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It's Time To End 'Too Big To Fail'

August 17, 2009

By Nicole Gelinas

Last week, the Federal Reserve and many private-sector economists said they believe the worst of the downturn is over, or nearly so. But the emergency measures that Presidents Bush and Obama enacted to ensure the financial rescue have created the very conditions for the next disaster.

Consider: The financial crisis didn’t start in 2007 or 2008. It started in 1984 -- when Washington decided that some financial firms were “too big to fail.”

Until the early 1980s, the financial world understood that failure was a possibility for banking institutions, along with losses for investors who had lent the firms money. Sensible regulation underpinned the assumption. Back in the mid-1930s, during the trough of the Great Depression, the federal government had created a way for commercial banks to go bust without catastrophically damaging the economy -- as had happened in previous panics.

The feds’ instrument was the FDIC, a government-chartered body that insured small depositors’ funds so that they wouldn’t panic. With mom-and-pop depositors protected, the FDIC could then take over failed banks and wind them down, ensuring that shareholders and uninsured lenders -- depositors whose accounts exceeded FDIC limits, as well as bondholders -- took their lumps.

The FDIC covered only commercial banks -- the storehouses of the economy’s vital money and credit supplies. Investment banks failed through the normal bankruptcy process.

Fifty years of policy died in 1984. That May, the nation’s eighth-largest commercial bank, Chicago’s Continental Illinois, found itself in deep trouble.

Like any enterprising company, it had exercised its right to establish a competitive edge and pursue greater profits -- with a risk of failure, which had now arrived.

Continental’s biggest error was how it paid for its investments. All banks use depositors’ money and other funding sources to make loans and other investments. But beyond using funds from FDIC-insured small depositors and other stable, long-term lenders (such as bondholders), Continental relied more than most banks on short-term, uninsured lenders.

In the modern age, global corporations and other investors often park their money overnight or for a few weeks at a time in bank accounts that offer slightly higher rates because, once they’ve exceeded the FDIC limits, they carry risk.

For a lender who doesn’t mind the risk, these short-term accounts are attractive, since he can pull his money at any time if he needs cash, finds a better rate elsewhere, or perceives a new danger.

But for the borrower, like Continental, that ease of withdrawal made the funding source perilous. A panic could leave the accounts depleted and the bank without money just at the very time it needed funding the most.

Continental’s reliance on uninsured short-term lenders was especially negligent because the bank had invested heavily in speculative loans, meaning that a drop in its lenders’ confidence was almost inevitable. Only long-term lenders or guaranteed depositors, who wouldn’t yank their money out immediately in a crisis, could insulate the bank in such a situation.

As rumors swirled that Continental’s investments were going bad, the short-term global lenders pulled their funds. Fear of Continental’s books metastasized into worldwide bank run on all American banks.

So the US government did something radical.

The Federal Reserve and the FDIC, in a “race to save Continental and thereby sustain confidence in the nation’s banking system,” as the New York Times reported at the time, pledged that no uninsured depositor or other lender to the bank, including bondholders, would lose money should the bank collapse.

That July, to avoid “a major financial crisis,” the Reagan administration nationalized the hobbled bank, with the FDIC taking 80% ownership.

The era of “too big to fail” had begun -- and the business and financial communities quickly learned the new phrase.

The break divided the administration. Treasury Secretary Donald Regan found the intervention outrageous: “We believe it is bad public policy, would be seen to be unfair

. . . and represents an unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy,” he wrote to his colleagues.

But the White House had feared that the alternative was to risk a systemic crisis in the banks.

After the bailout, one bank regulator made it clear that a permanent shift in policy had taken place, telling Congress that none of the nation’s top 11 banks would be allowed to fail.

Small banks were apoplectic. Jokes flourished about investors’ not wanting to put money into the nation’s 12th-largest bank.

“Too big to fail” persisted and grew, changing the industry.

By protecting “too big to fail” financial institutions instead of allowing the market to enforce its finding that some such firms were too big to exist, Washington got more too-big-to-fail institutions.

Washington’s guarantee was a government subsidy: big financial firms could borrow on cheaper terms than other companies could, because their lenders felt safe.

To be sure, shareholders -- who own companies rather than lend to them -- still took losses. But all that meant was that shareholders demanded a higher return for this risk -- and financial firms borrowed cheaply to take ever-riskier bets to earn that high return.

Eventually, Washington’s subsidy grew, so that lenders to small financial firms enjoyed protection from market discipline, too.

In 1998, the Federal Reserve engineered the bailout of a hedge fund, Long-Term Capital Management. The Fed’s involvement made it clear that it was OK for lenders to lend to small investment firms, too, without worrying about loss.

Washington’s panicked bailouts over the decades did grave harm to the economy. Because lenders to the financial industry didn’t bear risk, their critical role in disciplining the financial system -- by refusing to lend to overly risky institutions -- was gone.

The predictable result?

Financial firms borrowed so profligately that they had no room for error. The slightest downturn would leave them with debt that couldn’t be repaid absent a government bailout.

Financial firms borrowed much of that money just so that they could lend it to American consumers. Between 1980 and 2008, total debt more than doubled as a percentage of gross domestic product.

All that easy money helped create the housing bubble that burst, starting in 2006, and took the global economy down with it.

In 2008, the government’s longstanding bailout policy reached its natural conclusion.

Starting in March, the financial industry proved how fragile it had become after the government had insulated it from market discipline.

As the world’s investors fled an impossibly complex financial system, the feds had to protect lenders to Bear Stearns from bankruptcy, offering $29 billion in guarantees to JPMorgan Chase so that JPMorgan would buy the foundering investment bank.

The government-engineered avoidance of bankruptcy kept Bear’s lenders from selling tens of billions of dollars’ worth of the firm’s assets, which would have further depressed world markets.

