In April of 1929, a yellow taxicab turned into the White House grounds carrying the great Wall Street speculator William Durant, Earl Sparling recounts (Sparling 1930). It was after 9:30 P.M. and the visitor had no appointment. After convincing the staff and the private secretary to President Hoover that the matter was urgent and, indeed, secret, the visitor was shown up to the second floor study. After a while the president appeared and listened to one of Wall Street’s greatest investors warn that the worst financial panic in the history of the republic impended. He cautioned the president that unless the Federal Reserve Board was forced to cease its attempts to curtail brokerage loans and security credit, a crisis was inevitable.

Of course, the Federal Reserve Board did not end its attempts to restrict the use of credit on Wall Street in the early part of 1929. Applying a gold standard model, the Fed felt compelled to continue to restrict credit. By May, the crisis of which Durant warned was already visible and would increase like a massive storm, reaching its peak in October and November of that year.

Durant, being a sensible man, sailed to Europe the month following his meeting with President Hoover for a lengthy holiday. The master of the market knew what would happen and even predicted it in his audience with the Great Engineer. Though ruined in the 1920s after he lost control of GM for good, this pauper managed to trade stocks and ride the last desperate wave of speculation on Wall Street before the final collapse into the Great Crash.

As noted, the stock market crash of 1929 occurred just four years after the U.S. Supreme Court ruled in the Benedict case that an incomplete transfer of assets, whether by pledge as collateral on a loan or outright sale, “imputes fraud conclusively.” This meant, among other things, that lenders like the Fed would be very reluctant to make loans to troubled banks. It would take four more years for Congress to create the FDIC to be the insurer of deposits and receiver for any federally insured bank that went bankrupt after the 1933 bank holiday.

When Roosevelt took office in March 1933 (the presidential inauguration date was later moved to January due to events in early 1933) bank holidays had been declared in most states. On inauguration morning, the head of the Detroit bank holding company that owned the banks serving Ford Motor Company (and many of its suppliers and employees) advised Roosevelt that it would file for receivership and close those banks. The holding company for the banks that similarly served GM filed for receivership within weeks thereafter.

The auto firms were America’s largest employers, with supply chains and facilities around the world. Within two weeks, 90 percent of the banking assets of Michigan were in receivership. Workers’ paychecks could not be cashed. Supplier payments could not be processed. The center of U.S. manufacturing was falling into a financial wastebasket because of the speculations of the Gilded Age and of the 1920s, and the failure of U.S. legislators (state and federal) to understand and resolve the effects of the downturn that began in the mid-1920s with the implosion of the Florida real estate market.

By 1933, automobile production was about 30 percent of the highs achieved in the late 1920s. Pre-Depression levels of auto sales would not be restored until 1949. To support the war effort, domestic automotive manufacturing was stopped from 1942–1945. When production resumed, trucks (built first for the war and later for personal use) replaced a lot of cars.

In the 1950s, Detroit’s Big Three controlled 93 percent of domestic automobile production (and 48 percent of worldwide production). In the early 1970s, domestic production peaked at levels nearly twice as high as those of 1929. Soon, however, imports took an ever-larger share of the market and U.S. affiliates of foreign manufacturers began to build new and more efficient assembly plants in the United States.

Before the Great Depression, Detroit was a place of industrial growth unlike any seen before or since. In 1910, some 10,000 automobiles were produced there. By the late 1920s, total automotive assembly exceeded 4 million. Putting $50 into the right Detroit business in 1910 netted an investor millions by 1929. From the 1920s through the 1950s, GM actually sent buses to scour America’s countryside for employees to fill its plants.

In 1933, the Ford family and GM each established new national banks in Detroit to serve their respective firms’ check-clearing needs and the other banking needs of the firms, their employees, dealers, and suppliers. It would take years to work out the colossal muddles left by the failure of Michigan’s major banking empires after the end of the Roaring Twenties.

Six months after FDR was inaugurated Michigan passed a law that precluded the operation of bank holding companies and their subsidiary banks in Michigan. That law prevented any corporation authorized to do business in Michigan from owning even one share of bank stock—a restriction that remained in place until the 1970s. General Motors, therefore, spun off its National Bank of Detroit subsidiary to shareholders. Through a 1996 acquisition it eventually became Chicago’s largest bank. After merging with Banc One, the combined bank became part of JPMorgan Chase Bank, N.A. The successor to the Fords’ bank, Comerica, is now headquartered in Texas.

