Freeman

ARTICLE

Too Big to Fail

A Government Safety Net Encourages Excessive Risk-Taking

MARCH 02, 2009 by MICHAEL HEBERLING

“Once you lose your freedom to fail, you also lose your freedom to succeed and you cease to be a free society.” —U.S. Rep. Jeb Hensarling of Texas

In March 2008 the investment banking firm Bear Sterns failed and the federal government quickly stepped in. The public was inundated with the phrase “too big to fail” (TBTF) by the financial news media. You had to go back to 1998 for the last time it was used so often. In that year the troubled hedge fund Long-Term Capital Management had $4.6 billion in losses. The Federal Reserve stepped in to orchestrate a restructuring deal to avoid bankruptcy. With this government intervention, the precedent was established for future calls for help. In 1999 Kevin Dowd, writing for the Cato Institute, stated: “[T]he intervention implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking. . . .”

An institution is deemed “too big to fail” if its collapse would be expected to create a devastating ripple effect throughout the economy, creating a “systemic risk.” When this occurs the government is expected to provide some form of assistance. This can vary from a guaranteed loan, where management and stockholders get off scot-free (as with Chrysler in 1979), to guaranteeing the assets of a failing bank, to facilitating an outside takeover (Bear Stearns). In the event of an outside takeover thousands of employees could be shown the door and stockholders left with pennies on the dollar. Since the public only notices that it is paying the bill, it has a hard time discerning these subtle differences. As a result, the term “bailout” is used broadly to describe any form of government financial intervention to assist a crashing TBTF company or its creditors.

Too Big to be Free-Market

There are no clear guidelines on who is (or what constitutes) TBTF. As a result the “systemic risk” scare is ad hoc and apparently meant to be taken on faith. Any large company can claim it is vital to the health of the economy because its failure would have a domino effect on suppliers. Other firms can pick up the slack and even acquire the assets of the failed firm, but this is usually ignored.

TBTF is problematic because it indirectly influences how companies are managed. If there is a real, or implied, government safety net should things “head south,” management might be inclined to take on more risk for greater profit. This illustrates the concept of “moral hazard,” an insurance term. If you are insured, you may be less cautious. TBTF is actually a state of mind that afflicts the senior management of our largest corporations. If they think they are TBTF, even if they aren’t, they still behave as if they are. This is the crux of our current financial problem.

In an ideal free-market environment, entrepreneurs would be willing to take on risk based on an expected return. Since returns are never guaranteed, the entrepreneur’s willingness to take on risk is tempered by the potential downside (a loss), if things don’t pan out. While the rewards for extremely risky investments may be great, so too are the penalties. In severe cases the company could go bankrupt. As a result, this risk/reward/loss relationship in the free market would force rational behavior into the business decision-making process.

TBTF companies are no longer on their own to succeed or fail. With TBTF we now have the government in the game—not so much as another player but as a non-neutral referee ready to step in if the game gets too rough. What’s more, TBTF companies operate under a different set of rules from merely mortal ones. In 2004 Gregory Mankiw, then chairman of the President’s Council of Economic Advisers, said, “Expecting a government bailout if things go wrong creates an incentive for a company to take on risk and enjoy the associated increase in return.”

So if you are (or think that you are) TBTF, there is little or no perceived penalty to counterbalance risky behavior. With a guaranteed—or at least an implied—government safety net, the sky is the limit when it comes to risk-taking. The siren song of big returns (with little or no risk) becomes irresistible—and you no longer operate in a free-market environment. According to Thomas Sowell, “The hybrid public-and-private nature of these activities amounts to ‘privatizing profit and socializing risk’ since taxpayers get stuck with the tab when high-risk finances don’t work out.” In other words, it is a travesty to say or imply that our current crisis stems from market failure.

Mixed Signals

What makes the TBTF phenomenon so difficult to follow (and understand) is that there is no official list of “too big” companies put out by the Treasury Department. The taxpayer only finds out that a company is on the list after the company fails.

The tab to the taxpayer for bailing out Bear Stearns is $29 billion and counting. What remained of Bear Sterns’ assets, along with government guarantees, were transferred to JPMorgan Chase. The next TBTF firm to run into trouble was the investment bank Lehman Brothers Holdings Inc. Although conventional wisdom held that Lehman, with $615 billion in debt, was TBTF, this time the Fed said no.

These mixed signals about what was and what was not TBTF sent the financial markets into a tailspin. Some federal policymakers and many in the financial news media saw this as the beginning of the credit “crunch.” (In fact, while credit standards have tightened, money is still being lent for all kinds of loans.) It was no longer prudent to do business with any “troubled” bank. Since no one knew which banks the government would or would not bail out, inhibition set in.

The next TBTF firm to ask for federal help was the world’s biggest insurance company, American International Group Inc. (AIG). Not wishing to mishandle another TBTF firm, the Fed quickly agreed to lend $85 billion to AIG in September to avert bankruptcy. The following month AIG came back to the Fed asking for an additional $37.8 billion, citing liquidity problems. The Fed’s response: No problem. But are you sure $123 billion will be enough? AIG is intricately involved in America’s money-market funds. In November AIG came back and said: “On second thought, could you make that an even $150 billion?” The government response: Fine, but only on one condition, and you may find this to be exceedingly harsh. We absolutely insist that your top 70 executives not get any bonuses this year. AIG’s response: “You drive a hard bargain, but we have a deal.”

