Too Big to Fail

¶ … fall 2007, the United States economy was rolling along in a healthy fashion having enjoyed 24 consecutive quarters of positive Gross Domestic Product growth. The Standard and Poors Index was over 1,500 and unemployment was below 5%. There was essentially no inflation. These were all good numbers and normally indicative of a health economy (Bloomberg Business Week).

Roughly 12 months later everything had changed. Treasury Secretary Henry Paulson surprised everyone by announcing that the Government was intending to intervene in the U.S. economy by holding reverse auctions where the troubled assets of several domestic financial institutions would be bought (Landler). As matters worsened quickly, the proposed auction concept was expanded to the point that the Government would actually purchase equity positions in some of the country's largest banks. The argument offered by Paulson was that such measures were needed to stabilize the troubled financial markets, avoid bank failures, and prevent a credit freeze.

Paulson had no sooner announced these measures when the rest of the economy also seemed to fall apart. The stock market prices fell sharply, housing prices continued the slide that had begun in late 2006, and retail sales contracted. It was as if the entire economy had come to a complete standstill at the same time.

There is no lack of opinions on what caused this sudden turn in fortunes for the U.S. economy (Zeckhauser). Financial experts and politicians have offered all sorts of explanations such as excessive risk-taking by the private sector, inadequate or inappropriate regulation, deficient financial management, and so on but the one factor that is discussed the least may be the single most important one: misguided federal policies.

Since the end of the Second World War the U.S. Government has promoted the idea of homeownership (Carliner). Over those years the Government has designed a number of programs and developed policies that have resulted in the creation of a number of several powerful and influential agencies. Some of these agencies include the Federal Housing Administration, the Federal Home Loan Banks, Fannie Mae, Sallie Mae, and Freddie Mac. Each of these agencies was created in some fashion to assist in the policy of promoting home ownership. Additionally, the Internal Revenue Service participated in the promotion through the allowance of home interest deduction, favored treatment of capital gains on housing, and the inclusion of the Homestead Exception in the bankruptcy code.

For many decades the Government's housing promotion policy had no noticeable negative effects. The reason for this is that where the Government did intervene in what should have been free market activities it did so responsibly. This all changed, however, as the Government began to involve itself in the promotion of homeownership for low-income households (Shay). At some point in the 90's, the Department of Housing and Urban Development suddenly began applying pressure on the private lenders to provide mortgage loans to those who had traditionally been unable to procure such financing. Adding to the problem was the fact that political pressure was also being applied to government agencies like Fannie Mae and Freddie Mac to finance the same high risk individuals. By late 2003 and early 2004 the result of these pressures was the creation of thousands of mortgages to individuals with extremely poor credit histories.

A second federal policy also contributed to the situation. Unbeknown to many taxpayers, the U.S. Government has been bailing out institutions involved in private risk-taking for some time. This has been the Government's policy for some time as several different banks have been provided with funds in order to protect them from going under. These bailouts have been going on for some with little fanfare (Gup). This practice of providing bailouts to potentially failing financial institutions seemed to create an expectation among the industry that the government would step in if necessary to cushion any potential losses from risky investments. With the Government encouraging financial institutions to expand their involvement in high risk mortgage debt and, at the same time, indicating that they were willing to bail out those who might fail as a result, financial institutions had every incentive to continue participating in the high risk mortgage market. The industry could not continue in this fashion and a crash was inevitable but no one was willing to admit it. There was too much money being made and no one was willing to step forward and cry wolf. As long as housing prices continued to rise the situation could continue but once housing prices began to decline it was only a matter of time before the financial institutions would begin tightening the market.

The federal policies mentioned herein were not the only cause of the major bailout that was eventually required in the early days of the Obama administration. Wall Street greed, inadequate and inappropriate regulation, and failures of the rating agencies all contributed to the situation as well. The long-standing federal policy of promoting homeownership, however, was at the center of the controversy. It is implausible that greed, improper regulation, or rating failure would have been able to orchestrate the problems that faced the nation's financial institutions at the time of the 2009 bailout. Greed and regulation failure certainly contributed but it was federal policy that created the original problem.

The bank bailout plan offered by Treasury Secretary Paulson was intended to provide failing banks with sufficient money to improve their balance sheets which in turn would allow the bailed out banks the opportunity to lend money to the public (Manns). The logic offered for the bailout was that these failing banks were adversely affected by the falling housing market as the assets they were holding to guarantee the high-risk mortgages that they had granted were declining in value.

In the public discussion that occurred regarding the need for a bailout there were few who questioned that there were many financial institutions that were in danger of failing. The potential of financial failure, however, is not a basis for granting wholesale bailouts. Financial failures are a reality of capitalism. Businesses of all kinds make good and bad investments and, as a result, businesses enjoy profits and suffer losses every day. That is how the system works and the government cannot be placed in a position of bailing out every business in America that is in danger of failing.

The argument that was advanced by the troubled financial industry in the fall of 2008 was that allowing a significant number of financial institutions to fail would harm, and possibly, cripple the nation's economy (Zumbrun). The industry claimed that a failure by one bank impacts on other banks to the point that a complete credit freeze was a likely. As the bailout occurred, this theory was never tested but, regardless of the possible effects, the bailout was not sound policy.