If holders of GM stock in 1933 were corporations that did business in Michigan, of course, they also were forced to sell or spin off their bank shares. Since there were many suppliers and customers of the auto giants around the country, Michigan’s law was the primary source of the widely held belief that federal banking law required the separation of banking and commerce. After Michigan ended that prohibition, Sears, Roebuck & Co. entered the lending business and thereby proved that the principle of separation had never been part of federal law.

Between the stock market crash of 1929 and creation of the FDIC in 1933, there was no intervention similar to what Walter Bagehot saw the Bank of England doing in the crisis of May 1866. Although the 1913 law creating the Fed had been enacted to address the nation’s need for an agency that could provide a flexible currency to stabilize finance and end periodic financial crises, there was, as yet, no federal receivership for state banks. Failed state banks were placed into the hands of state receivers.

Thousands of writings on the Great Depression cast blame on everything from mistaken economic theories of the time to the untimely 1928 death of Benjamin Strong, the man who led the Federal Reserve Bank of New York throughout World War I. Consider, however, the enormous practical and legal hurdles the Fed faced if it had chosen to conduct operations like those performed on London’s Lombard Street in 1866. Agents of the Bank of England (BOE) had gone out searching for notes on which the bank could lend, which were secured only by a common law pledge and possession of the notes themselves. The pledged loans continued to be collected by the banks that pledged them to the BOE. The BOE, moreover, could attract any money it needed by offering to pay whatever interest rate was required to get sound banks to lend it the funds required to introduce liquidity into the system.

By the early 1930s the U.S. crisis that began in 1929 affected banks all over the nation, not just those located on Wall Street in New York. While there were district Federal Reserve banks in other cities, banks everywhere were in need of funds. A few affected banks were subject to national regulation, but most were regulated by the states and could employ the powers of state-appointed receivers in the event advances against collateral proved insufficient to prevent insolvency and failure. Not only did Bagehot’s dictum require that a bank of last resort take only good collateral as security for an advance, but Bagehot also said a punitive rate of interest should be charged so as to ensure that money hidden outside of the markets would return. In those days, because of the gold standard, central banks could not expand their balance sheets at will.

Could state-appointed receivers for a U.S. bank that became insolvent, despite the Fed’s best efforts to revive it, successfully challenge a pledge of loans that the bank continued to manage if the borrowing bank did not survive? If so, the Fed would become just another unsecured creditor of the insolvent bank—and one charging a punitive rate, no less. If you think of the views that applied to the Fed and all of government finance in the early twentieth century, the problems created by the powers of state receivers were immense.

As is the case today, it was not uncommon a century ago for state laws to give a preference favoring depositors over other bank creditors in insolvency. Indeed, a depositor preference rule is now part of U.S. law, and has been recommended for adoption as part of planned banking reform in Europe. The purpose is to prevent depositors’ rights (to which a receiver succeeds) from being diluted by the need to pay other creditors. In the United States, for example, after 1989 the depositors of a failed bank became senior to all other unsecured creditors.

Until 1933, if a state bank’s receiver challenged the Fed’s acceptance of pledged collateral as “conclusively” fraudulent (under the 1925 U.S. Supreme Court ruling), the case would be heard by the same elected state court judge that appointed the receiver. If the receiver’s argument was accepted, the court’s decision would shift much-needed federal money to depositors in the insolvent bank’s state and result in a loss to the Fed.

All told, speaking as a lender’s counsel prior to 1933, it would be hard in those circumstances to opine that a pledge of collateral was free of receivership risk. The problems of pledging raised in the Benedict opinion, moreover, had to be addressed state by state.

