FROM ISSUE NUMBER 2 ~ WINTER 2010 GO TO TABLE OF CONTENTS
Too Big Not To Fail
The catastrophe that struck America's financial system in 2008 was not inevitable. Rather than a failure of markets, it was a failure by government to understand its proper role in markets — and the product of an unwise (and unnecessary) abandonment of a sensible system of rules and boundaries that had served American finance well for six decades.
Beginning in the 1980s, and continuing over the quarter-century that followed, Washington afforded the world of big finance a terrible luxury: freedom from the fear of failure. Managers and lenders at financial companies came to understand that the larger and more complex their firms got, the more immunity from market discipline they would enjoy — since they could depend on government guarantees when necessary to protect the broader economy from their mistakes. The government thus countenanced and subsidized an untenable financial system. And it inevitably got more of what it paid for: reckless risk building up to disaster.
The errors laid bare by the financial crisis clearly call for regulatory reform. But in designing that reform, we should avoid the temptation to seek heavy-handed new approaches — and should instead look to the long-term success of the system of rules whose decay brought about the crisis.
THE OLD RULES
It is easy to abuse analogies between the recent crisis and the Great Depression, but such analogies really are helpful in the arena of financial regulation. The searing experience of the late 1920s — and the Depression that followed — showed that the world of finance, if left completely unrestrained, can threaten the free market itself. In the 1920s, as in the past decade, bankers, corporate executives, and investors expected only more good times — and acted accordingly. They borrowed against every last dollar of expected future profit and then some, leaving themselves no cushion if those future profits slipped even slightly. To wring ever more money out of tomorrow's earnings for today, these titans designed financial instruments many magnitudes more complex than straightforward stocks and bonds. And they were left free by the government to do it.
Most significantly, banks and investment firms lent freely for the purpose of making bets on stock securities. The lending allowed the fevers of short-term speculation to affect credit creation — the long-term business of borrowing and lending. Borrowing and lending are vital to any healthy economy, because some companies will always need to borrow, at least modestly, in order to grow. Contaminating credit creation with excessive speculation, then, made the entire economy vulnerable to a financial crisis. But bankers simply didn't understand the risks that they were taking, and no one forced them to confront those risks. "Young men thought they could do anything," Albert Gordon, an executive who had helped rescue the Wall Street firm Kidder Peabody from the depths of the Great Depression, later said.
When something finally went wrong, starting in 1929, it wasn't only the rarefied financial world that suffered. The bankers had used the public's savings — the hard-earned dollars of regular Americans — as fuel for their financial experiments. People stopped trusting their neighborhood banks, which fell victim to the crisis. And without customer deposits to lend out, surviving banks couldn't make new loans or recoup their losses on old ones. The infrastructure of money and credit disintegrated.
It took a decade for the economy to recover from the shock that American finance had dealt it. During the 1930s, President Franklin Roosevelt and his policy wonks certainly committed policy errors that contributed to the length and depth of the Depression. But they also designed regulations to protect financiers from themselves and, more important, to protect the economy from financiers' future mistakes.
Because failing banks had helped cripple the economy, policymakers developed a mechanism — the Federal Deposit Insurance Corporation, created by the Banking Act of 1933 — to allow bad banks to fail in an orderly fashion without imperiling the rest of the economy. And when banks did fail, FDIC guarantees of small banking deposits assured ordinary citizens that they wouldn't lose their savings. These regulations made it less likely that masses of people would again suck the economy's lifeblood — money and credit — out of the banks. Failed banks would still go out of business, but the economy would not suffer needlessly in the process. Market discipline would continue to operate on banks, but the core system of money and credit would retain the public confidence it needed to function, particularly in times of economic woe. The government would provide a buffer between banks and the public to protect against panic.
