US Policy Changes Vol.34 (Deregulation Vol.5 – Finance)

Here is an article: A Short History of Financial Deregulation in the United States (PDF; Jul 2009) | Matthew Sherman @ceprdc. Excerpt is on our own.

p1 Timeline of Key Events

p3-4 Background
… The experience of the Great Depression changed attitudes regarding the regulation of financial markets. Much of the current system is the result of changes put in place during the 1930s. In 1933, Congress fundamentally reformed banking with the Glass-Steagall Act. One provision of the act, named Regulation Q, placed limits on the interest rates banks could offer on deposits. The federal control removed the possibility of competitive rate wars and kept rates from soaring to exorbitant levels. Regulation Q also made a small exception for institutions specializing in mortgage lending, especially the savings and loan associations. Deposits at these firms received a quarter-percent advantage over other consumer deposits. This was explicitly designed to encourage a flow of money into housing. …

p5 Usury Laws
… In one instance, the state of South Dakota considered completely eliminating usury ceiling legislation in the state in order to attract the credit card operations of Citibank. The arrangement promised to create new jobs in the languishing economy of South Dakota while removing interest rate restrictions for the national commercial bank. …the process moved so quickly that the legislation was introduced and passed in one day. Overnight, South Dakota had become a regulatory haven for the credit card industry. …

p6 Removing Interest Rate Ceilings
After the Great Depression, banks were restricted in the rate of interest they could charge on all types of deposit accounts. Under Regulation Q of the Banking Act of 1933, savings accounts were capped at 5.25 percent, and time deposits were limited to between 5.75 and 7.75 percent, depending on maturity. Checking accounts were restricted to an interest rate of zero. The regulation was intended to prevent rate wars at exorbitant levels, but it made a special distinction for institutions specializing in mortgage lending. In order to encourage mortgage lending within local communities, thrift institutions were allowed to offer deposit accounts interest rates a quarter-percent higher than banks.
In the late 1970s, inflation caused market interest rates to rise above the limits mandated by Regulation Q. The restrictions may have been prudent when inflation was around 3 or 4 percent, but with inflation as high as 10 or 11 percent, investors began to seek out and find alternatives to traditional deposit accounts. In the commercial paper market, investors could lend directly to borrowers, bypassing banks as intermediaries. Brokerage firms and other financial institutions began to create money market mutual funds, which pooled small investors’ funds to purchase commercial paper. These money market funds operated without reserve requirements or restrictions on rates of return. They quickly became popular among small investors who shifted their money out of the regulated accounts in depositary institutions, which paid considerably lower interest rates. …
In a deregulated industry with poor supervision, the competition for deposits could spiral out of control. Some institutions attracted capital by offering large brokered deposits at above-market rates of return. Between the years of 1982 and 1985, deposits flowed in and the savings and loan industry underwent a rapid expansion. Investors saw potential for profit in the new investment powers granted to thrifts, and invested in condominiums and other commercial real estate. This meant that the investment portfolios of savings and loan associations shifted away from traditional home mortgage loans into higher-risk loans. From 1981 to 1986, the percent of savings and loan assets in home mortgage loans decreased from 78 percent to 56 percent. …

p8-9 Repealing Glass-Steagall
The Glass-Steagall Act of 1933 had established a firm separation between commerce and banking in the financial world. The bill prevented institutions that were “engaged principally” in banking activities from underwriting or dealing in securities of any kind, and vice versa. The Bank Holding Act of 1956 applied the same wall of separation to bank holding companies. After the experience of the Great Depression, the restrictions were intended to curb conflicts of interest and excessive risk-taking in the combination of banking and securities dealing. The structure of regulation and deposit insurance created under Glass-Steagall was very effective at minimizing bank failures throughout the mid-twentieth century.
Banks began lobbying Congress as early as the 1960s to loosen the restrictions of Glass-Steagall. With money market mutual funds and other complex financial instruments that blurred the lines between deposits and securities, the banking industry complained the Glass-Steagall restrictions were becoming obsolete. Banks wanted to enter the municipal bond market, among other securities markets, to remain competitive. Regulators in government were sympathetic to the industry’s concerns on some accounts. There was always a fear that financial deregulation in foreign countries would entice firms to take their capital abroad, and many in government shared the free market
ideology of deregulation. …
… The crumbling walls of Glass-Steagall received a final blow in 1999 when Congress passed the Financial Modernization Act, also known as the Gramm-Leach-Bliley Act. The act repealed all restrictions against the combination of banking, securities and insurance operations for financial institutions. The deregulation was a boon for national commercial banks, allowing for the formation of “mega-banks.” The Gramm-Leach-Bliley Act was the crowning achievement of decades and millions of dollars worth of lobbying efforts on behalf of the finance industry. The repeal of Glass-Steagall was a monumental piece of deregulation, but in many ways it ratified the status quo of the time.

