Glass-Steagall and the almost panic of 1970

Recently, a group of U.S. senators led by John McCain, R-Ariz., and Elizabeth Warren, D-Mass., introduced a bill to reinstate the Glass-Steagall Act separating commercial and investment banking.

The principal argument for this bill appears grounded in the fact that there were no financial crises in the United States while Glass-Steagall was law of the land from 1933 to 1999. The only financial crisis that our country has experienced since the Depression was in 2008, after Glass-Steagall was repealed.

Ergo, bring back Glass-Steagall.

Opponents of the new Glass-Steagall Act argue that it wouldn't have prevented the 2008 financial crisis.

The investment banks that ran into trouble, such as The Bear Stearns Cos. Inc., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. Inc., weren't commercial banks. Glass-Steagall wouldn't have prevented their problems.

The commercial banks that ran into trouble — Bank of America Corp., Wachovia Corp. and Washington Mutual Inc. — had problems with bad mortgages, which is a commercial, not an investment banking, problem. Again, Glass-Steagall would have been irrelevant.

And some of the biggest troublemakers — American International Group Inc., Fannie Mae and Freddie Mac — were outside the scope of Glass-Steagall altogether.

Citigroup Inc.'s problems, meanwhile, arguably occurred on both sides of the line. But it didn't become an issue until most of the others had run aground and the larger financial crisis was at hand.

I am not a financial historian, but it seems a critical piece of financial history has been absent from the debate on Glass-Steagall. No one appears to take account of the forgotten “almost panic of 1970,” which was narrowly avoided, no thanks to Glass-Steagall but to mere luck.

LONG AGO AND FAR AWAY

It is easy to understand why 1970 is overlooked. There was no actual stock market crash or panic, and it happened long ago.

Unless you worked on Wall Street at the time, the events and protagonists are likely unfamiliar. Most don't remember old-line brokers with names such as Cogan Berlind Weill & Levitt, Goodbody & Co., Hayden Stone & Co., Ira Haupt & Co. and McDonnell & Co.

But the almost panic of 1970 deserves special attention when it comes to Glass-Steagall because it nearly happened with the old law in full force, and thus Glass-Steagall wasn't the prophylactic that saved us.

So what happened? An out-of-print book by financial author Charles Ellis, “The Second Crash” (Ballantine Books, 1973), tells the story in vivid detail.

In 1970, many leading brokerage firms were overleveraged (debt-equity ratios of 20-to-1 were allowed back then). They borrowed to make markets in stocks.

Although the stock market indexes were up for the year, they spent most of 1970 down substantially — at one point, more than 20%. As the stock market swooned, the value of the brokers' assets declined, eating up their equity and threatening failure.

Many also had serious issues and lost money with failed trades, owing to the increase in stock market volume in the late 1960s and lack of appropriate technology to handle it.

The commercial banks were at risk, too.

As Mr. Ellis noted in his book, they were “much more deeply involved in the stock market than most observers had realized.”

ACTIVE LENDERS

Glass-Steagall didn't prevent the banks from being active lenders to the brokers or from accepting stock as collateral on major corporate transactions.

A number of brokerage firms did fail. But it was the potential failure of one large firm, Hayden Stone, that threatened a domino effect of ruin for other firms and an overall crash.

Sound eerily like 2008?

A plan was hashed out in the late summer for Hayden Stone to merge with CBWL. The plan required the approval of Hayden Stone's creditors.

One group of creditors, led by Oklahoma City businessman Jack Golsen, held out. Wall Street leaders tried for days to convince him to go along, but to no avail.

The Oklahoma City group legitimately had the right to hold Hayden Stone in default and not agree to subordinate their rights to allow the CBWL merger to occur. They also had a grievance that Hayden Stone had misrepresented its financial position at the time the loans were made.

It is hard to be sympathetic with a debtor in that situation.

The deadline for action was, of all dates, Sept. 11, before the market opened.

“Unless Golsen agreed to go along with the refinancing plan before trading was opened, Hayden Stone would … fail. Its failure would bring havoc and panic to Wall Street,” and result in “a crash more swift and cruel than in "29,” Mr. Ellis wrote.

It “would make 1929 look like a "technical correction,'” he wrote.

Shortly before the market opened Sept. 11, Mr. Golsen and the Oklahoma City group agreed to the Hayden Stone bailout, and disaster was averted.

A CALL FROM A FRIEND

According to Mr. Golsen, a call from Alan “Ace” Greenberg, an old Oklahoma City high school friend and then former chairman of the executive committee of Bear Stearns, was what finally persuaded him to go along with the plan.

So the almost panic of 1970 was averted, not by Glass-Steagall, which was in full force, but by the lucky circumstance that Mr. Golsen and Mr. Greenberg were longtime friends, and Mr. Golsen accepted Mr. Greenberg's advice.

It can't be minimized what the alternative would have been if Mr. Golsen rejected the Hayden Stone bailout plan: “an enormous stock market crash, a financial panic and an international monetary crisis of a severity that has never been seen before,” Mr. Ellis wrote.

If enacted today, the “21st Century Glass-Steagall Act,” as it is called, would require the money center banks to spend the next five years undertaking the arduous task of splitting their investment and commercial-banking businesses. But the events of 1970 show that it isn't a real solution.

The problems in 1970, and again in 2008, stemmed from overleveraged institutions or firms with too much debt. The real armor against these financial crises is to place limits on the use of leverage and require banks to have sufficient capital cushions to absorb losses.

Regulations on capital levels have been moving into place, but these rules remain incomplete. Instead of re-enacting the artifice of Glass-Steagall, our political leaders would be better off directing efforts at completion of these capital rules.

There may be other laws and regulations worth enacting to prevent the next financial crisis, but Glass-Steagall isn't one of them.

Bruce M. Zessar is a managing director at investment management firm Advisory Research Inc.