The first thing that must be considered when reviewing the possible effect of bank failures is the fact that the Federal Deposit Insurance Corporation would have prevented any significant loss being felt by the depositors thus preventing their being any run on the banks occurring (Ashcraft). At the time of the Great Depression, this occurrence crippled the U.S. economy and made it difficult for the financial market at the time to re-stabilize itself. Analysts at the time of the present bailout were suggesting that a similar thing might happen but the FDIC program was designed to avoid such contingency. Additionally, the United States bankruptcy code has been designed over the years to supervise the activities of financial institutions that are on the brink of failing (Morrison). The image of hundreds of banks suddenly shutting their doors and ceasing to operate is merely a scare tactic to induce emotional reactions from the public. The bankruptcy Court would have stepped in and either appointed trustees to operate the failing banks until such time as they became viable again or forced a liquidation of the failed bank's assets to a healthier bank or financial institution. In either case, the individuals suffering the losses would be the investors, either shareholders or bondholders. The monies on deposit would be protected under the insurance provided by the FDIC. This is the way the system is supposed to work. Depositing money into a bank is not considered to be an investment. There is not expected to be any risk. Buying shares in a bank or purchasing a bank's bonds is, however, considered an investment. There is supposed to be risk involved. If the government is going to provide bailouts to troubled financial institutions, where is the supposed risk?

What the bailout has effectively done is, once again, completely altered the playing field in regard to how the government treats the wealthy and privileged classes in the United States. The bailout, in effect, serves as an insurance policy for the wealthy that guarantees the viability of their "investment" in our nation's financial institutions.

The first way that this is done is that the bailout perversely takes the money provided by taxpayers and transfers it to protect the risky investments made by those who are already well-off enough to be able to make such investments. These well- off individuals have already profited greatly from their investments while, because of the bailout, never really having absorbed any risk. This procedure violates the very essence of the investment process. Excessive returns are justified under the normal scenario where an investor is asked to assume substantial risk that his investment might be lost but if the risk of loss is obviated by government bailouts the risk of loss has been eliminated. The investors in this situation are in a win-win position. They reap the benefits garnered by high return on the investment while never really facing any risk of loss. The risk of loss is absorbed by the taxpayers who provided the funds for the bailout.

The use of bailouts also creates unnatural conditions in the market place. The fact that the government has positioned itself so as to be willing to bailout failing financial institutions and other industries such as the automobile companies have effectively sent a message throughout the economy that it is okay to adopt goals and objectives that are not economically sensible. The attitude develops that it is not necessary to operate one's business on sound financial policies. The Government will be there to provide assistance in the event that an investment or project fails so why not roll the dice? If the venture succeeds the institution benefits greatly from the profits while if the venture fails the taxpayers shoulder the burden. This is the attitude that caused the housing crunch in the first place and that precipitated the mortgage default crisis and the bailouts served to perpetuate this attitude and financial approach. The nation's financial institutions did not suffer as a result of their failed fiscal policies the America taxpayers did.

The bailout also placed the U.S. Government in the position of being an owner of several large financial institutions. Financial decision making is, in theory, to be made on the basis of sound fiscal policy. Money is loaned and invested based on a variety of factors such as credit worthiness, risk, and potential return on investment. Political considerations are not ordinarily a part of the equation but once the Government enters the picture, politics automatically becomes a factor. With the Government involved the potential for credit extensions and the allocation of capital being affected by political considerations is increased. Government assuming a position of ownership in private financial institutions increases the likelihood that decisions by said institutions will be subject to the persuasions of powerful legislators who have the interests of their favorite projects or their legislative district in mind and not the general welfare of the financial institution. Once again, it is the taxpayers' money that is at risk and not the money of the individual political leader. It is always easier to take risks with someone else's money.

If the opinion of experts who predicted that widespread bank failures would have caused a credit freeze were correct, the bailout provisions would have made sense. The continued extension of credit is a necessary component of transacting business in the American economy and the economy could not withstand a prolonged credit freeze. If a prolonged credit freeze would have resulted, than the argument for a bailout is made much stronger and allowing the application of the FDIC protections and the operations of the bankruptcy code make far less sense. Unfortunately, however, there is no empirical evidence that strongly supports the opinions of the experts who predicted a credit freeze (Simons). The market was not allowed to determine the fate of the financial institutions that had exercised unsound fiscal policies. Instead, government intervention through the bailouts distorted the situation. There is a distinct possibility that the financial markets may have been made healthier if the Government had allowed the process to operate like it was designed and allowed the financial institutions in question to fail.

It is quite possible that a brief credit freeze may have occurred if the bankruptcy approach had been adopted and the credit market, in general, would have been adversely affected by the filing of bankruptcies by a number of financial institutions but the question is: Did these possibilities justify the bailout actions taken by the U.S. Government? Did the circumstances give rise to the Government's taking such a drastic approach?

