The Long History of the 2008 Financial Mess

Heather Whipps

Date: 19 September 2008 Time: 10:09 AM ET

A history of finance may once have sounded about as exciting as, say, a day spent rolling pennies, but events of late have made this a rather exciting topic.

Observed this week: Lehman Brothers issued the largest bankruptcy protection filing in history. The iconic Merrill Lynch, at least in name, is no more. AIG insurance just got a colossal $85 billion bailout from the U.S. government. Wall Street investors world-wide are knocking their knees and biting their nails. The scenario was so unprecedented that the White House and U.S. Treasury Secretary Henry Paulson are scrambling to reassure markets with promises of even more money in what is expected to be the biggest bailout since the Great Depression.

So where did this mess come from, anyway?

The latest credit crisis, the one that sent Wall Street into the latest downward spiral, was about a year in the making, economists say. But more fundamentally, decades' worth of policies have led to this moment, changing the basics of banking.

Until recently, there was a clear dividing line between commercial banks and investment banks, said George Morgan, professor of banking at Virginia Tech's Pamplin College of Business, but that line became blurry in recent years and the blurring has been central to the downfall of the big investment giants.

"What will happen in the next crisis when there will no longer be a distinction and separation? Who will be the last ones standing?" Morgan asked, echoing the fears held by many beleaguered Wall Street execs.

But that's jumping ahead. Let's back up further.

Cows as currency?

Which was invented first — money, or the banks that kept it safe? Once you recall the era of cows-as-currency, the answer is, strangely, banks.

The world's first banking system sprung up in Mesopotamia more than 3,000 years ago, in the form of storehouses used to keep large reserves of grain and animals. These edible deposits were logged for withdrawal later, while those controlling the books made loans and charged interest, much like today.

The first modern-style money banks appeared in medieval Italy, where prominent families such as the Medici of Florence set up loan and deposit services to get around the problem of multiple-currency use along thriving intercontinental trade routes. The Italian method was improved upon by the Dutch and British banking systems which, in turn, were modified when carried over into the new American colonies.

After some growing pains through a period of minimal regulation, legislation during the Civil War brought the entire U.S. banking system under federal supervision.

Banks get depressed

Federal banking didn't necessarily mean smooth sailing, however. There were credit crises late in the 19th century and in 1907, well before the great stock market crash of 1929 which significantly changed the face of American banking.

The Great Crash, eerily similar to the recent events on Wall Street, was caused — in short — by too many people having too many high-risk loans, which were doled out on the assumption that the stock market would continue to rise unabated.

It didn't.

When the bubble popped in October of 1929, there was a run on the nation's banks. People who'd lost almost all of their stock holdings tried to withdraw money from their bank accounts but found nothing, since banks had engaged in risky investments themselves with the depositors' cash, only to lose it all.

With banks basically ceasing to function in 1933, newly-elected President Franklin Roosevelt put a few measures in place to prevent the same thing from happening again:

The Glass-Steagall Act, which forbid regular commercial banks (think Bank of America, pre-Merrill) from offering the services of investment and insurance banks (think AIG).
The Federal Deposit Insurance Corporation (FDIC), which promised to reimburse customers should a bank go out of business.

Combined with the "lender of last resort" role of the Federal Reserve — the central bank of the United States that was created in 1913 — the policies slowly brought confidence in the banking system back up and helped end the Great Depression.

Lehman and Merrill gamble big, and lose

Fast-forward to 1999, when the portions of the Glass-Steagall Act that banned mixed banking were repealed due to pressure from commercial banks wanting to re-enter the lucrative stocks biz.

What that meant was the investment banks — think of them as bankers for big players such as governments and corporations — could now own regular commercial banks (and, less often, vice-versa), and engage in each other's activities, which they began to do to a limited degree. With a surging market, the independent investment banks were poised to make all kinds of money.

Propelling growth for the investment banks was the housing market, which, a few years ago, seemed unstoppable. Companies such as Merrill Lynch and Lehman Brothers offered mortgages left and right, many to people with poor credit records, gambling that housing prices would continue to rise.

They didn't.

With home foreclosures occurring at an alarming rate in the past year, the investment banks didn't have a leg to stand on. On Sept. 15, Lehman filed for Chapter 11 bankruptcy. The same day, a press conference announced the $50 billion sale of investment giant Merrill Lynch to Bank of America.

In some ways, the Glass-Steagall repeal that allowed commercial and investment banks to mingle has saved Wall Street from further ruin, Morgan said.

"Prior to the repeal of parts of Glass-Steagall in 1999, a commercial bank like Bank of America would not have been permitted to buy a company like Merrill Lynch," Morgan told LiveScience, adding that "Bank of America and Barclays are able to keep those firms from complete collapse because the banks were not so risky and were less engaged in the practices of the large independent investment banks that have brought them down."

With the mixing of services now the new norm — as it was prior to the 1929 crash — today's winners (commercial banks) and losers (investment banks) have to be careful not to repeat mistakes made in the last year, said Morgan.

"Let us hope that as the commercial bankers come out on top this time, they will be able to suffuse their new family members with the kind of traditional banking practices that will indeed limit the size of the trauma next time," he said.

By traditional, we doubt he means simple notebooks scribbled with tallies of grain and heads of cattle, but even that might be comforting at this point.