Too Big to Fail - 2 of 3 on the new bank bail out

Too big to fail is more than just a media word being thrown around in the news lately, but a term that has been studied in great detail over the last 30 years in the academia of money and banking. However, many are probably not too familiar with the concept.

Most are already familiar with the first part of the too big to fail scenario. The largest financial institutions are too interconnected to the economy to be allowed to fail when they become distressed. Therefore, the government must come in and bailout the institution. However, there are consequences to the bailout. Many probably are not aware that bailouts promote risky behavior in the financial sector.

Bailouts are nothing new to the Fed and government. Over the past 30 years there have been a consistent number of bailouts including Continent Illinois and the Savings and Loan crisis at the end of the 80’s. The successes of these bailouts have only bolstered the idea that a bailout is a certainty. Most people outraged by the collapse of Fanny and Freddie Mac were people confident that the government would insure the bank's losses. It is important to note that Lehman was the first financial institution that failed to receive a bailout since bailouts began. In fact, it is likely that today’s mortgage crisis is a result of the too big to fail concept playing itself out over the years.

With the confidence of government assistance, where is the threat of failure which forces prudence and good decision making? Going back to Lehman, the company was so sure of a bailout, they had not made strides towards an alternative when they found out they were not going to get assistance. I used to work in the mortgage industry and I worked closely with Citimortgage (the 3rd largest mortgage company with over 3.5 million mortgages). Citimortgage gives us a clue of management’s mentality regarding their risk taking. Prior to the economic meltdown, Citimortgage was working hard building their kingdom of mortgages in their race to be the largest mortgage company in the US. They acquired company after company. All the while, not reviewing loan origination standards nor assessing the risk they were taking by acquiring these loans. In fact, few loans were ever originated by Citimortgage themselves, but were bought up second hand. The focus was clearly on the size of the portfolio and not the substance. Now that they are bailed out, what lesson will they learn and what incentive do they have to change?

Another aspect is that by mitigating the losses of an ailing financial institution, the government allows the poor business practices of the past and often the present to continue without redress. When companies are bailed out, we are not guaranteeing a change in management behavior. The purpose of TARP was to provide money to financial institutions so that they could relieve themselves of their burdened assets. Just as the state stimulus money was to be used for infrastructure, but in actuality many states are using the money for budget gaps. TARP funds were not used to relieve the assets as intended but used as an influx of cash to go into their various operations and protect the company’s earnings. Bailout does not promote change! While AIG may have needed to keep people on the payroll using retention bonuses to do so, how hard were they negotiating when the tax payers were subsidizing the payroll? How much time was spent looking into alternative options? I can only speculate.

Most would rather chalk the recent problem to deregulation, but that is only a piece of the puzzle. Despite deregulation, there are still regulations and regulators, but regulators rarely catch on until it’s too late and no amount of regulation will change that fact. This is because regulation violations are rarely evident until there is a problem. If you walked through the halls of AIG 2 years ago, I'm sure anyone would have been convinced of their stability. Even if there was proper regulation, that does not mean that banks cannot exploit holes in the regulation system. AIG’s troubles were related not to deregulation, but taking advantage of regulation holes. Like computer viruses, no regulation written can be perfect and cover all possibilities. Most regulation issues are not from a lack of regulation, but a gray area in regulation. By the time a regulator has figured it out, the damage is already done.

We are now looking at a new bailout bill, complete with new regulations looking to gain new bailout power (please stay tuned for the next post on why the new regulations are bad). Yet, how will this bailout and these regulations fix the underlying problem above? It will not end the problem of too big to fail, but promote it. It will not deal with the trouble of regulation loopholes; it will create more of them. It will not promote good management in the bailed out companies; it will grant amnesty to them. Finally, it will not end the fact that these bad mortgages have borrowers who cannot pay; it will only forestall the reality until bank bailout number three is needed.

We don’t need new bailouts and we don’t need new regulations. We need the old regulations that helped limit the size of these financial institutions from the time of FDR. This may tighten up the easy credit this country has enjoyed, but in limiting size it should promote competition and keep the cost of credit low. Finally, I believe we need to break up these large companies so that the healthy segments can continue while the troubled ones are allowed to fail.