The Great Depression and Glass-Steagall
Fueled by post-World War I consumer optimism and rapid migration from rural towns to cities, the Dow Jones Industrial Average increased tenfold. This period of time, referred to as “The Roaring Twenties”, ended when the market crashed and the Great Depression began. The Dow Jones reached an all time high on September 3rd, 1929 of 381.7, a level that would not be seen again until 1954, in inflation-adjusted numbers. Just over a month later, between October 24th and October 29th, 1929, the Dow fell from 305.85 to 230.07, a record total loss of nearly 25%. This was the start of the Great Depression.
A federal investigation has followed every financial crisis in United States history, and after the Crash of 1929 the Pecora Commission was formed. Led by Ferdinand Pecora, the Commission came to the conclusion that the Great Depression was a result of universal banking operations. In order to remedy the problem, Carter Glass and Henry Steagall sponsored the Banking Act of 1933, commonly referred to as Glass-Steagall. With this legislation came the creation of the FDIC and the separation of commercial and investment banks. This legislation remained in place for more than 65 years with very few amendments and allowed the American economy to remain relatively stable throughout the rest of the 20th century.
Sandy Weill, John Reed, and the Formation of Citigroup
Sandy Weill began his career in 1955 as a runner for Bear Stearns. After several other ventures, he became the CEO of Travelers Group in 1993. By 1997, Weill had begun to consider a merger with Citicorp. John Reed, the CEO of Citicorp, had spent the last six years bringing his company back from the brink of bankruptcy. Weill and Reed were casual acquaintances, having been major players in similar industries for decades. Talks of a merger began on February 25, 1998, when Weill approached Reed at a conference in Washington.5 Reed agreed that the two companies were perfect candidates for a merger. However, the pair also realized that there were numerous hurdles to overcome, the greatest of which would be gaining Fed approval to violate Glass-Steagall.
If Weill and Reed were successful in organizing a merger, they would be creating the world’s largest financial services company. Citigroup would have nearly $700 billion in assets and combined revenues of nearly $50 billion, making it the largest merger in history. In the weeks leading up to the merger Weill made several calls to President Clinton, Treasury Secretary Robert Rubin and Fed Chairman Alan Greenspan. In these calls, Weill warned them that they were close to announcing a major deal that would violate Glass-Steagall. After telling Rubin that he had big news, Rubin joked, “Let me guess…you’re buying the government.”5 More important than the size of the deal was what it would mean for the United States financial industry. Since 1933, American banks were not able to compete with the universal banks in Europe and Asia. Citigroup would create a new era of finance in America; for the first time in over 65 years an American firm would be able to offer both banking and insurance products.
On April 6, 1998, the merger was announced as a $70 billion dollar stock swap, where Travelers Group would purchase Citicorp with stock and adopt C as its new ticker under the name Citigroup. Wall Street analysts and reporters were generally in favor of the megamerger. While the deal violated the Glass-Steagall mandate that banks, insurance companies, and securities firms could not operate as a single entity, Congress temporarily approved the deal. Through Weill and Reed’s lobbying efforts, Citigroup was given a two-year window to operate as a bank holding company. However, if Congress did not repeal Glass-Steagall, the company would be forced to split in order to conform to the law.
By the time Weill and Reed announced their megamerger, Glass-Steagall was already seen as unnecessary and outdated. As William Gruver writes in his article A Big Regulator for the Little Investor, “By 1999, however, the idea that risky investments and public deposits should never be offered by the same institution had become an anachronism of the New Deal.”2 Gruver is criticizing Glass-Steagall as legislation that was put in place during a different era and as a result of the government’s inability to accurately find the cause of the Crash of 1929, an opinion that is in no way unique. In 1999, The Economist published an article titled The Wall Falls which asserts Glass-Steagall was “implemented in the darkest days of the Great Depression, the act played to populist beliefs that banks’ securities activities caused the Wall Street crash of 1929 and the economic misery that follow in its wake.”7 Each of these opinions reflects a larger issue in United States financial regulation. Sometimes federal investigations correctly identify a problem and sometimes they do not, but they always pass new legislation. In the eyes of Gruver and The Economist, the Pecora Commission did not correctly identify the underlying issue, but because they had spent taxpayer money, they wrote new legislation anyway in the form of Glass-Steagall.