Financial experts quickly came to understand the importance of orderly bank failures. In 1934, the New York Times reported that the then-chairman of the board of the Federal Reserve Bank of Chicago, Eugene Stevens, told delegates of the American Bankers Association that the cleansing of the American banking structure of "the parasites of occasional incompetency and dishonesty" in the previous year and a half had put it in the strongest position of safety and good management. A year later, many former opponents of the FDIC had changed their minds and embraced banking insurance.
In the same Banking Act of 1933, Congress also forced financial institutions to decide whether they wanted to be in the securities business or the banking business, thereby separating the relatively sober world of long-term bank lending and borrowing from the often frenzied world of underwriting and trading stocks and bonds. This separation gave commercial banks some insulation (but not immunity) from the short-term shocks — whether exuberant optimism or abject pessimism — of future economic cycles.
Wisely, Washington did not entirely banish risk-taking from the financial world. The Roosevelt administration understood that financial sophistication had helped drive American economic growth after World War I, attracting the world's money to American shores. Instead, policymakers imposed clear, consistent limits on risk-taking in the securities business, which remained freer than the banking business. New regulations prohibited securities firms and their customers from borrowing excessively to purchase securities, whose values could swing wildly. These restraints on speculative borrowing reduced the risk that debt supported by securities wouldn't be repaid if the value of the securities plummeted, thereby reducing the risk of dangerous strain on the financial system.
Meanwhile, through the Securities and Exchange Act of 1934, the government also imposed an obligation of full and fair disclosure on the securities industry. The new law required companies that wished to raise money by selling stocks or bonds to the public to explain — soberly, clearly, and regularly — the financial, business, and economic risks that the companies and their investors faced. The public could then make investments with open eyes.
Taken together, these measures sought to protect the economy from risk without eliminating it entirely, and so to allow for financial experimentation and growth while averting panic and financial collapse. Yet even in its chastened state, Wall Street often reacted violently to these new requirements and regulations. "The financial liabilities imposed upon practically every person connected with the creation and distribution of new issues are proving to be serious obstacles in the way of important and necessary financing by reputable concerns," declared the Chamber of Commerce in 1933, after the first major securities bill became law. It took years for the White House to convince the business and financial sectors that the new regulations were permanent and wouldn't be quietly lifted once the crisis was over.
Over time, however, the new laws and rules governing banking and markets succeeded. With the protections these regulations provided, bad banks could fail and bad ideas could die, allowing markets to discipline the financial world without unduly harming the economy. Armed with basic facts available to everyone, investors could take risks in pursuit of profit and would suffer losses if their expectations proved wrong. Automatic financial stabilizers — like limits on borrowing to buy stock — helped check irrational exuberance.
Because these Depression-era regulations encouraged free markets rather than smothering them, they served the country well for more than half a century — helping to propel American capital markets to even greater dominance after World War II. The world's investors knew that their wealth was safest in America. But in the 1980s, this regulatory infrastructure began to decay — and financial companies gradually grew so large, complex, and globally interconnected that they broke through the old rules' capacity to impose economic discipline. Washington did not understand the implications of this change — which insulated some companies from important market forces — until it was too late. The financial industry, buoyed by an implicit government subsidy, became an even stronger force in Washington with its lobbyists, campaign contributions, and even cultural influence. It became harder and more politically costly for policymakers and regulators to rein in the industry's power.
Through a series of discrete incidents that over the years added up to a dangerous pattern, regulators and elected officials signaled to the financial world that the biggest and most complex players would be immune from failure — and so could take all the risks they wanted. In 1984, the government stepped in to rescue a large commercial bank, Continental Illinois, which had reached the brink of insolvency through a combination of bad loans and funding liquidity risk. Confronted with the demise of one of the nation's largest banks, the FDIC extended protection not just to the bank's insured depositors but also to all its other lenders — including big corporate depositors whose accounts exceeded FDIC limits — as well as to global bondholders.
The event proved a watershed, setting a now-familiar precedent. It also introduced a new phrase into the lexicon: As regulators explained their decision, they argued that the bank was simply "too big to fail."
