Too Big To Fail Vs. Moral Hazard The False Conflict
By the early fall of 2008, the shaky situation of America’s financial system and economy was becoming increasingly apparent. After Lehman Brothers, a well respected 158 year old firm made the largest Chapter 11 bankruptcy filing in US History, even President George W Bush described the events as “painful” in a Rose Garden Speech. It hasty became apparent that in order to prevent more financial firms from collapsing, especially American International Group (AIG) and Citigroup, government support would be necessary. The government support eventually came from the Emergency Economic Stabilization Act of 2008, with the primary vehicle for propping up the at risk institutions being the Troubled Asset Relief Program (TARP), which was administered by the treasury.
Although the final version of the Emergency Economic Stabilization Act of 2008 passed in the Senate by a vote of 74 to 21 (with both then presidential contenders Obama and McCain supporting it) and in the House by a vote of 263-171, on October 1 – October 3 of 2008, the bill failed to pass on the first vote in late September. A large reason the Emergency Economic Stabilization Act failed to pass the house on September 29, 2008 (causing a 700 point + plunge in the Dow Jones Industrial Average the next day) was the debate over moral hazard. Moral hazard, according to the Wall Street Journal, creates “the tendency to occupy on more risk because (government) help is likely if a scheme tanks”. In other words, the factual hazard of bailing out a bank creates a situation where, in the future, a financial institution that believes it will get bailed out if things go wrong is more likely to retract more risk, possibly leading to more bailouts in the future. On the other side of the debate over the Emergency Economic Stabilization Act of 2008 was the understanding of Too Big to Fail, which, according to the Federal Reserve Bank of Atlanta means a firm has such influence “on financial stability and the valid economy” that allowing it to fail would create further crisis in the economy.
While Too Big to Fail and Upright Hazard were pitted against each other during the 2008 debate over how (or if) to rescue the financial system, there are elements of truth in both of them, and both raise issues that need to be addressed. There certainly are Moral Hazards in practicing Too Ample To Fail. Too Big To Fail is not a new concept, although its importance has certainly been elevated to novel heights. It was practiced during the Great Depression when “Roosevelt signed the Banking Act of 1933 [sic], which created the Federal Deposit Insurance Corporation, and a ‘temporary’ deposit insurance fund” (Moyer). Despite (or because) the practice was used then, and then again in another gain during the Continental Illinois bank liquidity crisis of 1984, it was necessary to spend it again in 2008. Moral Hazard is a problem that must be addressed – after one bailout, an expectation has been created, and history shows that the expectation does indeed lead to future bailouts. However, while Moral Hazard is an important problem, it alone doesn’t solve the problem of what to do when a bank is indeed Too Big to Fail. For example, during the financial crisis of 2008, Citigroup had FDIC insured deposits of at least $126 billion, according to Portfolio.com. On the other hand, the total cost of TARP is now estimated to be $89 billion, according to a April 2010 Reuters article. So, the cost of allowing Citigroup to fail and then paying out FDIC insurance would be more than the cost of rescuing it, AIG, and saving the entire financial system from further damage.
Since there are financial firms that are Too Big to Fail (letting Citigroup fail – not counting the enormous ripple effects, would cost more than saving it), and since Moral Hazard is an equally real problem, the most important discussion is not whether to avoid Moral Hazard or save banks that are Too Tall to Fail, but on how to either prevent banks from becoming Too Big to Fail or prevent banks that are Too Big to Fail from taking risks that could cause them to fail. Conception how to prevent firms that are Too Big to Fail from reaching the precipice requires understanding what lead to the last financial crisis.
The main causes of the last financial crisis were the sub-prime mortgages and the culture that encouraged them, as well as the risky dealing on Wall Street based on the bundles of sub-prime mortgages (underestimating risk). With articles appearing in magazines as prominent as Time in September 2006 titled, “Does God Want You To Be Rich? ” and the growth of what the Atlantic Magazine termed the “prosperity gospel” found in many mega-churches, coupled with Bush’s Ownership Society that he championed during the 2004 re-election campaign (Karabell), more and more Americans were encouraged to buy houses, at record prices during a housing bubble, that they could not afford. Their mechanism for purchasing them was often sub prime mortgages – essentially adjustable rate mortgages that required little or no down payment and that did not require a strong credit history or extensive income checks by banks. So, the first part of the jam was making too many of these risky loans in the first place. The second part of the problem was how the financial industry dealt with sub prime mortgages once they were made. The financial industry never correctly recognized the high degree of risk associated with the loans. According to Thomas Friedman in his book, Hot, Flat, and Crowded, “After 2005, subprime mortgages went from 2 percent to 95 percent of the consumer loan packages that AIGFP (Financial Products) was guaranteeing, without maintaining anywhere near the capital to cover them if there were widespread defaults” (Friedman 16). In 2007, an AIG executive told shareholders on a conference call that, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would stare us losing $1 on any of those transactions (the supposedly safe bundled sub-prime mortgages)”.
