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Beyond Glass-Steagall: Repairing Investment Banking

by: BruceMcF

Fri Nov 11, 2011 at 23:26:52 PM EST


We've heard some mutterings from the radical reactionary camp about breaking up TooBigTooFail (TBTF) banks. Over at Agent Orange, I reacted as followed:
Breaking up TBTF banks is a ...
... one-off intervention. Given a commitment at the same time to unfettered corporate bank activity, within a short time, the TBTF banks will be reconstituted.

What we need is to ban chartered corporations or subsidiaries of chartered corporations from engaging in investment banking activities.

Having the economic institutions that engage in creation and underwriting of corporate share and debentures for sales in publicly traded markets be publicly traded corporations themselves has been proven by the past thirty years to be a catastrophically flawed institution, and we should return to the days of investment banks as independent partnerships.

"Break up the TBTF banks" is just an empty slogan to fill up air, and help keep real solutions from being heard.

 
BruceMcF :: Beyond Glass-Steagall: Repairing Investment Banking
To go into this point in more depth ...


So, what's the problem?

There are a lot of benefits to a corporation in managing the process of underwriting stocks and bonds ("shares" and "corporate debentures"). The best benefit comes when you are able to manage the process to obtain better terms than you can get from an independent underwriter, focused on returns over years rather than months, and with their net worth undermined if they offer more generous underwriting terms than are justified.

Investment banking includes, among other services, underwriting of new issues of new corporate shares. They have to be able to hold shares. And a substantial institution that gave our major investment banks serious incentive to look out for the long haul was the fact that they were partnerships and then closely held corporations. They were not publicly traded corporations.

One of the principle checks on the tendency of underwriters to act like used car salesmen is the threat that they will be left holding a lot of stock that is worth less than the effort they put into underwriting the issue. But if the activity is done by somebody that does not care what the returns are for their own company five years down the track ... then they equally well do not care about the likely value in five years time of the stock they are underwriting.

As long as some people can be conned into buying it at an inflated price now, and the part of the stock issue that ends up being held by the investment bank is marked down as being worth that inflated price ... under the "next three months results" fixation of big publicly traded firms, that's good enough.

So publicly traded corporations engaging in investment banking ... is a problem. And, immersed as they are in the minute to minute micro-events of following the stock markets, even many "sophisticated investors" are unaware that there is a real alternative ~ since, after all, publicly traded corporations at one time turned to investment banking firms organized as partnerships for their underwriting services.


What's the history of the problem?

The Glass-Steagall Act protected our commercial banking system ~ which creates clears payments involving over 90% of our money supply ~ from getting caught up in the ever-present risk of losing their shirts in the collapse of some stock market bubble. But that meant that there were financial services that had to be provided on the other side of that wall, and that is the role that the investment banks provided.

And this brings us to this often unrecognized aspect of what has happened in the past forty years. Long before the TBTF banks used bailout money to buy up every investment bank in the country ...

... the investment banks switched from partnerships to closely held corporations and finally to publicly traded corporations.

In a traditional partnership, the partners are not protected by corporate limited liability. A partnership goes bankrupt because the senior partners are completely tapped out ~ not just savings, but house, car, working lawn mower ... the works.

In the post-WWII era, investment banks switched from traditional partnerships to corporations ~ but they were closely held corporations, rather than publicly traded, and so they were still not consumers of their own underwriting services. And even if the senior partners were no longer subject to losing their car if the firm went bankrupt ~ they were still subject to losing a massive chunk of their personal wealth and, perhaps just as importantly, could not inflate their wealth merely by impressing traders in the public stock markets.

Up through the Panic of 2008, they continued to be named like partnerships ~ Goldman Sachs, Merrill, Lynch, etc. ~ but starting in the 1970's, and picking up steam in the 1980's, they stopped being anything remotely like partnerships, in a wave of conversion to publicly traded corporations.

For instance, Merrill Lynch, Peirce, Fenner & Beane was a partnership formed in 1941 from a sequence of mergers of earlier smaller partnerships. In 1952, Merrill Lynch incorporated a holding company. But it continued to be a closely held corporation for another two decades, until it went public in 1971.

Merrill Lynch was followed by Bache & Company also going public in 1971 ~ a name you likely don't recognize, but a major building block of what became the Prudential Securities division of Prudential. One name you are more likely to recognize is Morgan Stanley, spun off from JP Morgan Chase in the 1930's as a result of Glass Steagall, which went public in 1986. Another is Goldman Sachs, which went public in 1999.

And many investment banks that were closely held corporations went public by the backdoor route of being bought up by a publicly traded corporation to build up its investment banking operations, in various merger and acquisitions waves among financial firm.

Now, "going public" does not always mean that the majority of the shares of the company were available to the general public. Goldman Sachs, for instance, has less than 1/5 of its shares publicly held. But it does mean that the wealth of the partners can be ramped up by short term stock market games. And that is a problem, as described above.


Something simple could be done about it.

One of the reasons for the longevity of Glass-Steagall was the simplicity of its underlying concept: Commercial Banks should not bet on Wall Street.

However, reconstituting Glass-Steagall would still leave us with the incestuous mess of investment banking service being provided by publicly trade corporations.

So what I argue is that we should add to the basic firewall represented by Glass-Steagall, and also forbid publicly traded corporations from engaging in investment banking activity or owning corporations that engage in investment banking activity.

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