The break from normal practice that the bailout represented divided the Reagan administration. Donald Regan, the Treasury secretary, found the intervention troubling: "We believe it is bad public policy, would be seen to be unfair..., and represents an unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy," he wrote in a memo to his colleagues. But the White House, by offering its quiet support despite Regan's objections, agreed implicitly with the regulators' compelling argument that the only other choice was to "risk worldwide financial havoc."
Big, complicated financial institutions, then, had begun to outgrow the government's ability to enforce the market's verdict by shutting them down, since too much was at stake for the economy if they went under. But the government did little to address this new problem, and in fact made it worse. Uninsured lenders to big banks no longer worried that they would lose their investments; the government would intervene if things spiraled out of control. As a result, financial innovations proceeded without the natural checks and balances of market forces. Banks became adept at turning their insulation from disorderly failure into insulation from market discipline.
Innovations in finance, mostly in the world of credit, began to blur the 1930s-drawn line between traditional banking and the securities industry. Financial firms learned how to turn long-term debt, such as corporate bonds and mortgages, into tradeable securities. In doing so, they made the vital business of credit creation more vulnerable to short-term fluctuations between optimism and pessimism.
The financial world also found ways to avoid the Depression-era regulations that restrained financiers from borrowing unreservedly to speculate on stocks, by creating financial instruments in the derivatives world that escaped the regulations. Often, such innovations also escaped Depression-era disclosure requirements. The public and the media, and even regulators, had a hard time identifying, understanding, and quantifying the changes.
In the late '80s and early '90s, financiers' experiments with making tradeable securities out of long-term debt — from junk bonds at investment bank Drexel Burnham Lambert, to mortgage-backed securities at the Askin Capital Management hedge fund — caused miniature financial explosions that Washington should have seen as warnings. Instead, they were regarded as aberrations. Similar eruptions in unregulated derivatives competed for attention just as vainly.
In 1998, a combination of the two — unbridled derivatives creation and speculation on long-term credit — led to near-disaster. An obscure hedge fund, Long-Term Capital Management, proved that even though it was not a large bank (or a bank at all, actually), it, too, was too complex to fail through the normal bankruptcy process. The fund's opaque endeavors, enabled by unregulated borrowing and involving nearly every major Wall Street institution, seemed likely to result in a calamitous chain reaction — and the Federal Reserve Bank of New York orchestrated a bailout funded by its member banks.
Three years later, the Enron scandal — in which the energy giant used complex financial deceptions to create the illusion of profits — demonstrated how easy it was to use modern innovations to create credit out of nothing but blind trust. The scandal also revealed how eagerly the nation's biggest financial firms had enabled such spurious credit creation. Enron's collapse showed how quickly everything could fall apart once the trust vanished.
The government treated the failures that the increasingly fragile system served up from time to time as isolated matters, best addressed with one-off, extraordinary solutions ranging from weekend financial rescues to criminal prosecutions. Mainstream thinkers said that financial markets didn't need much regulation. Alan Greenspan, who took the helm of the Federal Reserve in 1987, told lawmakers and the public that financial companies, powered by a rational motive not to lose money, could police themselves and one another. Their use of new financial innovations, he argued, would decrease risk, not increase it.
The financial world operated ever more freely under a long-running illusion that elegant modern theories and technologies made the creation of nearly all manner of credit — lending to corporations and consumers alike — perfectly safe. Yet with each new innovation, financiers left themselves even less room for error should the tiniest thing go wrong (just as they had in the '20s). They also left themselves increasingly reliant on that ultimate guarantee (and market distortion): government rescue.
Thanks to this illusion of safety, financiers were able to manufacture vast amounts of debt, and they encouraged Americans to become more dependent on borrowing — whether on credit cards or against the value of their homes. In this way, ordinary Americans, too, became more vulnerable to any eventual sharp decline in the availability of credit. Bankers had accomplished the opposite of what they, and regulators, had thought they were doing: They hadn't created safety out of danger, but danger out of safety, eventually turning the most sober investment that many people make — the purchase of a home — into a risky bet.
