Wednesday, July 17, 2013

Remember why Glass-Steagall was passed is a story about need for transparency

In his Bloomberg column, James Greiff succinctly summarizes why Glass-Steagall was passed in the 1930s.  The story he tells also applies to the adoption of transparency as the foundation of our financial system.

Regular readers know that our financial system is based on the FDR Framework.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under this framework, governments are given the responsibility for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Under this framework, market participants are responsible for all losses on their exposures.  As a result, they have an incentive to use the information disclosed to assess risk and limit their exposures to what they can afford to lose.

By design, this framework makes it possible to invest rather than just gamble when buying or selling a security.

The investment process has 3 steps:

  1. Independently assess the information disclosed on an investment to determine its risk and value;
  2. Solicit prices from Wall Street;
  3. Compare the prices provided by Wall Street to the independent valuation and make a buy, hold or sell portfolio management decision.
If the government fails to require all the useful, relevant information be disclosed in an appropriate, timely manner, then market participants cannot go through the investment process.  If market participants cannot go through the investment process, making buy, hold or sell decisions is simply gambling on the value of the contents of a brown paper bag.
It seemed like a good idea at the time. After making loans to borrowers who were unable or unwilling to repay them, one of the nation's biggest banks came up with a solution: Take the loans, repackage them and sell them to customers and, in effect, bail out the bank from its money-losing positions. 
As for telling investors about the distressed state of the borrowers, well, why bother? 
The head of J.P. Morgan, perhaps the most respected banker of his era, had already sounded the tocsin about the consequences of deteriorating credit standards. ``A warning needs to be given against indiscriminate lending and indiscriminate borrowing,'' he said. 
Yes, this is a trick. The banker wasn't Jamie Dimon, chief executive officer of what now is JPMorgan Chase & Co.; it was Thomas W. Lamont, speaking in 1927. And the bank selling securities in the bum loans wasn't one of today's too-big-to-fail behemoths, but National City Co., the predecessor of Citigroup Inc.
These anecdotes come from a report issued in 1934 by the Pecora Commission, which was charged with digging into the financial industry's misdeeds in the run-up to the stock market crash of 1929. 
The commission's hearings and findings provided a rationale for many of the laws adopted in the 1930s to regulate banking and the securities markets, including the Glass-Steagall Act, which forced banks to split their lending and securities businesses.
Please note that Mr. Greiff chose a story that is really about securitization transactions (sound familiar? think subprime RMBS) and the need for disclosure so that investors could know what they were buying or know what they owned. 

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