work to craft a long-term solution that benefits the nation as a whole.
*unlisted on a company’s balance sheet of assets and liabilities.