The financiers made mortgage lending seem risk-free to many investors. As a result, money became available to anyone who wanted to get a mortgage for any house, regardless of his ability to repay the debt. This, in turn, led to the ultimately calamitous housing bubble: When more money is available to buy something, the price of that item goes up. And once the risks emerged and the easy credit tightened, the plunge proved even more disorienting than the rise.
The ensuing financial catastrophe reminded us of something that we had forgotten. When financial markets are too free of rational regulation — and worse, free, by virtue of an implicit government guarantee, from the threat of failure — they will eventually destroy themselves, and damage everything around them.
Starting in 2007, the financial world began to shatter its own carefully constructed illusions. One financial institution after another collapsed in swift succession. By 2008, sober-minded people feared that the government, with all its modern knowledge and powers, would not be able to prevent another Depression. To avoid the severe economic disruptions that cascading failures of financial firms would cause, the government, on behalf of taxpayers, effectively assumed all the risk in finance.
Private investors, having so thoroughly miscalculated the risk that they had freely undertaken, no longer wanted any part in the system. Policymakers from both parties felt that they had no choice but to use trillions of taxpayer dollars to protect failed firms and their lenders from tremendous losses. Much of the financial industry's survival now depended on its ability to hold the economy hostage.
THE MARKET AT WORK
The popular narrative after the financial system's collapse held that capitalism had failed. Citigroup, a global emblem of American finance with branches from Buenos Aires to Paris, seemed the perfect symbol of this failure. But capitalism didn't fail; companies did — after having adopted the idea, en masse, that any loan, bond, or other bank asset could be sliced up and turned into an instantly liquid, priceable, and tradeable security, with all its risk quantified and distributed scientifically to parties willing and able to bear it.
What Citi's fate in fact testified to was the enduring power of markets. By the end of 2008, Citigroup and other banks, in concert with the government, had tried for more than a year to hide the real losses that were starting to seep through the industry's balance sheets and toward the government's books.
And despite all the efforts of government and corporate leaders, the markets still showed that something was very rotten at companies like Bear Stearns, Lehman Brothers, Merrill Lynch — and, finally, Citigroup. While financial executives and government officials kept insisting that everything was under control, the markets determined that the opposite was true, forcing firm after firm to capitulate to reality.
The government was the last entity to do so. Throughout 2008, then-Treasury Secretary Henry Paulson and other federal policymakers still seemed to think that if the government handed out enough capital to a big enough group of banks, it could avoid revealing which of the largest surviving firms were actually desperate for the money. The market saw through the smoke screen, forcing a bigger, individual bailout of Citigroup.
In truth, markets had been trying to work since the fall of Continental Illinois in 1984. They had desperately been sending signals that the modern financial system was beset by untenable risks that required a renewal of long-held regulatory principles. But government bailouts, and repeated failures to fix regulations in their aftermaths, thwarted the markets' generation of genuine, accurate information at every turn.
The world's biggest financial and political powers couldn't hide the truth forever. In both of its precedent-setting bailouts — Continental Illinois and Long-Term Capital Management — the government's goal was to avoid a wholesale breakdown of the entire financial system. But two and a half decades after the Reagan administration began the too-big-to-fail policy, the entire financial system failed anyway.
Our economy is now paying a heavy price for our failure to prudently regulate the markets. Government's extraordinary interventions have given it great power over the financial industry, eclipsing the private sector in one of the core functions of a free economy: deciding which people, companies, and projects deserve investment, and on what terms.
This development is a serious threat to the market economy. The financiers and investors who decide which businesses, new and old, are worthy of investment must make decisions based on their judgments of the risks and rewards involved. They will not judge effectively if they have an implicit understanding that the government will save them from their bad decisions. They certainly cannot do so if they have an eye toward the political concessions that a government guarantor, implicit or explicit, inevitably demands.