p11 Hands-Off Regulation
… Ultimately, the fate of derivatives regulation was decided in Congress. Senator Phil Gramm, co-sponsor of the Gramm-Leach-Bliley Act, was one of several Congressman to push legislation that would deregulate the market. Gramm, in particular, wanted strict language to limit the direct oversight of the CFTC and SEC. A group of regulators, including the Chairs of the CFTC and SEC as well as Treasury Secretary Summers, reached a compromise with Gramm, and Congress moved quickly on the bill. The day after the Supreme Court effectively decided the fate of the 2000 Presidential election, the Commodity Futures Modernization Act of 2000 passed in Congress, attached as a rider to an 11,000-page spending bill. The legislation, passed without debate or review, exempted derivatives from regulation and made a special exemption for energy derivative trading that would gain notoriety as the “Enron loophole.” …

p12 Inflating the Bubble
… The mortgage market began to evolve as early as the 1980s. The Alternative Mortgage Transactions Parity Act of 1982 lifted restrictions against classes of mortgage loans with exotic features, such as adjustable-rate and interest-only mortgages. These loans carried low “teaser” rates during the first few years, after which interest rates reset at much higher levels. Consumers often did not understand the complex financial arrangements they entered into. Mortgage lenders also targeted lower-income, higher-risk borrowers with lower credit ratings through the use of alt-A and subprime loans. As these markets became more and more profitable, the mortgage industry aggressively pushed these non-conforming loans onto consumers. The Wall Street Journal reported the surprising fact that in 2006, 61 percent of subprime borrowers had credit scores high enough to qualify them for conventional mortgages. …
… There was enormous opportunity for profit with house prices at bubble-inflated prices, and the mortgage industry found creative ways to expand lending. Complex financial instruments were labeled as safe, while their underlying mortgage assets could be shoddy. All the while, government regulators took a hands-off approach to the activities of private actors. The system was highly vulnerable, and the inevitable collapse would have ramifications for the broader economy.

p13-14 Crisis
… Since the spring of 2008, financial markets have experienced turmoil not seen since the Great Depression. The prominent investment bank Bear Stearns was liquidated and sold to JP Morgan Chase at a fire-sale price. Lehman Brothers, another prominent major investment bank, declared bankruptcy. The other large investment banks either merged with investment banks or changed their status to become bank holding companies. Some of the largest financial firms, including Bank of America and Citigroup and AIG, received huge sums of capital assistance from the federal government. The system of non-bank institutions, sometimes referred to as the “shadow banking system,” experienced a massive withdrawal of funds in a sort of modern day bank run.
Regulators have responded to the current crisis with various emergency measures. The Federal Deposit Insurance Corporation (FDIC) oversaw the takeover of the failed bank IndyMac, the largest failure of an insured bank in history. The FDIC completed the sale of IndyMac in March of 2009. The FDIC also authorized the Temporary Liquidity Guarantee Program, providing a federal guarantee to newly issued unsecured debt as well as non-interest bearing transaction accounts. Congress also passed legislation that raised the level of deposit insurance at FDIC to $250,000.
The distress in the housing market also prompted changes in regulation for the government-sponsored entities of Fannie Mae and Freddie Mac. The Housing and Economic Recovery Act of 2008 guaranteed up to $300 billion in loans to subprime borrowers on the condition that lenders write down the loan principal to 90 percent of the current value of the home. The legislation also created the Federal Housing Finance Agency (FHFA) to oversee the government-sponsored enterprises. In September of 2008, with assistance from the Treasury, Fannie Mae and Freddie Mac were placed under the conservatorship of the FHFA. …