By the fall of 1999 Citigroup had already been operating as a universal bank for a year, but Congress had failed to repeal Glass-Steagall. If Weill and Reed could not successfully lobby for financial reform, all of their efforts to create Citigroup would amount to nothing. Each of the co-CEOs understood the long road ahead of them. Together, they decided that Weill would take the lead in lobbying efforts for new legislation. However, as is typical in Congress, there were more hurdles than Weill had anticipated. Weill needed to persuade President Clinton and both parties of Congress. Weill realized that he could leverage a change in the Community Reinvestment Act, which required banks to increase lending in low-income neighborhoods, to ensure new legislation that would guarantee the longevity of Citigroup. The chair of the committee for Weill’s bill was Phil Gramm, a Republican senator from Texas who was adamantly against any restrictions on banks and the Community Reinvestment Act. Gramm was already on Weill’s side, but he needed to find a way to gain Democratic support. To do this he called on Jesse Jackson, an old friend who had recruited Weill to be a cochairman of his project to increase diversity at the big banks. Weill had his own share of difficulties breaking into the discriminatory finance industry as a Jewish man from humble beginnings, so he continued to take part in more of Jackson’s initiatives. When Weill asked his friend for help, Jackson scheduled a private meeting with Phil Gramm where he agreed that to support a less restrictive version of the Community Reinvestment Act.4
Through Weill and Jackson’s efforts, all of the pieces were beginning to fall into place. He had successfully overcome his challenges with the Republicans and had a plan to convince the Democrats with Jackson on his side. His final challenge was to convince President Clinton to sign the bill into law if it got past congress. The committee had a marathon session on October 21st, 1999 to negotiate the bill, but Gramm could not persuade the Democrats who were standing behind President Clinton. In a fit of rage, Phil Gramm stormed out of the meeting room and screamed at Citigroup’s senior lobbyist, Robert Levy, to get Weill on the phone with Clinton or, he threatened, the bill would be dead in one hour. Weill called Clinton in the middle of the night and relayed a message he had received from Gramm who said, “If my wife were running for Senate in New York, I would not veto this bill.”4 Gramm’s message rang clear. If this bill did not go through, Hillary Clinton would not have the support she needed from Wall Street to win the Senate race in New York. The committee emerged in the middle of the night with a bipartisan bill, and on November 12th, 1999, President Clinton signed Financial Services Modernization Act of 1999, now commonly referred to as the Gramm-Leach-Bliley Act (GLBA), into law. Weill and Reed’s efforts to change the American financial landscape had finally been realized.
Megamergers and the Subprime Mortgage Crisis
After Glass-Steagall was repealed, banks could sell securities and accept public deposits for the first time since 1933. Mergers and acquisitions created massive banks like JPMorgan Chase and every large bank began leveraging their balance sheets by creating public mortgage debt and simultaneously underwriting collateralized debt obligations (CDOs). Insurance companies like AIG began allowing banks to hedge their exposure to CDOs by issuing credit default swaps (CDSs). However, with Glass-Steagall gone, the market began to look as it had during The Roaring Twenties. The Dow Jones fell when the tech bubble burst in 2000, but high public investment in residential real estate allowed it to grow by 20% between the signing of GLBA and the subprime mortgage crisis.
On October 9th, 2007 the Dow Jones reached an all-time high of 14,164.53 that would remain the peak until 2013. Slightly less than one year later on September 29th, 2008, the Dow fell 777 points in the wake of the bankruptcy of Lehmann Brothers and Washington Mutual, the largest single day point drop in history. Leading up to September 13th, 2008, the day Tim Geithner called a meeting at the New York Federal Reserve to discuss the future of Lehmann, investors began to realize Lehmann’s financial instability. Lehmann’s stock was falling and it quickly became clear they were not going to get the same deal Bear Stearns received in May. William Gruver published an article the same day that said “when lawmakers permitted commercial banks and investment banks to merge into new behemoths like Citigroup, they did not follow through…Congress allowed the government’s financial regulatory structure to remain stuck in the 1930s.”2 Gruver is blaming regulators for creating an environment where leverage and high public investment were possible without providing necessary oversight. He later writes, “Carter Glass saved American capitalism through prudent regulation that prevented excesses without stifling new innovation.”2 This opinion furthers his argument and calls for reasonable regulation that is considers the complex financial instruments that regulators from the Carter Glass era had never seen. Ironically, two and a half years later, Weill was quoted in a CNBC interview saying, “What we should probably do is go and split up investment banking from banking… have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail.”8 Both Gruver and Weill blame faulty regulation and oversight for the high level of risk taken on by banks before the subprime mortgage crisis, but both fail to mention the failure of self-regulation and individual executive responsibility.
Could Virtue Ethics Have Saved Us From Crisis?
