Invest Like the Best with Patrick O'Shaughnessy
· Alan Waxman
[00:00:00] S1: There's a lot going on in the news. What I'd say is what you're reading in the news today are the symptoms, but not really the root cause. And as an investor, when we try to figure out what's happening in the current moment, which is – we're definitely in a moment right now. We do two things. First of all, we think about it from the standpoint of, how did this get here? What's the history of it? How did we get here, to really figure out the current moment and also determine where we're going? So I think we'll talk a little bit about the history of how we got here. And then the second thing, and you hit this, is looking at everything through systems. And we think about systems. We think about the incentive system, guardrails, and market structure. First of all, I'm not an economic historian. What I'm going to do is tell the story of history as it relates to the current moment. I think you've got to go back to pre-1929 crash. And when you think about the American financial system, it was basically like the Wild Wild West. It was pretty unregulated. And there were many causes of the 1929 crash. There was poor monetary policy, agricultural recession, margin lending. But one of the main parts that caused it is you had this idea of commercial banks. So think about commercial banks. So individuals go put their money into a bank as deposits. Commercial banks basically were in the same house as principal risk-taking activities, so the investment banks. So these were all part of the same thing. As you can imagine, when that happens, there's a massive conflict of interest. So really, the story starts for the current moment, starts in 1933. So this is after the 1929 crash. This is after 9,000 banks fail. Think about that. 9,000 banks fail. 1933, Glass-Steagall, probably one of the most important regulations that took place, and also the establishment of the FDIC, which ensured deposits for individuals at banks up to a certain limit. And Glass-Steagall basically said, these commercial banks, which were deposit-taking institutions from individuals, just got really burned in the 1929 crash, basically become separated from the investment banks, who at the time – think about principal risk-taking. So think about in today's parlance, private capital, investment banks. Those got separated. And that's kind of the first system.
· Alan Waxman, Patrick O'Shaughnessy
When I think about the first system that explains where we got to the current moment, let's just call it System 1, it's from 1933 to 1999. And when you look at post-World War II with the separation of commercial banks and investment banks, you basically have, after post-World War II, 50 years, a pretty stable system other than the S&L crisis in the 1980s, which was a big event. It was a pretty good system. But the system wasn't optimized for economic growth. Because you only had a pretty conservative – with a lot of guardrails – commercial bank providing finance. [00:00:00] S0: Yeah, it's just low risk appetite. [00:00:00] S1: So it's a low risk appetite. And again, because one, the fixed income market hadn't developed, which is part of the story here. But also, because investment banks, they were more in the moving business than the storage business. They were pricing securities to basically sell to other people. They weren't pricing it to hold for their own balance sheet. Now, that changed as we get into the 80s. But again, broadly speaking, for this first system from 1933 to 1999, it was working, it just wasn't optimized. [00:00:00] S0: The lesson from this is with really good guardrails, you can get long stability.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: The lesson from this is with really good guardrails, you can get long stability. [00:00:00] S1: You can get long stability. But again, you also have to think about job creation and economic growth. And I think if there's one criticism of the system, which is why the Glass-Steagall Act got repealed in 1999,and I can talk about why it got repealed, what sort of steps led up to that, is that it wasn't optimized. And as you go to a more globalized world and you're competing with, say, European banks, you become less and less competitive. So in a non-globalized world, it was probably OK. But as we got to a more globalized world, it wasn't really optimized to maximize economic growth for the country. [00:00:00] S0: OK, so we get to the mid-late 90s. What happens? In addition to new competitive pressures, walk us through that transition into what becomes System 2.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: OK, so we get to the mid-late 90s. What happens? In addition to new competitive pressures, walk us through that transition into what becomes System 2. [00:00:00] S1: So at the time, again, we've got separation of investment banks and commercial banks. All of a sudden, European banks who weren't part of the same Glass-Steagall regulation, they started to unite with each other. So commercial banks and investment banks in Europe started to come together, which started to put the American commercial banks at a big disadvantage. And not only were they coming together, but they were also taking on more leverage than what was allowed with the guardrails of American commercial banks. So as a result of that, as you can imagine, all the commercial banks – and many market participants were saying, "Hey, we can't really compete against some of these European guys." In 1998, Deutsche Bank bought Bankers Trust, and that was definitely a moment. Citibank announced that it was merging with Travelers, which at the time when they announced the merger, it actually wasn't allowed under Glass-Steagall, under the current regulation. So that's what sort of led up to it. So I think it's a couple of things – globalization. Now, all of a sudden, you're competing against Europeans who have – think about it, they can provide services and balance sheet and capital. You're at a pretty big disadvantage. So the System 1 started to get less competitive as we moved into a globalized world. And that led to 1999 when Glass-Steagall was repealed.
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: So at the time, again, we've got separation of investment banks and commercial banks. All of a sudden, European banks who weren't part of the same Glass-Steagall regulation, they started to unite with each other. So commercial banks and investment banks in Europe started to come together, which started to put the American commercial banks at a big disadvantage. And not only were they coming together, but they were also taking on more leverage than what was allowed with the guardrails of American commercial banks. So as a result of that, as you can imagine, all the commercial banks – and many market participants were saying, "Hey, we can't really compete against some of these European guys." In 1998, Deutsche Bank bought Bankers Trust, and that was definitely a moment. Citibank announced that it was merging with Travelers, which at the time when they announced the merger, it actually wasn't allowed under Glass-Steagall, under the current regulation. So that's what sort of led up to it. So I think it's a couple of things – globalization. Now, all of a sudden, you're competing against Europeans who have – think about it, they can provide services and balance sheet and capital. You're at a pretty big disadvantage. So the System 1 started to get less competitive as we moved into a globalized world. And that led to 1999 when Glass-Steagall was repealed. [00:00:00] S0: So what comes in its place? It's basically just deregulation.
· Alan Waxman
[00:00:00] S1: It's deregulation. And literally after that, you saw a wave of mergers of combining commercial banks and investment banks. So you saw JPMorgan Chase. There's many others, but with everything, there's knock-on effects. So that came together, created these powerhouses that could compete with what was going on in Europe. But now you had all these investment banks that weren't commercial banks. So think about my old firm, Goldman Sachs, and many others. Now they had to start competing. They didn't have access to cheap capital because they weren't a commercial bank. They had to compete with combined investment banks and commercial banks because a lot of the commercial banks, both in Europe and the US, they started to use their balance sheet to get investment banking business. So what did all the investment banks do? They started to leverage up. And that's one of the other stories leading into the system, the development of the fixed income market. So think about corporate bonds, mortgage-backed securities, asset-backed securities, sovereign debt. That went, literally from the 80s to the 90s, went from $7 trillion to $14 trillion. These are all financing mechanisms that could finance the investment banks to basically allow them to leverage up. And that's what started to happen. So literally from the time of Glass-Steagall being repealed, you had commercial banks uniting with investment banks, both in US and Europe. You had leverage going up. Leverage went up for commercial banks, in some cases 20, 30 times leverage. And all the investment banks were operating with leverage because they had to take on leverage to be able to compete with the combined commercial banks, investment banks. And then nine years later, what happened? You had the GFC. Now, just to be clear, there's a lot of polarizing debate of how much attribution the repeal of Glass-Steagall had on the GFC.