The Supreme Court opinion declaring that a common law pledge of collateral “imputes fraud conclusively” was just a few years old when the Great Crash occurred in 1929. Every finance lawyer debated it (and lawyers still do). Even when collateral is pledged correctly, a matter of considerable difficulty to assure when pledged notes are being gathered by agents around the nation, the pledging bank continues to act as lender and collects for the secured party. Only the 1978 U.S. Bankruptcy Code and adoption of the Uniform Fraudulent Transfer Act resolved that issue. Today the UFTA deems any creditor (or buyer) that advances funds without knowing that it is receiving a fraudulent transfer to be a secured creditor with a lien on the assets it receives for the amount of its advance.

In 1929, however, it could be argued forcefully that if the Fed allowed a bank leeway to collect pledged assets, a lien granted to the Fed for last resort advances was entirely fraudulent with respect to bank depositors. In short, the Fed could face a total loss on a loan to a troubled bank.

Ask yourself if you, as a Federal Reserve official in the 1930s, would be willing to advance what would likely be the equivalent of the Fed’s current $4 trillion portfolio in those circumstances. Moreover, even if the Fed could have overcome the legal hurdles to receiving proper collateral, where would it have gotten the funds? Until 2008, the Fed was denied the right to pay interest to draw reserves from banks that held excess funds.

This fact may explain why Eugene Meyer, the conservative chairman of the Fed during the early 1930s (who went on to buy the then-bankrupt Washington Post in 1933 and restored the paper to health) supported expansive use of fiscal policy (deficit spending) during the Depression, but not the use of the Fed to create a similar result. If there was a lot of government borrowing and spending, the Fed could provide liquidity by printing money to buy new government debt and fund those expenditures without the risk of losing money to a bank receiver.

Without an expansive fiscal policy, the Depression-era Fed was powerless, by law, to perform the lender of last resort duty for which it had been created in 1913.

Roosevelt voiced clear opposition to deficit spending and any federal guaranty of deposits during the presidential campaign of 1932. He had changed course entirely by the time of his inauguration, after spending months ignoring pleas from President Hoover to act jointly to stem the mounting banking crisis.

Early in 1932, FDR had been contacted by Jesse Jones at the Reconstruction Finance Corporation and so was fully aware of the scope of the banking crisis before the election. He waited for inauguration, however, before presenting new laws to Congress and, through his famous fireside chat regarding the bank holiday, assured a worried nation that only sound banks would reopen after the holiday and that consumer deposits would be insured.

To their credit, Presidents Bush and Obama chose a different path in 2008. They immediately and fully cooperated to resolve the financial crisis.

We will never know if the legal obstacles to secured lending persuaded FDR to change course and support an aggressive fiscal policy in 1933. The package of laws Congress adopted in the first few months of Roosevelt’s first term changed everything. Along with suspension of the gold standard, New Deal spending allowed the Fed to expand money by purchasing federal debt. In addition, new banking laws ended the legal risks associated with the Fed accepting a pledge of collateral from insured banks.

The Fed could safely make advances to troubled banks before or after they were in receivership, because along with guaranteeing deposits, the 1933 laws made the Federal Deposit Insurance Corporation—an agency of the federal government—the sole receiver for any insolvent insured bank. As a result, any Fed decision to advance against a pledge of sound assets became easy because the central bank no longer had to deal with state-appointed bank receivers.

With the FDIC as sole receiver for federally insured state and national banks, the Fed was assured consistent national standards for receiverships. Since people appointed to act as receivers for the FDIC are indemnified for their actions (but only if approved by the FDIC) it became inconceivable that any receiver would challenge a pledge of collateral to the Fed. Using solvency tests, sound banks were allowed to reopen with FDIC-insured deposits. Banks that could not qualify for FDIC insurance were restructured by the Reconstruction Finance Corporation.

By means of these changes, the United States effectively nationalized all banks in 1933. For the next 20 years, American banks became risk averse to a degree that is little noted in much of the economic literature on the Great Depression. Public records of banks that became regional banks of last resort by being placed in conservatorship (so they could fund, as federal agents, local banks that did not survive the bank crisis that followed the 1929 crash) show a pattern of limiting extensions of credit, which choked the nation.