Washington cannot solve this problem simply by extricating itself from its direct role as lender, guarantor, and sometimes part owner of financial firms as the acute phase of the crisis continues to ease. Financial companies and their own lenders will know that, absent credible regulations to prevent such a step, the government will again save the industry in the next crisis. Such distortion of market incentives harms the private sector's free assumption of financial and economic risk, which powered the American economy to its industrial and technological heights and has helped hundreds of millions of people around the world escape poverty.
The government's response to the financial crisis has further harmed free markets by undermining the global perception that investors in America can expect fair treatment according to a predictable and consistent rule of law. Washington has used its new leverage over the financial sector to intervene arbitrarily in cases like the Chrysler and General Motors bankruptcies, upsetting centuries-old precedents guiding the treatment of creditors to bankrupt firms.
The damage is done. But the nation must make sure that it does not turn these recent episodes — which show the world that we don't trust markets to work the way they should — into precedents as well. At the height of the financial crisis, American leaders' loss of faith in free markets was so troubling that Mart Laar, the former prime minister of the once-communist state of Estonia, took to the pages of the Wall Street Journal to remind readers that the biggest threat to the economy was the perception that markets had failed. "Actually it is not markets that have failed but governments, which did not fulfill their role of...creating and guaranteeing market rules," he wrote. If America fails to understand this truth, it may lose its status as the nexus of the world's wealth, as investors worry that personal contacts and political power matter more than laws and rules.
The biggest peril that the economy now faces is that Washington will not muster the political willpower to do its job — and to keep doing it — as Wall Street creates new ways to escape limits on risk-taking. Solid regulations would of course require an adjustment period, as happened in the 1930s; they could slow the economy in the short term. And it is not clear that the current administration or the opposing party will let people take pain now in exchange for long-term prosperity, as President Reagan did when he allowed Federal Reserve chairman Paul Volcker to hike interest rates in the early '80s to break inflation.
There is much cause to worry that the financial world and the government together may just try to pretend that nothing ever happened. Financial firms may then use cheap money available under the too-big-to-fail regime to try to wring out one last cycle of wealth and postpone the mathematically inevitable adjustment: Americans borrowing less and buying less, and much of the rest of the world doing the opposite.
Washington may also be tempted to go on as before for the same reason it did in the wake of its Continental Illinois and Long-Term Capital Management bailouts. Back then, government regulators and financial executives came to believe: "If we can fix this, we can fix anything." This time around, if the economy allows Lehman's collapse and the visceral fear that it created to recede into history, elected officials and regulators may feel a similar sense of accomplishment. They may convince themselves that they rescued the economy from a new depression — not that they won a temporary reprieve that, without real reform, only increases future danger.
The next time the markets try to correct our unsustainable financial system, as they brutally have tried to do in this crisis, Washington may not be able to pull us back from the brink. With trillions of taxpayer dollars tied up in bad financial institutions and spent on economic stimulus, the federal government will inevitably shortchange needed improvements to America's physical infrastructure, making it harder for private companies to grow. We also risk inflation and the desertion of the dollar just as Social Security and Medicare are laying painful claims on growth.
A financial industry in need of even bigger bailouts after yet another bad cycle could take down with it the federal government's ability to issue bonds affordably. In this event, we would have to revive our economy after having lost the world's confidence and hampered our own ability to grow and prosper.
NEW RULES, OLD PRINCIPLES
The financial crisis should not have come as a surprise. It was the natural result of two and a half decades of decisions and non-decisions that made the financial regulatory system irrelevant. Nor are novel, complicated solutions required to prevent another such catastrophe: The same regulatory philosophy that protected the post-Depression economy, and created the conditions for the prosperity that followed, would have prevented the post-millennial financial meltdown. And this approach can work again, if policymakers apply it to the financial system that exists today.
