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Aside from signaling the end of an era for Lehman Brothers and Merrill Lynch, this weekend's activity definitively drew a line at the end of another historical era: the Age of Glass-Steagall.
The Glass-Steagall Act is the Depression-era law that separated commercial and investment banking. It was functionally repealed in 1998, when Travelers (the parent company of Salomon Smith Barney) acquired Citicorp. And it was officially repealed in 1999. But recent events on Wall Street—the failure or sale of three of the five largest independent investment banks—have effectively turned back the clock to the 1920s, when investment banks and commercial banks cohabited under the same corporate umbrella.
Glass-Steagall was one of the many necessary measures taken by Franklin Delano Roosevelt and the Democratic Congress to deal with the Great Depression. Crudely speaking, in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble popped in 1929, exposure to Wall Street helped drag down the commercial banks. In the absence of deposit insurance and other backstops, the results were devastating. Wall Street's failure helped destroy Main Street.
The policy response was to erect a wall between investment banking and commercial banking. It outlasted the Berlin Wall by a few decades. In the 1990s, as another bull market took hold, momentum built to overturn Glass-Steagall. Commercial banks were eager to get into high-margin businesses like underwriting hot tech stocks. Brokerage firms saw commercial banks, with their massive customer bases, as great distribution channels for stocks, mutual funds, and other financial products that they created. Generally speaking, the investment banks were the aggressors. In April 1998, Sandy Weill's Travelers, which owned Salomon Smith Barney, merged with Citicorp. The following year, Congress passed and President Clinton signed the Financial Services Modernization Act of 1999, known as the Gramm-Leach-Bliley Act. This law effectively deleted the prohibition on commercial banks owning investment banks and vice versa.
Since then, the two industries have come together to a degree. And generally, the investment banks, which weren't subject to regulation by the Federal Reserve and didn't have to adhere to stodgy capital requirements, have been the alpha dogs. In 2000, the investment banking firm J.P. Morgan bought commercial bank Chase. Commercial banks like Bank of America and Wachovia have tried to build up their own investment-banking operations, but they haven't had much success in eating into the core franchises of the five big independent investment banks: Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns.
Up until the summer of 2007, the debt-powered independent broker-dealers who minted money with stock brokering, proprietary trading, and advising on mergers and acquisitions looked set to leave boring commercial banks in their dust. But 2008 has been another story. In March, faltering Bear Stearns was swallowed by JPMorgan Chase. Lehman has gone bankrupt. Now the investment bank with the largest brokerage force, Merrill Lynch, is being bought by Bank of America. The historic democratizer of stock ownership will henceforth be owned by the historic democratizer of credit.
And then there were two: Goldman Sachs (Wall Street's last great partnership until it went public a few years ago) and Morgan Stanley (a portion of the House of Morgan that was set up as an independent entity after Glass-Steagall). But there are now doubts as to whether even these titans can survive as independents. The reason: In the wake of the global credit crunch, the investments banks' 2006 source of relative strength has become a major 2008 weakness. Investment banks are creatures of the global capital markets. They can borrow seemingly unlimited amounts of funds from investors around the world and deploy them as they see fit. By contrast, fuddy-duddy commercial banks, which borrowed money from their depositors, from the Federal Reserve, and from outfits like the Federal Home Loan Banks, accepted greater restrictions on the amount of leverage they could use. Between 2001 and 2006, that meant investment banks were better businesses to own than commercial banks. In today's climate, that means highly leveraged independent investment banks now face continuing struggles to finance their operations while less-leveraged commercial banks enjoy relatively stable sources of capital. The alpha dogs have essentially turned tail and are now scared of their own shadows. After today's press conference announcing the sale of once-proud Merrill Lynch to Bank of America, Merrill CEO John Thain, one of the biggest shots on Wall Street in the last decade, practically scurried—scurried!—away as a reporter called out to bid him farewell and wish him luck.