Wall Street

The Dow Jones Index had a greater than $1,000 trading range this past week (actually, just the last two days of the week!). That’s nearly a 10% move in the price. And the volume of the market was close to, and perhaps even was, at an all time high. But even with all that, the major indices ended up effectively where they had started the week. This was all in reaction to the bankruptcy of Lehman Brothers, the take over of Merrill Lynch by Bank of America, the (effective) take over of AIG by the Federal Goverment, and the announced plan for the Federal Government (that is, the U.S. taxpayer) to buy a very huge chunk of all the bad mortgages that are causing all these irresponsible financial companies to fail.

I’d like to reiterate and expand on something I said towards the end of my Fact Checking post on August 24th. Here’s the portion I want to reiterate:

I want to touch on the “$12 trillion” drop in home equity. I don’t know if the figure itself is accurate. But the number isn’t important. What’s important is that the email doesn’t mention the even larger rise in home equity that started back in the late 1990’s, and ballooned into the now infamous “housing bubble” after 2001. Why did that occur? This takes us back to 9/11. Prior to that day, we had already seen a huge bubble in the stock market that was still in the process of deflating and was only hurt more by 9/11. One of the decisions made at that time was to drastically and quickly reduce the Prime Lending Rate, eventually all the way down to 1%. And it stayed low for a long time. This artificially low rate for such a long time made money “cheap” to borrow. Combine that with people being afraid of the stock market after what happened with that bubble, and you have a perfect recipe for real estate prices to skyrocket. People and institutions wanted to put their money somewhere, but were hesitant to go back into the stock market. They saw how cheap it was to borrow money, and the rest is history that we’re still living through.

I learned two more pieces of information this week that I’d like to add to the above as additional reasons for why and how all of this mess was able to happen.

1. In 1999, President Clinton signed the Gramm-Leach-Bliley Act into law. This Act repealed an important part of the 1933 Glass-Steagall Act. The Glass-Steagall Act was passed during the depression in response to the partial collapse of the banking system in 1933. Among other things, it contained several reforms designed to help prevent a similar collapse from occurring again. The part of Glass-Steagall that the Gramm-Leach-Bliley Act repealed had to do with allowing different types of financial services to exist within the same company. The reason this prohibition was put in place is explained by this quote from a 1987 Congressional Research Service report:

In the nineteenth and early twentieth centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the “commercial” and “investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.

President Clinton did not veto the legislation, but it likely would not have mattered if he had because it had been passed by the senate by a 90 to 8 (with 1 ‘present’) vote and the house by a 362 to 57 (with 15 ‘present’) vote, margins which were significantly more than veto proof.

Incidentally, Phil Gramm, co-sponsor of the Gramm-Leach-Bliley Act, is now a Vice Chairman of (read lobbyist for) UBS, one of the world’s largest financial services company. UBS acquired the U.S. investment bank, Paine Webber, shortly after the Gramm-Leach-Bliley Act was enacted into law. Oh, and did I mention Mr. Gramm was the co-chair of Senator John McCain’s presidential campaign and one of Senator McCain’s senior economic advisers up until July 18th, 2008?

2. In July 2007, the SEC eliminated the Uptick Rule, which, similar to the Glass-Steagall Act, had been in place since the depression, specifically since 1938. I won’t go into the specifics of the rule itself, but its purpose was to help prevent what are called “Bear Raids” on a stock. A bear raid is trading strategy, some would call it a form of market manipulation, which can drive the price of a stock down very quickly. Although the uptick rule can’t necessarily prevent a bear raid, it does make it more difficult to accomplish, giving investors time to analyze the situation and the company itself time to counter the underlying cause (often a rumor, which may be true or false) of the bear raid.

The Uptick Rule does reduce, to a certain extent, the liquidity of the market, and its elimination doesn’t guarantee that a stock won’t plummet or the market won’t fall. However, many people argue that the loss in liquidity is a small price to pay for some defense against unscrupulous traders who seek to profit by short-selling a stock after starting a negative rumor concerning a company. In times such as we’re seeing in the market now, having the Uptick Rule in place may have helped cool some of the wild selling that we’ve seen in recent weeks and months. Last week, the Federal Reserve banned short-selling of approximately 800 stocks in the financial sector. It can be argued that the Fed may have been less likely to do this if the Uptick Rule had not been eliminated last year.

The repeal of Glass-Steagall may not have caused the real estate bubble and its subsequent bursting. And the elimination of the Uptick Rule may not have caused stock prices of major corporations to plummet. However, when combined with the economic conditions caused by the bursting of the stock market bubble and the 9/11 attacks, it is not unreasonable to think that the current crisis has been made worse because Gramm-Leach-Bliley was enacted and the Uptick Rule was eliminated. Only time, and the inevitable investigations, will tell. But in my opinion, some serious thought should be given to what impact and consequences these two events may have had.

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