Glass-Steagall, The Fed & Investment Bank Access

In light of Bear Stearns' demise, and the hand-wringing over Lehman being next, do we need a new equivalent of Glass-Steagall? I wrote about the unintended consequences of its removal here and here recently.

Or do we, as Treasury Secretary Hank Paulson is promising, need a regulatory overhaul to unify regulation of investment and commercial banks, now that Glass-Steagall's absence has finally led to the Fed lending to non-commercial banks? In that regard, the second of the above-linked posts discussed Henry Kaufman's idea for a 'super-regulator.' I still don't see the need for another regulatory body, but this past weekend's historic and unprecedented granting access by non-commercial banks to the discount window suggest regulatory structure has to finally catch up with Glass Steagall's removal.



But what about moral hazard? Are we just seeing the final consolidation of financial services that is long overdue?


For example, mortgage origination and trading capacity could be trimmed. What about trading and asset management in hedge funds and private equity firms? Don't they constitute significant capacities of these product/market segments that don't typically need much capital?


If they are over-leveraged and make unwise investments, they go under. Must we be afraid of these legitimate consequences of our capitalistic system?


Isn't that what Bear Stearns did, except they were publicly owned?


Don't we want to squeeze out excess capacity, a la Schumpeterian dynamics?


Is the underwriting business really so rare and profitable that we need all the capacity the Street had? Even prime brokerage is probably looking a bit over-served right now.


Maybe what we should acknowledge, with Glass Steagall's demise, is that most investment banks and brokerages like Bear Stearns should really be part of commercial banks. They currently exist, for the most part, due to the desire of commercial banks to offer 'broker loans.' Their funding is due to repo's to commercial banks, the latter having always had access to the Fed window.


Maybe now, we should not only allow investment banks access to the Fed, but simply realize that all brokers are implicit extensions of commercial banks, because the latter can do all that the former can, and have permanent, rather than temporary, Fed and banking system access.


This fundamental new reality has become apparent due to mortgage-related CDOs.


As the values of, and markets for these opaque securities have evaporated, the liabilities with which they are funded are being called- by commercial banks.


If only investment banks and brokerages had stuck to existing, fairly understandable assets like bonds and equities. Of course, profits on those are thinner, thanks to competition.


That's why the Street invents vehicles like CDOs. They are less-easily understood, and, thus, more profitable.

Could it be that this latter truth is really an indication of the over-served nature of financial services?

This morning, on CNBC, former Vanguard chairman John Bogle opined that, instead of adding value to our economy, the financial services sector now sucks value out, as witnessed by the sector's recent annual profit which exceeded that of the semiconductor sector.

I believe he has a valid point. By its creation of purely speculative, no-money-down mortgages and the packaging of these mortgages in CDOs, financial services firms have polluted the markets with opaque, now-unmarketable securities, after first taking profits for the creation of both instruments.

The result, as I observed in a recent phone call with my business partner, is what Alan Greenspan sees, correctly, as a financial debacle of historic proportions.

Ordinary, plain-vanilla fixed-income products such as bonds, and equities, tend to have nearly-constantly available markets which provide price discovery. You just don't see those markets ceasing to function unless an issuer goes bankrupt.

Now, however, we have performing structured finance instruments which have no markets because of their questionable asset value, not their income streams. And commercial banks are as culpable as any other financial institution in this mess.

BofA, Chase and Citigroup aren't your father's bank anymore. It's debatable, in the wake of Glass Steagall's demise, that any publicly-held brokers or investment banks should or can really exist independently of a commercial bank. In the new environment of securitized toxic structured finance instruments, a large commercial bank is uniquely able to survive, by dint of its Fed access and judicious use of its 'investment account' provisions.

There's much more to these topics. But for now, those are my initial thoughts.