The reality is that the housing market in the United States, which was the major contributing factor in the poor financial condition of many of the financial institutions, needed an adjustment. The housing industry was suffering from overinvestment and prices had spiraled much too high. In order for the American economy to remain healthy an adjustment in the housing industry was necessary. The industry needed restructuring (Case). This restructuring required less investment in residential housing, a decline in housing prices, and less mortgage activity by banks and other lending institutions. An economic recession was likely but it would have forced the financial and housing industries to re-adjust and a more normal, and healthier, condition to exist in America. There would have been some temporary hard times but the hard times would have been felt most severely by those who should have felt the hard times and not by the taxpayers who ultimately shouldered the burden. Again, it should have been the investors in the failing institutions who should have borne the loss and not the taxpayers.

Interestingly, the bailout may have impacted the credit market as greatly as any potential bankruptcies might have (Unterman). The announcement and ultimate application of the bailouts likely scared the credit markets as it caused fears to develop that the economy was on the verge of collapse. It caused many banks to hold onto unprofitable investments as they recognized that the Government was going to rescue them from them anyway. Meanwhile, the healthy financial institutions took little or no action waiting for the uncertainty over the effects of the bailout to play out. During the weeks proceeding the proposed bailout financial institutions were waiting to see how much, what form, for whom, and when the bailout was to occur. Once the bailout occurred, the same institutions waited to see what the effects might be. The practical effect of both situations is that a sort of economic stagnation set in as financial institutions, both those that were healthy and those that were not, took little or no action based on the uncertainty of the market. The result was that credit freeze that was feared by experts in the days before the bailout occurred anyway but not because of failing institutions but because of natural market conditions.

Adding to the fuel to the fire in the argument against bailouts was the reaction of the financial industry once the bailouts had been received. The purpose of the bailouts was to rescue the industry from total collapse. It was argued that the industry was "too big to fail." Yet, once the dust had cleared, big financial institutions on the brink of collapse began announcing that they were paying huge bonuses to the very individuals who just a few weeks earlier had put the country on the brink of a depression or worse and that they were buying luxury items such as the $50 million jet bought by Citigroup (New York Times). These occurrences did not sit well with the taxpaying public and what was even more upsetting were the excuses and explanations offered by the industry for taking these actions.

The actions of the financial industry in granting the bonuses and making extravagant purchases and their subsequent dismissive comments toward the public in response are an indication of how out of touch the elite class in America is with the bulk of American society. Such class possesses an attitude of entitlement that is pervasive and that causes a further feeling of isolation between them and the general public.

The banking industry would like to believe that the general public is simply too unsophisticated to understand why they must pay huge bonuses to the very people who caused the conditions that necessitated the bailout in the first place. Such arrogance is unacceptable (Taibbi). The public is not confused and does not fail to understand how the money is being used. The public is fully aware that the very same behavior that blinded the financial industry to what was occurring in the market place that helped to nearly destroy the nation's economy, is still the norm on Wall Street and other financial centers throughout the nation. It is no wonder why the public is so outraged with the bailouts.

The actions taken by many of the financial institutions who were the beneficiaries of the bailout following the Government's saving efforts are similar to what has been taking place for many years. Banks and other financial institutions have been rewarding their top executives in such fashion based on phantom profits for decades and, in the process, the industry has been encouraging further irresponsibility. Now, after virtually bringing the nation to an economic standstill, they have reverted to their old behaviors without missing hardly a beat. They repay the largesse of the American public by showering their executives with million dollar bonuses while the rest of America suffers through near double digit unemployment. The same executives who lost billions for their companies are being rewarded with the same million dollar bonuses that they always received. Bonuses paid with taxpayer money.

This situation is not just poor money management it is insensitive and arrogant. Such behavior would never be accepted in any small business or in any individual home so why should it be acceptable in our nation's largest institutions? The argument was suggested that the financial industry was too big to fail but it should have been that it was too big not to fail. It was one thing for the industry to adopt a financially irresponsible position by pumping up the subprime market with junk loans and phony collateralized debt and distributing million dollar bonuses when times are good but it is an entirely different matter when the country is in economic crisis and they are using taxpayers' money.

The United States continues to suffer from a lack of confidence. This lack of confidence continues to stifle economic conditions in the United States and financial industry figures point toward this lack of confidence as the cause of economic stagnation. The reality is that these individuals do not get it. They do not, and have not, assumed any responsibility for the situation that the country presently finds itself. They do not comprehend that the lack of confidence is really a lack of confidence in our nation's financial institutions. A recent study released by the Edelman Trust Barometer indicates that the public trust in business dropped 20% in the year following the bailout and is at a lower level than in the aftermath of Enron, the dot-com bust or 9/11. The study reveals that only 17% of Americans trust the information provided the public by the nation's leading CEOs (Edelman Trust Barometer). Edelman CEO Richard Edelman states: "Our survey confirms that it's going to be harder to rebuild our economies because no institution has captured the trust that business has lost -- trust is not a zero-sum game. Business must recast its role in society and move beyond simply generating return on investment to its shareholders. It must partner with government and other institutions to assume societal responsibilities (Edelman Trust Barometer)."