In the past six months the US government, partly through the agency of the Fed and JP Morgan Chase, has rescued no less than four major financial institutions, Bear Stearns, Fannie Mae, Freddie Mac and AIG, at a probable cost to the taxpayer of over $300 billion. A fifth, Lehman Brothers, was allowed to go under. One problem (apart from the philosophical questions surrounding state rescues): in making the decisions as to whether rescue was warranted in each case, Treasury Secretary Hank Paulson went 0 for 5.
In a pure capitalist system there would be no state bailouts – so much is obvious. There would also be a very small state sector, so little temptation for such bailouts, and a highly competitive financial system in which no one institution could grow dominant. In the 19th century British economy, for example, Pole, Thornton, a private London-based bank taking deposits from wealthy individuals and from country bankers went bankrupt in 1825. Since it was among the largest banks of its day, this caused considerable disruption, but there was no question of a bailout.
Indeed, only a few months earlier, at the peak of the 1825 speculative bubble the prime minister Robert, Lord Liverpool had opined on the subject of bailouts in the House of Lords “I wish it however to be clearly understood, that those who now engage in Joint- Stock Companies, or other enterprises, enter on those speculations at their peril and risk. I think it my duty to declare, that I never will advise the introduction of any bill for their relief; on the contrary, if such a measure is proposed, I will oppose it, and I hope that Parliament will resist any measure of the kind.”
Similarly, later in the century, the huge wholesale money broker Overend, Gurney failed in 1866, and the Bank of England notably held back from providing assistance – not least because the Gurneys had been aggressive in their battles against Bank of England dominance only a few years earlier.
The opposite decision was taken in 1890, when the merchant bank Barings got into trouble over its loans to South America. Barings was considerably smaller than Overend, Gurney but established over a century and with the finest political and financial connections (a former Baring partner was currently running Egypt on behalf of the British government.) On this occasion the Bank of England arranged a consortium of leading London banks and bailed out Barings, which survived until further disaster struck a century later.
Thus over the course of the nineteenth century, British official policy on bailouts became established. Size and connections within the system were not the primary factors in deciding whether a bank should be bailed out. Both Pole, Thornton and Overend, Gurney were among the largest financial institutions, and both had very extensive networks of connections: Pole, Thornton with 43 country banks which were its correspondent depositors and Overend, Gurney with the entire money market through short term paper trading.
However their “names” were not such as to cause a crisis of confidence through their failure. Pole Thornton’s business of pure private banking was of only modest importance in the overall economy (even back then, a Rothschilds or Barings bankruptcy, with their domination of international capital markets, would have posed a much bigger problem.) Overend, Gurney had already acquired a questionable reputation through aggressive business practices. Indeed Overend, Gurney, which by the time of its collapse had married dominance in short term money markets with huge investments in unsound private equity deals, bore a striking resemblance to a 2008 investment bank.
On the other hand Barings, although smaller than Overend, Gurney, was among the longest-established and most eminent merchant banks in the City of London. Hence it could not be allowed to fail because its failure would cause a collapse of confidence in Britain’s banking system that could do immense economic and even geopolitical damage.
In the United States, the validity in extreme circumstances of the “too big to fail” doctrine was demonstrated in 1836-41, when the withdrawal from interstate business and subsequent failure of the Second Bank of the United States, as a result of a primitive vendetta by the financially illiterate President Andrew Jackson, caused the worst economic downturn of the nineteenth century. The US continued to follow the principle of no bank bailouts, including through the Great Depression, until the FDIC’s first major bailout, of First Pennsylvania Corporation, as late as 1980. First Penn did not quite qualify under “too big to fail” (it was much smaller than Continental Illinois, which was bailed out four years later) but having been founded in 1782 it certainly qualified on a “name” basis. It also presented little “moral hazard” since it had got into trouble by buying Treasury bonds and failing to recognize that regulatory changes were about to cause its short-term funding costs to skyrocket – the fecklessness here was primarily in the inept fiscal and monetary management of the US Treasury and the Fed.
In Britain, the “level playing field” mantra of the 1986 Financial Services Act caused the decidedly anti-free-market Chancellor of the Exchequer Kenneth Clarke to refuse to bail out Barings in 1995. This was a big mistake, since as in 1890 Barings, while only a medium sized operation was one of the finest “names” in the City. Its collapse caused a general loss of confidence in the London merchant banks, which almost disappeared as independent entities by 2000. The “moral hazard” of a Barings rescue would have been minimal. First, Barings was almost unique. Second, its losses were caused not by its overall business but by the ineptness and dishonesty of a single trader – the remainder of its business was perfectly sound, although clearly its control systems needed attention.