As a result of this action, the government now owns 80 percent of the company’s assets.

In September the federal government took over two more TBTF firms. The quasi-governmental Fannie Mae and Freddie Mac own or guarantee about 40 percent of the nation’s mortgages. This bailout will cost the taxpayer $200 billion. Egged on by influential members of Congress, Freddie and Fannie blatantly abused their government-sponsored-enterprise (GSE) designations, and no two firms better exemplify the “moral hazard” argument. Since they were chartered by Congress, many believed their mortgage-backed securities were guaranteed by the federal government. Then-Fed chairman Alan Greenspan told Congress in 2004: “The Federal Reserve is concerned that Fannie Mae and Freddie Mac were using this implicit reliance on a government bailout in a crisis to take more risks, in order to multiply the profitability of subsidized debt.” When housing prices started to tank we found out that this was exactly what was going on.

Bad Medicine and a Hail Mary

One would think that with all of the government oversight these TBTF events would not keep popping up. Since the government doctor has utterly failed to prevent this disease, why should we think the same government doctor suddenly knows how to cure the disease now that it has metastasized throughout the economy?

The Treasury, with the help of Congress, has thrown a $700 billion “Hail Mary” called the Troubled Asset Relief Program (TARP). Whether or not this bailout “restore[s] confidence in our financial system” (Treasury Secretary Henry Paulson) remains to be seen. Judging by the stock market, the early results are not good. Ironically, the first step of the plan was to identify publicly the banks that are really TBTF by buying their preferred stock. Nine TBTF banks, which account for 50 percent of all U.S. deposits, will get half the $250 billion earmarked for banks and thrifts. These include JPMorgan Chase, Wells Fargo, Citigroup, Bank of America (plus Merrill Lynch, which is being acquired by BoA), Goldman Sachs, New York Mellon, Morgan Stanley, and State Street. The bailout bill also includes a provision for the FDIC to offer an unlimited guarantee on bank deposits in business accounts that do not bear interest. For individual depositors, the FDIC insurance limits will increase from $100,000 to $250,000. How do these actions reduce the “moral hazard” problem? The last time the individual deposit insurance limit was raised—from $40,000 to $100,000 in 1980—we had the S&L crisis, which ended up costing the taxpayer $150 billion.

Being on the official TBTF list has its pros and cons. On the positive side, you can’t fail. The government guarantee is no longer implied. It’s real. But being on the official TBTF list has a severe downside: additional regulation. The government will be very close at hand to make sure that our biggest banks become and remain stodgy. In other words: We’re from the government and we’re here to make sure that your risk level remains in the “safe zone.” In October New York Senator Charles Schumer, a member of both the finance and banking committees, wrote Paulson demanding that “banks receiving capital eliminate their dividends, restrict executive pay and stick to safe and sustainable, rather than exotic, financial activities.” Given the makeup of the new Congress and administration, expect even more intrusive micromanaging of our financial institutions—but that is only to be expected if the Treasury becomes a stockholder. From now on innovation will be discouraged, downplayed, or slow-rolled by the government. As a result of these rescue actions, our entire financial system has effectively become nationalized.

A Troubling Cultural Shift

The most troubling aspect of the ever-increasing number of government bailouts is the subtle change overtaking the entire country. The mindset of companies and individuals today is shifting away from self-responsibility. We blame everyone else for our mistakes and look to others (the taxpayer) to come to the rescue.

When it comes to handouts and bailouts the government is no longer simply on the slippery slope—it’s in free-fall. Every bailout makes it harder to say no when the next TBTF request comes forward. Aren’t the Big Three automakers too big to fail as well? In many people’s eyes the answer is yes. At the end of September Congress approved a $25 billion low-cost loan package to help the automakers and their suppliers modernize their facilities so as to be “more green.” But this wasn’t enough. General Motors CEO Rick Wagoner, whose company was hemorrhaging cash, sought another $10 billion in federal assistance the next month to help finance the merger of GM and Chrysler. However, this request was denied. Then in November the Big Three found sympathetic ears from the big two in Congress, House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid, for yet another $25 billion “bridge” loan for the Big Three. The Bush administration ultimately dished out $17.4 billion from the $700 billion TARP fund to assist GM and Chrysler. It also handed the problem of deciding the long-term future of the bailouts to the Obama administration, which had already expressed support for a bailout package. (Notably, the several profitable foreign-owned automakers with facilities in the United States weren’t looking for help.)

It shouldn’t need pointing out that the “too big to fail” doctrine fundamentally changes the nature of a market economy, which when free is a profit-and-loss system. Not only does the doctrine reward error, sloth, and inefficiency, it deprives other, more competent entrepreneurs of the scarce resources they need to serve consumers. Who knows what products and opportunities would arise if the free market, not politicians, determined who had access to capital?

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March 2009

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