First, no private company in a free-market economy should be too big, or too interconnected to other firms, to fail. The government must once again create a credible, consistent way in which failed financial firms can go out of business — allowing lenders as well as shareholders to take losses, if warranted — without dragging the economy down with them. This power cannot be vested directly in the Treasury Department, as the Obama administration has proposed; direct executive authority to wind down firms will inevitably render the process too vulnerable to politics. Instead, it should be done through changes in the judicial bankruptcy process for large or interconnected financial firms; or by vesting the independent FDIC with a new power; or through some combination of both.
Second, the government must once again insulate the core economic functions of long-term borrowing and lending from potential short-term excesses. The government can do this by requiring financial institutions to hold uniform levels of capital against all of their investments — cushioning them from some losses — so that firms cannot game the system by structuring some securities to avoid robust capital requirements. Government regulators should also require financial firms that depend disproportionately on short-term lenders for their own funding to hold more capital. (Financial firms that depend too much on short-term capital are particularly vulnerable to a panic, since if their lenders pull their funding, the firms are forced to sell their own holdings at fire-sale prices.)
Third, the government must re-impose clear, well-defined limits on activities such as borrowing for speculation. Financial firms should not be able to make hundreds of billions of dollars in promises with negligible cash down, as the insurance giant American International Group did through unregulated financial instruments called credit-default swaps. Nor should regular Americans be able to purchase homes with zero cash down, leaving them — and their lenders and the economy — unduly vulnerable to declines in the values of those homes.
Last, the government must make sure that markets do not become opaque over time as new financial creations escape existing reporting requirements. Financiers must disclose the scope of their innovations to the public and to investors. Creative financial risk-taking can then flourish within these reasonable limits.
All of these prudent regulations reinforce the first principle — that no one can be made immune to failure — because they would help make the entire financial and economic system more resistant to the inevitable failures of individual companies, as well as to financial-instrument crashes.
A REGULATED MARKET
Such pro-market regulation of finance is essential to our economy's future security. And it is the right response to the public's concerns in the wake of the crisis. Unfortunately, President Obama and Congress are charting a different course, with little constructive criticism from congressional Republicans.
The Democrats would create a regulatory system that formally enshrines the too-big-to-fail doctrine, rather than repudiating it. They would achieve this by giving the Treasury Department permanent new power to lend money to large financial institutions in a crisis, and by officially designating some firms as systemically important — just another term, in investors' eyes, for too big to fail. Such a regulatory system would ensure that finance continues to compete with other parts of the economy on unfair terms — allowing it to remain artificially large at the expense of growth elsewhere, and allowing it to stealthily rack up yet more liabilities for the government.
Ordinary citizens do not share Washington's new distrust of markets. Throughout the financial crisis and the deep recession that followed, they have consistently stood by the ideal of free enterprise. They have opposed bailout after bailout, even those meant to help their next-door neighbors who couldn't afford their mortgages.
Many politicians and executives have misinterpreted public anger as anti-rich and anti-capitalist sentiment. But this citizen outrage is not a reflection of heartless and mindless populism. Ordinary people understand that bailouts have perversely punished individuals and companies that acted responsibly while rewarding some who didn't, creating an incentive to act irresponsibly in the future. Americans can perceive the difference between a government that acts as an honest, transparent referee of fair competition, and one that acts as a guarantor of perceived favorites.
The public has grasped — better than many sophisticated financiers — what healthy capitalism requires. Americans enjoy seeing success rewarded with great wealth, as long as they aren't forced to subsidize failure. Americans don't want their government picking winners or losers in the economy. Just the opposite: The public wants the government to do its job of responsibly regulating financial markets so that those markets can then efficiently manage the private distribution of capital, funding good businesses that power the economy.
Washington must realize that rationally regulating Wall Street does not mean impeding capitalism. As history and recent events demonstrate, such regulation is a necessary condition for capitalism's survival. The nation finds itself in its current weakened position largely because of inadequate financial discipline. While it's sad that we could have prevented the crisis, it's also good news — because it means we know how to prevent the next one.
Nicole Gelinas is a senior fellow at the Manhattan Institute. This essay is adapted from her new book, After the Fall: Saving Capitalism from Wall Street and Washington.