The philosophy of rescue changed with the giddy years of the late 1990s, and the “easy money” atmosphere that surrounded the latter half of the decade. Whereas in Britain Barings had been thrown to the wolves in 1995, in the United States, previously less accommodative to rescues, the Fed in 1998 under Alan Greenspan broke all records for encouraging moral hazard by coming to the rescue of a hedge fund, Long Term Capital Management. LTCM was undertaking an extremely marginal albeit lucrative economic activity, using high-faluting theories that were complete rubbish (however many Nobelists stood behind them) and had no base of retail customers who might suffer from its default. A crash, and the losses that would have resulted, would have had an entirely salutary effect on the arrogant corner-cutters of Wall Street that might have prevented many of the subprime mortgage and securitization excesses of the following decade.
In the 2007-08 crash after a further decade of over-cheap money and spiraling moral hazard the initial tendency was naturally towards bailouts. In Britain the gimcrack Northern Rock empire, a kind of anti-Barings forced into failure within weeks of tighter money appearing, was bailed out by the British taxpayer at enormous cost, without any attempt being made to close it down or even initially to restrain its odious lending practices. Northern Rock was quintessentially the sort of bank that would have been allowed to fail in earlier eras, having no “name” and being hopelessly flawed in its entire business strategy and operations.
In the United States, similarly, the first house to get into difficulties (and hence the one with the worst business practices and the worst case for preservation) “got lucky.” Bear Stearns was over-leveraged, over-aggressive in its pursuit of poor quality and even fraudulent mortgage securitization business, and deserved to fail (though unlike Northern Rock, parts of its business had economic merit.) Instead it was rescued by JP Morgan Chase, at a cost of $30 billion of public money from the Fed. Moral hazard, already high, once again ran rampant.
Fannie Mae and Freddie Mac were institutions that in a well run economy would not exist, but their bailout was in a sense inevitable. Before committing taxpayer funding to the money-pits, Treasury Secretary Hank Paulson should have made it quite clear that he would only do so in order to wind down their operations, sell off their assets and put them out of business as soon as possible. Instead, he declared the status of Fannie and Freddie “too political” when it was in reality the central economic question surrounding their existence. The result was a bailout that will most probably devote hundreds of billions of taxpayer money to subsidizing the least deserving mortgage borrowers (those who had been the most financially feckless) before returning Fannie and Freddie to the “private sector” to engage in yet further gross distortion of the US economic system. The only saving grace is that sorting them out will take a considerable time, by the end of which the cheap money period will be over and extravagant bailouts may be treated by the electorate with the outright hostility they deserve.
Then we come to last week’s invalids, Lehman Brothers and AIG. AIG, first was an insurance company that for many years had been run by salesmen instead of risk managers, and had aggressively muscled its way into the most opaque and least actuarially sound areas of the derivatives business. While its mainstream insurance policies were sound (and will doubtless find buyers very quickly) its capital market businesses were rotten to the core, with aggressive profit management and questionable accounting obscuring whatever true value the businesses might have had. AIG’s capital market operations deserved to put out of business as quickly as possible, and certainly did not deserve to be rescued with $85 billion of taxpayer money. Moreover, AIG’s aggression and corner-cutting had always been so obvious that sensible wholesale counterparties avoided it; its bankruptcy would thus have reinforced the principles of sound risk management.
Conversely Lehman Brothers, while not as ancient and eminent as Barings, was a business with an excellent “name” that was mostly perfectly sound and fulfilled a valuable economic function in investment banking. Larger than Bear Stearns, Lehman was in terms of balance sheet only modestly smaller than Fannie, Freddie and AIG. By allowing it to fail Paulson made it almost inevitable that the other investment banks, Merrill Lynch (already taken over by Bank of America) Morgan Stanley and even Goldman Sachs would be unable to survive long as independent entities. The failure of a substantial business which sensible counterparties would have trusted reduced the rationality of global capital markets, thereby increasing their “random” risks for all participants. The cost to the global economy of Lehman’s failure is likely to exceed by a substantial factor the cost of AIG’s rescue; already a $21 billion utility, Constellation Energy, has been forced “at gunpoint” into a merger on very unattractive terms for its shareholders.
The principles of sound bailout policy are clear. Bailouts should be very rare. They should be confined to institutions that are important to the market as a whole, that have a long and eminent track record and the great majority of whose business is sound. Fly-by-night operations, or those with fraudulent or excessively aggressive business models, should be allowed to go to the wall, in order to discourage the piranha community.
By ignoring those principles, as both Britain and the US have in recent years, the quality of both countries’ financial sectors has been spectacularly degraded, and the costs and risks of doing business in both environments have been increased. It is likely that in the next economic upswing the nexus of the world’s financial activity will move to a more competently run location.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)