So, the last financial crisis was caused mostly by underestimating risk (hence the firms that were Too Big To Fail taking to much of it) and making what in hindsight seem to be reckless bets (believing that sub-prime mortgages were very score investments). The key question is how government regulators can ensure that, in the future, risks are held at adequate levels so that the dilemma between Moral Hazard and Too Big To Fail doesn’t occur in the first place. The financial reform bills working their intention through Congress are a start. Among other things, the Senate Bill, according to a May 21, 2010 Wall Street Journal article, establishes, “a new council of ’systemic risk’ regulators to monitor growing risks in the financial system”, “empowers the Federal Reserve to supervise the largest, most complex financial companies to ensure that the government understands the risks and complexities of firms that could pose a risk to the broader economy” and “allows the government … to seize and liquidate a failing financial company in a blueprint that protects taxpayers from future bailouts”. There is no doubt that after the last of many financial crises, government financial regulators need more power. This bill will give them the jaws they need to grow teeth, but only time will tell if the teeth they grow will be sharp enough, large enough, and strong enough to prevent the next financial crisis before it becomes an unsolvable dilemma between banks that are Too Big To Fail and reinforcing Moral Hazards.
The last financial crisis was one in a string of crises that pitted “Too Great To Fail” against “Moral Hazard”. Those claiming that banks were Too Immense To Fail claimed that the damage to the financial system would be too great not to prop up failing firms. Opponents of this approach claim that it leads to a vicious cycle where, since expectations of a future bailout are set by the last one, there is an endless expose of ample firms taking wild risks, leading to a situation where gains are privatized and losses are socialized. Both of these assertions are legitimate, grounded in facts, and hold relevant truth that should not be ignored. By the time a firm is in grief, Too Big To Fail, and the resulting Moral Hazard comes into play, no pleasurable options are left and stakeholders and policy makers are left to choose between the least of two evils (a bailout), almost guaranteeing a future one. While the unique financial reform legislation in Congress is a commence, there is no way to tell yet whether regulators will rise to the challenge. The only workable long term solution that does not cause short term afflict or a very negative long term precedent is vigilant and aggressive regulation so that large financial institutions don’t reach the precipice.
Sources
Branigin, William. “Bush: Economy Strong Enough to Handle Turmoil.” Washignton Post Web. 15 Sep 2008.
Friedman, Thomas. Hot, Flat, and Crowded. 2nd. New York: Picador, 2009. 16. Print.
Gaffen, David, and Annelena Lobb. “The ‘Moral Hazard’ of Being ‘Too Big To Fail’.” Wall Street Journal 10 July 2008: Web. 24 May 2010.
Hitt, Greg. “Senate Passes Finance Bill.” Wall Street Journal 21 May 2010: Web. 24 May 2010.
Karabell, Zachary. “End of the ‘Ownership Society’.” Newsweek 11 Oct 2008: Web. 24 May 2010.
Moyer, Charles. “‘Too colossal to fail’”: rationale, consequences, and alternatives – banking.” Findarticles.com. FindArticles, Jul 1992. Web. 24 May 2010.
Rosin, Hanna. “Did Christianity Cause the Crash? .” Atlantic 10 Dec 2009: Web. 24 May 2010.
Salmon, Felix. “Citi’s Achilles Heel: Foreign Depositors.” Portfolio.com 14 Nov 2008: Web. 24 May 2010.
“U.S. bailout cost seen lower at $89 billion: report.” Reuters 12 Apr 2010: Web. 24 May 2010.
Van Biema, David. “Does God Want You To Be Rich? .” Time 10 Sep 2006: Web. 24 May 2010.
Wall, Larry. “Too Big to Fail: No Simple Solutions.” Center for Financial Innovation and Stability. Federal Reserve Bank of Atlanta, Apr 2010. Web. 24 May 2010.
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