Glass-Steagal might have kept the subprime mess more manageable

By Thomas Kostigen
MarketWatch.com
Friday, September 7, 2007

http://www.marketwatch.com/news/story/would-glass-steagall-save-day-cred...

SANTA MONICA, Calif. -- Time was when banks and brokerages were separate entities, banned from uniting for fear of conflicts of interest, a financial meltdown, a monopoly on the markets, all of these things.

In 1999, the law banning brokerages and banks from marrying one another -- the Glass-Steagall Act of 1933 -- was lifted, and voila, the financial supermarket has grown to be the places we know as Citigroup, UBS, Deutsche Bank, et al.

But now that banks seemingly have stumbled over their bad mortgages, it's worth asking whether the fallout would be wreaking so much havoc on the rest of the financial markets had Glass-Steagall been kept in place.

Diversity has always been the pathway to lowering risk. And Glass-Steagall kept diversity in place by separating the financial powers that be: banks and brokerages.

Glass-Steagall was passed by Congress to prohibit banks from owning full-service brokerage firms and vice versa so investment banking activities, such as underwriting corporate or municipal securities, couldn't be called into question and also to insulate bank depositors from the risks of a stock market collapse such as the one that precipitated the Great Depression.

But as banks increasingly encroached upon the securities business by offering discount trades and mutual funds, the securities industry cried foul. So in that telling year of 1999, the prohibition ended and financial giants swooped in. Citigroup led the way and others followed. We saw Smith Barney, Salomon Brothers, PaineWebber and lots of other well-known brokerage brands gobbled up.

At brokerage firms there are supposed to be Chinese walls that separate investment banking from trading and research activities. These separations are supposed to prevent dealmakers from pressuring their colleague analysts to give better results to clients, all in the name of increasing their mutual bottom line.

Well, we saw how well these walls held up during the heyday of the dot-com era when ridiculously high estimates were placed on corporations that happened to be underwritten by the same firm that was also trading its securities. When these walls were placed within their new bank homes, cracks appeared and -- it looks ever so apparent -- ignored.

No one really questioned the new fad of collateralizing bank mortgage debt into different types of financial instruments and selling them through a different arm of the same institution. They are now.

I'm not saying that Glass-Steagall would have made a difference to the evolution of the collateralized debt obligations. But it might have helped identify and isolated the damage.

When banks are being scrutinized and subject to due diligence by third-party securities analysts more questions are raised than when the scrutiny is by people who share the same cafeteria. Besides, fees, deals and the like would all be subject to salesmanship, which means people would be hammering prices and questioning things much more to increase their own profit -- not working together to increase their shared bonus pool.

Glass-Steagall would have at least provided what the first of its names portends: transparency. And that is best accomplished when outsiders are peering in. When every one is on the inside looking out, they have the same view. That isn't good because then you can't see things coming (or falling) and everyone is subject to the roof caving in.

Congress is now investigating the subprime mortgage debacle. Lawmakers are looking at tightening lending rules, holding secondary debt buyers responsible for abusive practices and, on a positive note, even bailing out some homeowners.

These are Band-Aid measures, however, that won't patch what's broken: the system of conflicts that arise when sellers, salesmen and evaluators are all on the same team.

Glass-Steagall forced separation. Something like it, where conflicts and losses can be mitigated, should be considered again.

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