Still too big to fail and only getting bigger

2012-DEC-13

One of the problems exposed by the financial crisis of 2008 was that certain firms had become so large and interconnected with one another that they were deemed too big to fail. Because of this the government decided to use taxpayer money, in combination with the creation of new money by the Federal Reserve, to bailout several large banks. The thinking was that if these entities failed, there would be chaos similar to the conditions experienced after the Lehman Brothers failure – but on a much larger scale.

It can be debated whether these entities should have been allowed to fail – although I would argue that it would have been in the best interests of the global economy in the long-term if they had been. However, despite all of the new regulations that have been passed since 2008, the “too-big-to-fail” problem still exists. Given the continuing weakness in the economy and the highly levered nature of these firms (courtesy in-large part of over-the-counter derivatives), it is a strong possibility that one or more of these institutions will again need bailing out in the not-to-distant future.

In one sense the bailouts never stopped. Quantitative easing is a pseudo-bailout for the banks, a policy that is now open-ended. It’s helpful to take a step back and think about the factors that caused the economy to be so weak and led to all of the quantitative easing to begin with.

While the distortions created by government policy have affected many areas of the market, one of the main problems continues to be the housing market. During the past decade the US experienced an unprecedented housing bubble, and when it exploded the response was to have the government and Fed balance sheets assume the majority of the liabilities. Some losses were recognised, but due to the aggressive mortgage backed security purchasing of the Fed, much of the potential pain has been kicked down the road. Rather than forcing the banks to take the full loss and mark the securities to market, the losses have been hidden on the Fed's balance sheet.

Think about who the Fed was buying these mortgage-backed securities from. These were largely held on bank balance sheets and without Fed assistance many of these banks would have likely been insolvent. So when the Fed is buying the securities through quantitative easing, they are effectively bailing out the banks before the insolvency is recognised. And if one of these banks does experience an actual failure it is still hard to imagine the Obama administration and the Bernanke Fed allowing them to go under. Far more likely is an explicit bailout.

By continuing the quantitative easing policies there is also little incentive for the banks to change their behavior. Markets are governed by two counterbalancing forces, which are the desire for profit and the fear of loss. As was saw in the build-up to the mortgage crisis, removing the fear of loss heavily skewed market behaviour. The implicit guarantees of Fannie Mae and Freddie Mac were a key factor that allowed so many of these securities to be created. Loans were made because investors were able to take a free roll. If the deals went well they profited, and if they went bad the government would socialise the loss. And despite government claims that these agency bonds were not guaranteed, in the end that's exactly what they were.

This reminds me of a personal experience during the summer of 2004. Between my two years on the Wharton MBA programme I had an internship on Merrill Lynch's trading desk. I remember sitting with one of the agency traders who explained to me that these agency bonds were the equivalent of a Aaa rating because they were backed by the government. He was well aware that it was not an explicit guarantee but it was clear that to him and the other agency traders that these agency bonds were considered the equivalent of Treasuries. Therefore traders were willing to take on risk that they otherwise would not because of the bailout feature of the bonds. The behavior still has not changed as many of the large firms know that they can take unlimited risk. If it goes bad the US government and Fed have made it clear that another bailout will be waiting.

Despite all of the legislation contained in the Dodd-Frank bill nothing has been done to address this issue of too big to fail. When the next bailout is issued it will be accompanied with an explanation of how catastrophic a failure would be. There is some truth to this last particular point, as much like in 2008 a failing mega-bank would cause extreme stress to the financial system. However, just allowing the problem to become bigger and bigger while ignoring it is hardly an effective solution. Recently several of the clearing agencies were also added to the list of too big to fail firms, which further concentrates all of this risk on US taxpayers and dollar holders.

It is another significant risk present in today's financial world. It is also a good example of why the current financial system is going to eventually collapse. This is no longer some hypothetical futuristic concept, but rather something that is going to be impossible to avoid over the next few years. And while there will be a great deal of chaos associated with this ultimate outcome, it will hopefully go some way to restoring free market discipline into this hugely important sector of the economy.