It is easy for Wall Street executives to blame a lack of regulation for the cause of the financial crisis. Congress repealed Glass-Steagall and allowed too-big-to-fail banks to emerge through unrestricted subprime lending. From 2002 to 2007, the market seemed like it could continue growing forever. However, the Federal Reserve did not do its job, which is, as former Fed Chairman William Martin, Jr. said, “to take away the punch bowl just as the party gets going”. Should Greenspan have raised rates in 2006, considering a nearly flat yield curve and a booming economy? Maybe, but it is unfair to blame Bernanke for the behavior of executives like Richard Fuld of Lehmann Brothers, Joe Cassano of AIG, and Angelo Mozilo of Countrywide Financial. These executives all knew how much risk they were taking on by betting on subprime mortgages. The reality is that there was a multitude of factors that resulted in the subprime mortgage crisis, and part of the story was deregulation, but that is far from the whole story.
The subprime mortgage crisis could have been avoided if government officials and Wall Street managers had used virtue ethics. Virtue ethics is defined by the ethics and integrity of one’s community. Everyone is a member of multiple communities that include professional associations, religious organizations and families. When practicing virtue ethics, the user must consider the community that would hold them to the highest ethical standard. Treviño and Nelson write in Managing Business Ethics, “A shortcut approach…is known as “the disclosure rule”…[it] asks “How would you feel if your behavior appeared on _____?”…The Wall Street Journal, your hometown newspaper, your family.”6 Considering the disclosure rule, there are countless opportunities in the story leading up to the financial crisis. Would Robert Rubin joke about Weill buying the government if CNN was listening? If Phil Gramm’s voters knew he was restricting bank operations as a compromise for repealing Glass-Steagall, would Jackson still have been able to convince him? Would Clinton cave in to Gramm’s subtle threats in a televised hearing? Each of these events is against the principles of virtue ethics. All of these people would have made different decisions if they considered the community outside the one where the events took place. These situations clearly show the lack of virtue ethics in government, asking similar questions about Wall Street makes the problems even more evident. For example, would Richard Fuld’s NYU M.B.A. peers agree with his decision to lever a $600 billion bank as high as 31 times debt-to-equity? Would Joe Cassano have sold $441 billion in CDSs to his best friends? If Angelo Mozilo’s parents asked him for a subprime mortgage, would he still say it was a good deal like his bankers did to so many unsuspecting Americans? The answer to all of these questions is clear: if anyone in this brief story of a financial crisis had considered virtue ethics properly and at the right time, we may have avoided the recession that destabilized America from 2007 to 2009.
Virtue ethics could have saved us from crisis. However, in every example of virtue ethics violations leading to the financial crisis, the disclosure rule referred to a community outside the one where the decision in question was made. While there is a set of ethics for government officials, there is no rigorous code of ethics for Wall Street managers. In Rakesh Khurana and Nitin Nohria’s journal It’s Time to Make Management a True Profession, they argue for a code of conduct for managers, similar to the Hippocratic oath for doctors. They write, “[codes] can trigger strong positive emotions such as pride…and equally strong negative emotions such as guilt or shame…the influence of such emotions can be significant.”3. They then proceed to provide “A Hippocratic Oath for Managers”, that, while too long to include here, would have persuaded all of the major actors involved in the financial crisis to behave differently. Glass-Steagall would likely have never been repealed, at least not entirely, lenders would have behaved responsibly, and the government would have provided the necessary oversight to keep the events of 2007 and 2008 from ever occurring.
- Brooker, Katrina. “Citi’s Creator, Alone With His Regrets.” The New York Times. The New York Times, 02 Jan. 2010. Web. 29 Mar. 2015.
- Gruver, William R. “A Big Regulator for the Little Investor.” The New York Times. The New York Times, 12 Sept. 2008. Web. 29 Mar. 2015.
- Khurana, Rakesh, and Nitin Nohria. “It’s Time to Make Management a True Profession.” Harvard Business Review (2008): n. pag. Print.
- Langley, Monica. Tearing down the Walls: How Sandy Weill Fought His Way to the Top of the Financial World– and Then Nearly Lost It All. New York: Simon & Schuster, 2003. Print.
- Stone, Amey, and Mike Brewster. King of Capital: Sandy Weill and the Making of Citigroup. New York: Wiley, 2002. Print.
- Treviño, Linda Klebe., and Katherine A. Nelson. “Deciding What’s Right: A Prescriptive Approach.” Managing Business Ethics: Straight Talk about How to Do It Right. New York: J. Wiley & Sons, 1995. N. pag. Print.
- “The Wall Falls.” The Economist. The Economist Newspaper, 30 Oct. 1999. Web. 29 Mar. 2015.
- “Wall Street Legend Sandy Weill: Break Up the Big Banks.” CNBC. N.p., 25 July 2012. Web. 29 Mar. 2015.