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Too Big to Fail

Some financial institutions could commit moral hazard by leveraging their implicit high credit ratings and tax-payer guarantees to load up on high-risk debts and obligations.

K. K. Fung

Between January 2008 and May 2010, 242 small banks have been taken over and dissolved by the FDIC (Federal Deposit Insurance Corp.) due to bad loans mostly related to housing and commercial real estate. Depositors were largely made whole, but shareholders were wiped out, and creditors suffered various degrees of capital losses. These failed banks mostly had assets below $1 billion each and could be liquidated with little systemic risk. In other words, they were too small to save.

On the other hand, Citibank received a $300 billion bailout from US taxpayers (seekingalpha.com 11/24/2008). Fannie Mae and Freddie Mac (government-sponsored enterprises engaged in promoting home mortgages) received $200 billion capital injection to save them from bankruptcy. AIG, the giant global insurance conglomerate, received a bridge loan of $85 billion from the US Treasury. JP Morgan Chase was extended a $29 billion credit line to take over Bear Sterns, a big investment bank. The institutions that received taxpayer bailouts were all deemed too big to fail due to systemic risk (Liu 9/23/2008).

For example, Citibank had assets equal to about 20% of US GDP (infoplease.com 5/30/2008. Kwak 4/23/2010. Johnson 4/8/2010). But the bigger the institutions, the bigger are their loss exposures. Estimates of losses for US financial institutions could reach $200 billion as a result of AIG default (Liu 9/23/2008). Fannie Mae and Freddie Mac were in danger of defaulting on $5 trillion of debt (Liu 7/22/2008) in a single week.

The issue is not how big some of these financial institutions are, but how they got so big in the first place. Mostly, they leveraged their high credit ratings to borrow cheaply and heavily (Wikipedia.org. Too big to fail) to load up on and “insure” securitized subprime mortgage and other consumer debts (See Bubble Economics). Their implied security against bankruptcy also encouraged moral hazard by empowering them to take on more risk. And their cross-nation expansion and debt guarantees across units of the same institutions make them extremely difficult to dissolve in parts or in whole when they get into trouble (Johnson 3/26/2010).

Bailouts are of course not free to the recipient institutions. But their owners and creditors suffered a lot less than outright liquidation via bankruptcy. And taxpayers are the ultimate victims if things do not work out.

Bailouts might have averted a systemic collapse, but they did not make the financial system healthier. In fact, the bailouts propped up over-valued debt values which should have been written down. Too many bad debts are still lurking below the surface on the balance sheets of big finance institutions who are too worried about conserving capital than to make new sound loans. The forced mergers between already big financial institutions during the bailouts ended up with even bigger entities that are even bigger to let fail. Unless the financial reform comes up with some sure-fire ways to deal with this too-big-to-fail issue, the stage is set for endless rounds of debt booms and busts.

References:

Glossary:

  • leverage
    The amount of debt used to finance an investment. For example, an investment valued at $10,000 but with only $1,000 equity capital is said to have a leverage ratio of 10:1 (i.e., 10,000/1000 = 10). In other words, $9,000 is financed by debt.
  • moral hazard
    A tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others (Wikipedia). For example, the tendency for the insured to take less care to prevent loss.
  • credit default swap
    A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default. It is essentially an unregulated insurance contract without any reserve requirement on the party of the seller or insurable interest on the party of the buyer. CDS gave unwarranted assurance of credit-worthiness to subprime asset-backed debt securities and contributed to the asset bubble and subsequent credit crunch of 2007.
  • Gross domestic product (GDP)
    Gross domestic product (GDP) measures the total market value of all final goods and services produced in a country in a given year, plus exports, minus imports. "Gross" means that capital depreciation allowances have not been netted out from the total.
  • injection
    A source of expenditure or funds. For example, a government stimulus in a recession is an extra source of expenditure. The purchase of long-term Treasury bonds by the Fed is an example of money injection into the credit market.

Topics:

Money and Credit, Boom and Bust

Keywords

AIG, bailouts, bankruptcy, Citibank, credit default swaps, credit ratings, Fannie Mae, FDIC, Freddie Mac, JP Morgan Chase, leverage, Moral hazard, securitized debt, subprime mortgage, too big to fail