Did the Gramm-Leach-Bliley Act open up the risky market of credit-default-swaps?
Striving to be an informed citizen, I am researching the financial meltdown. I’m going to give you my understanding of how the GLB act and the credit-default-swap contributed to the crisis, and I’d like you to tell me if it is accurate and, if not, critique it.
Here’s the way I see it. Before GLB and under Glass-Steagall, before the repeal of Glass-Steagall, your mortgage was between two entities, you and your bank. If you defaulted, your bank took the hit. GLB connected your bank to Wall Street and allowed it to sell your mortgage to investors and financial institutions. These investors in turn sold the mortgages to more investors, often in complicated bundles and using exotic financial tools like the credit-default-swap, something I still don’t understand. After passing through layers of investors, many of whom were respectable banks like Morgan Stanley, Lehman Brothers, etc. (since these institutions were “responsible,” rating agencies gave these mortgages AAA safety ratings), bundles of subprime mortgages were being marketed as sound investments. The entire chain became overleveraged, and once you, the buyer, couldn’t pay your mortgage, the defaults had a cascading effect throughout the entire financial system. Whereas before GLB, the default would have been limited to you and your bank.
So that’s my understanding of the whole matter, as simple as I can put it. My question is: is it true that before GLB, banks could not resell your mortgage to Wall St. using tools like a credit default swap? Did the Glass-Stegall regulation, repealed by GLB, prevent them from playing both the deposit/loan side of the game and the investing side?
Please don’t turn this discussion into a blame game. Provide an answer that is related to the GLB act. Thanks!
mishkin, your answer was very informative, I appreciate it. My question remains though: were the banks prohibited, before GLB, from reselling their mortgages to investors? You mentioned Freddie and Fannie. Before GLB, did banks sell their mortgages to them and did Fannie and Freddie in turn sell them to investors and investment companies? Or were those banks and/or freddie and fannie prohibited from that doing that due to the separations of depository institutions and investment banking of the Glass Steagall Act?