Six months later, such a bailout would seem laughably small, as the Fed and the Treasury offered the first installment of $183 billion in taxpayer money to save lenders to the failed insurance giant AIG.

True, the feds declined to bail out Lehman Brothers. But the panic after Lehman’s bankruptcy convinced officials that this aberration was a mistake.

By the end of last year, the government had offered trillions of dollars in bailouts, backstops or guarantees through its now-infamous TARP program and other initiatives, including nearly $294 billion to shore up the failing Citigroup.

And through a “temporary” new FDIC program, the government offered to guarantee virtually all new lending to banks.

IN every one of these cases -- from Continental Illinois way back in ’84 to the panicked response to AIG, nearly 25 years later -- the government’s immediate response was understandable.

If Washington had permitted disorderly failure in either 1984 or 1998, the short-term consequences would have been dire, bringing the risk of a deep recession as financial firms and instruments failed and survivors tightened lending.

Similarly, it was economically impossible for President Bush, last year, to force lenders to Bear Stearns, Citigroup and AIG to take losses when there was no consistent, orderly process through which they could do so without heightening the risk of depression.

Uninsured depositors and other lenders had come to expect bailouts over the decades and had acted accordingly, running risks that left the economy vulnerable to catastrophe.

What’s unforgivable is the government’s response after each crisis.

After their ad-hoc rescue of Continental Illinois, regulators and elected officials should have understood that the old regulations to wind down bad financial institutions had stopped working, necessitating credible new rules that would let uninsured lenders to banks know that they risked warranted losses.

Such enforcement of market discipline might have prevented the crisis that started to unfold in 2007.

Instead, we have had two and a half decades of punting.

Today, the government’s response threatens more of the same.

President Obama claims that he wants to create a way for bad financial firms to fail. Yet in its June financial-regulatory proposal, his administration formalizes “too big to fail,” giving the Treasury new power to “stabilize a failing institution . . . by providing loans to the firm, purchasing assets from the firm, guaranteeing the liabilities of the firm or making equity investments in the firm.”

The proposal says nothing about making sure that debtholders and other uninsured lenders take losses.

Reintroducing a predictable, credible way for lenders to financial firms to take losses when failure strikes would go a long way toward protecting the economy from speculative excesses.

Market forces, coupled with overdue new rules for inadequately regulated financial instruments, would have a better chance of reducing reckless risk-taking before it got out of control.

Market discipline, too, would complement other necessary regulations to prevent financial firms from getting too big or complicated in the first place. Such regulation would include reasonable, uniform limits on financial leverage, to rein in how much financial firms can borrow for every dollar of shareholder capital that they have.

Lenders, knowing that they could take losses, wouldn’t give firms the cheap money with which to get so big or to take such big risks.

As a first step toward restoring market discipline, the government should create an FDIC-style conservatorship for big or complex financial institutions that fail.

A new kind of bankruptcy could come into play in such a process, said University of Texas business-law professor Jay Westbrook.

A special bankruptcy process for big financial firms could keep some lenders to failing firms from immediately seizing their collateral, including bond securities and selling the securities into the market.

This prohibition would reduce the possibility that instant sales of billions of dollars’ worth of securities would push down prices of all securities and destabilize the financial system, as was the fear with Bear Stearns, and the reality with Lehman.

In the plan employed by Citigroup, economists R. Glenn Hubbard, Hal Scott, and Luigi Zingales have proposed an elegant FDIC-managed system that would split failed financial firms in two.

One new entity would take over the toxic assets that caused the firm’s problems. This “bad bank” would also bring the failed firm’s lenders with it, and the lenders would take losses based on the collapsed value of the assets.

The other new entity, no longer weighed down by the bad assets, could meet the original firm’s remaining obligations and raise new funds.

Lenders to the original failed firm, now lenders to the bad bank, would receive stock in the restructured firm, sharing in its future profits, just as lenders to an ordinary bankrupt firm can.

However the details take shape, the key factor is credibility. Lenders to big banks and other financial firms must worry that their money really is at risk -- that the feds won’t keep stepping in to save them.

If credibility isn’t established, Washington’s actions will have created a monster, stoking more reckless debt creation at a time when debt has already reached a record 350% of GDP.

Witness how quickly banks were able to borrow money earlier this year from private lenders -- sometimes without the FDIC’s new emergency guarantee.

The government heralded the loans as evidence that lenders were regaining confidence in the financial sector. They weren’t. Lenders merely had confidence that Washington would stick to its policy of bailouts for tottering financial companies.

“Too big to fail” imperils the economy’s long-term health. If big or complex financial firms keep their state subsidy, they’ll continue to divert lenders’ money away from other industries. Why lend money to Cisco when you can lend it to Citigroup risk-free?

Failure is necessary in a free market, since it improves economic efficiency. When a company fails, a more successful firm can buy its good assets, releasing them from incompetent management. Failed firms’ workers can likewise find more useful outlets for their labor.

Failure helps ensure that government and private resources aren’t wasted on a business model that doesn’t work.

If real reform doesn’t happen, get ready for a fearsome certainty: Markets will eventually correct our unsustainable financial system. They have tried to do so several times over the decades by punishing firms like Continental and Citigroup, as well as the lenders who financed them.

The government thwarted these necessary corrections.

But the price of maintaining our untenable system keeps growing, and eventually Washington won’t be able to pay.

The multitrillion-dollar price tag attached to the government’s current rescues already endangers the nation’s fiscal health.

A decade from now, failing financial firms could take the credit of the US government right down with them.

Original Source: http://www.nypost.com/seven/08162009/business/its_time_to_end_too_big_to_fail_184871.htm?page=0

 

 
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