When Sen. Elizabeth Warren, the former law-school professor and self-appointed scourge of Wall Street, gets her history terribly wrong - and proposes a new law based on that lack of understanding - there must be a reckoning.
On July 11, Warren introduced the "21st Century Glass-Steagall Act of 2013," theoretically designed to "reduce risks to the financial system by limiting banks' ability to engage in certain risky activities and limiting conflicts of interest."
Warren's allusion to the original Glass-Steagall Act of 1933 - which gave Wall Street's commercial banks and investment banks one year to choose to be one or the other - was intentional, of course.
The firebrand Democrat from Massachusetts - and, apparently, the bill's unlikely co-sponsor, Sen. John McCain, R-Ariz. - seem to believe that the 2008 financial crisis was caused by commercial banks taking undue risks with depositors' money.
While it's true enough that these banks courted too much risk, Warren's conclusion that this caused the financial crisis is simply inaccurate.
As I have detailed extensively in two books about the financial crisis - "House of Cards," about the collapse of Bear Stearns Cos., and "Money and Power," which in part documents how Goldman Sachs Group Inc. made it through financially unscathed - its causes were many and complex. What was key, though, was institutional investors' justifiable loss of confidence in the quality of the assets on the balance sheets of the large Wall Street investment houses - Bear Stearns, Lehman Brothers Holdings Inc., Merrill Lynch & Co. Inc. and Morgan Stanley.
These banks had been financing their short-term cash needs in the "overnight repo" market. And the nightly lenders - institutional investors such as Fidelity Investments and Federated Investors Inc. - used as collateral the piles of mortgaged-backed and other squirrelly, hard-to-value securities that had been building up on the banks' balance sheets. Fidelity and Federated began to question the value of these assets, then finally stopped accepting them as collateral.
During the middle of March 2008, for instance, Bear Stearns had $18 billion on its balance sheet but needed around $75 billion in cash daily to run its business. When the overnight-financing crowd stopped accepting its mortgage-related securities as collateral, the bank was left with only two options: File for bankruptcy or seek a merger partner. In September of that year, similar scenarios played out at Merrill Lynch, Morgan Stanley and Lehman Brothers.
These events shared two common denominators: The big Wall Street investment banks were far too reliant on cheap, short-term financing. And the go-to saviors were the big, diversified commercial banks.
The one exception to this narrative was Citigroup Inc., which failed despite being a diversified, global bank - in large part because, under the leadership of former Treasury Secretary Robert Rubin, it abandoned any semblance of risk-taking discipline.
I sympathize with Warren's desire to rein in imprudent risk-taking. Since the mid-1980s, when so many investment banks went from being private partnerships - in which partners largely risked their own capital - to being public companies with no personal exposure, the financial system has been subject to one crisis after another. Wall Street's ongoing problem is not the risk-taking itself but rather the incentives to engage in it. Bankers, traders and executives earn big bonuses for taking foolish chances with other people's money, but incur no liability - criminal, civil or financial - when things go wrong.
If Warren were serious about preventing the next crisis, she would do well to focus on changing how people on Wall Street get rewarded. Glass-Steagall kept financial calamity at bay for some 60 years by making risk-takers pay when things went wrong.
William D. Cohan is a Bloomberg View columnist and a former investment banker.