As an example, a national bank in the Midwest that had restored hundreds of local banks to local ownership while in FDIC conservatorship had invested about 80 percent of its assets in commercial loans before 1929. When the conservator finally returned control of the bank to its owners in the 1950s, 50 percent of the bank’s assets were cash in vault; roughly 40 percent were invested in federal, state, and local bonds; and only about 10 percent were in commercial and consumer loans. That’s an 87 percent decline in business and community lending, and the direction of the contraction in credit didn’t reverse itself for another 20 years. It took two decades to train enough loan officers for the bank to successfully revert to a true commercial bank that provided credit to the community it served by taking deposits. This is just one example of why the credit expansion by the U.S. government to cover the expense of fighting World War II and the post-war rebuilding of Europe and Japan was the only thing that saved the nation from the Great Depression.

While Justice Brandeis was certainly correct in his thinking about disclosure and transparency, his 1925 opinion in Benedict cast a long shadow over the markets of that day. Only enactment of the U.S. Assignment of Claims Act of 1940 made it safe for banks to lend on the collateral of U.S. government contract obligations. The law anticipated a build-up of contracts for FDR’s lend-lease program. However, 1941 letters from the agency charged with resolving questions about the law continue to indicate reluctance in accepting anything short of the strictest compliance with every detail before a lender could be assured that the government would pay the assignee bank. Small wonder, then, that it took four years before the United States could manufacture the supplies needed to successfully invade Normandy and save Europe from German control. There was little or no private credit available to American industry.

Even during World War II, the federal government was concerned that it would lose money if any other government agency had claims against a contractor (or a lender). Those claims would have needed to be resolved before sending money to a secured creditor of the contractor. In private contracts, this issue was contested until the Uniform Commercial Code, which was first approved for adoption in 1951, created a workable compromise that was eventually implemented throughout the United States.

From 1933 on, conservators, receivers, and bankers became entirely dependent on U.S. government support for their existence. They were not about to take risk. Likewise, borrowers were reluctant to get loans. Some 35 percent of all residences mortgaged in the 1920s had been foreclosed by the 1950s; estimates range as high as 50 percent for the Detroit area. During the 1950s and 1960s in Detroit it was so uncommon for homeowners to seek mortgages that as late as the 1970s Detroiters had a hard time adjusting to the more liberal mortgage lending practices they found in other American cities.

Disasters that struck mortgage insurers during the Great Depression caused regulators to shut the business down entirely until the late 1950s. Finally, a very wise and foresighted individual, Max Karl, created a reserve/investment structure that allowed reopening of the mortgage insurance business in the post-war era.

As the Uniform Commercial Code made it feasible for private banks to reenter the business of secured commercial lending, the absurdity of Depression- era rate controls required by Regulation Q (which set a ceiling on the rate banks paid on deposits—preventing banks from raising deposit rates to seek funds when liquidity needs rose) was soon apparent. How can a bank expand its lending safely if it cannot increase deposits by paying higher interest rates when liquidity is needed? What business, moreover, would borrow when banks can be cut off from funding at the whim of the federal government?

While many abuses arose following deregulation, a 1971 report by a bipartisan presidential commission was correct when it declared that Depression-era banking controls had to end if the U.S. economy was going to expand significantly. The trick is to establish a balance among leverage, growth, transparency, and disclosure that will endure and support a free society. That presidential commission cited as its primary recommendation the establishment of a level playing field where barriers to competition in finance are lifted.

Creating a level playing field meant eliminating the curbs on credit and monopoly practices created by depression-era restraints and the generation of new investment processes that could attract investors without federal guarantees or the payment of excessively high rates. The monopoly practices could be summed up by the Rule of 3-6-3: bankers of the 1950s and 1960s were said to take deposits at 3 percent, make loans at 6 percent (but only to customers that did not need them), and start a round of golf (with customers) by 3:00 P.M.

Blunders have occurred during 40 years of deregulation. Removing barriers to competition in finance led to mistakes and outright frauds that are hard for all honest people to tolerate. It took until 1983 for market participants to invent a structure (the stand-alone Collateralized Mortgage Obligation or “CMO”) that was sufficiently sound to attract funds at risk spreads that allowed homebuilders to fund mortgages without relying on the thrift industry. It took another decade to open other consumer credit markets to that innovation. The entire process was complex and fraught with risk, yet none of us would want to return the United States to the tightly constrained, slow-growth banking world of the 1950s and 1960s.