Gary Stern on Too Big to Fail
Oct 5 2009

Gary Stern, former President of the Minneapolis Federal Reserve Bank, talks with EconTalk host Russ Roberts about Stern's book, Too Big To Fail (co-authored with Ron Feldman), a prescient warning of the moral hazard created when government rescues creditors of financial institutions from the consequences of bankruptcy. Stern traces the origins of "too big to fail" to the rescue of Continental Illinois in 1984 and then follows more recent rescues including those of the current crisis. The conversation explores the incentive effects of such rescues on the decision-making by executives in large financial institutions. The discussion concludes with Stern's ideas for alternative ways to deal with large, troubled financial institutions.

Anat Admati on Financial Regulation
Anat Admati of Stanford University talks with EconTalk host Russ Roberts about ways to make the financial system more stable. In particular, Admati explores the implications of higher capital requirements. She argues that current policies subsidize leverage--high levels of debt...
Richard Fisher on Too Big to Fail and the Fed
Richard Fisher, President of the Federal Reserve Bank of Dallas, talks with EconTalk host Russ Roberts about the problems with "too big to fail"--the policy idea that certain financial institutions are too large to face the bankruptcy or failure and...
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Oct 5 2009 at 9:56am

Outstanding interview, thanks!

Mads Lindstrøm
Oct 5 2009 at 2:54pm

Hi Russ,

Thank you for yet another interesting podcast.

You seem to think it is impossible to recreate Fannie Mae, in such a way, that it is extremely unlikely to fail.

Being Danish, I would like to point you to the Danish system for mortgage lending. It has existed for more than 200 years without any bankruptcies (of mortgage originators). Geoeg Soros is advocating for it here . Mexico choose to pattern their system on the Danish system, after reviewing different models for financing housing .

My point is more than national pride, it is to suggest that if we, in Denmark, can have stable housing financing, then why not America? It seems that you are wrong, when you expect heavily regulated mortgage financing to inevitable result in trouble.

The Danish system is based on covered bonds. Wikipedia describes the Danish system better than I can including a comparison to the American system.

Personally, I think the two most important features are:

* Transparent by using standardized products
* Conservative and enforced rules (by government) for how much anybody can borrow. Currently you can only borrow 80% of value of house (it has been so for as long as I can remember).

To be honest, the system is not perfect. Our politicians choose at the hight of our own housing bubble to liberalize the lending, such as introducing loans that were temporarily (max 10 years) payment free. Also, variable interest-rate loans were introduced. I am not really against some liberalizations of our system, but one really should not do it when house prices are already very high.


Mads Lindstrøm

Oct 5 2009 at 3:03pm

I’m not sure I really understood the conclusions you guys reached here.

I still don’t understand why we’re not talking more about limited liability. I feel like people are afraid to question it for fear of sounding crazy. What’s crazy to me is that people can get together and contract away all their responsibility. I can’t write a contract with myself that absolves me of my responsibility for a future crime or debt… why does that change when a bunch of people get together?

Maybe I’m missing something?

Oct 6 2009 at 7:43pm

Overall, this was an interesting podcast. I came away more confident that the too-big-to-fail moral hazard certainly existed. If it didn’t, it certainly does now. I think I can summarise the argument fairly simply:

How the moral hazard works:

Lenders expect to be covered Lenders have a rational expectation that they will be covered in a worst case scenario. This is not a sure thing or an explicit promise. But, it is likely enough that they factor it in to their lending rates, they mis-price risk because part of the risk belongs to tax payers.

The price of borrowing money to make a high risk bet decreases Too-big-to-fail companies are able borrow money at rates that do not truly reflect the chance that these will not be repaid in the event of a collapse. As prices decrease, they consume more (loans).

Shareholders/Equity – Shareholders do not expect to get money back in case of failure. Share price will be zero if they fail. The risk of a bad bet cannot go above the total amount of equity they have in the company. However, the reward of a successful and highly leveraged bet is higher then it should be because the cost of borrowing/leveraging is lower then implied by the risk.

The risk/reward situation becomes more attractive Risk hasn’t changed. If the company fails, equity goes to zero.
Rewards have gone up. The cost of borrowing has decreased. This means that for good bets, shareholders get to keep a bigger piece then otherwise. Since they are incredibly leveraged, returns are very sensitive to small movements in the cost of borrowing. Slightly lower costs lead to much greater profits. It is rational to accept risk if you are being compensated for it. Risk can be managed via diversification.

To summarise the summary, the risk to lenders is reduced by the government. This leads to lower rates for borrowers, which is converted via leveraging to greater rewards. Lenders have had their risk reduced. Borrowers have had their rewards increased.

Oct 6 2009 at 11:29pm

Thanks for the summary, netsp. That clears things up a bit.

Oct 7 2009 at 10:36pm

Great podcast, thanks. Would be interesting to revisit in a year or two, when we are not in ‘crisis,’ to see if we have in fact taken any steps ‘to credibly put creditors of these systemic institutions at risk of loss.’

Greg A
Oct 7 2009 at 11:45pm

Great podcast Russ – I enjoyed this one a great deal.

On the issue of moral hazard, I’d just like to add one point: Ignoring moral hazard is easy if you’re not the only one doing it. That is, it’s easier to risk everything if the people around you are doing it.

You’re at Bear Stearns. You’re taking huge risks – but so are your next five biggest competitors. You figure, “if the world goes to hell, we’re going down with everyone else. If we blow up, then so will the next 5 guys. So as long as Lehman, Citi, and Merrill Lynch are doing it, it’s a lot easier for me to justify the risk taking. If we all fail, the government will HAVE to bail us out.”

Barry Kelly
Oct 8 2009 at 6:54am

I think the fallout of Lehman Brothers being let fail really proved the point: “to big to fail” really does mean that, and the only viable way forward is to break up banks, and make sure, through regulation, that they can’t get too big again.

Will Cochran
Oct 8 2009 at 10:32am

I came into banking from manufacturing in 1968. My observation is that from the standpoint of a manufacturer the risk that a bank takes is not paid for by his margins unless he is very conservative. If a single loan fails it can wipe away the profits from hundreds of other loans. Banking crises have occurred several times over the ensuing years. Regional banks, who were more conservative lenders, eventually took over many of the larger banks; First Chicago, Bank of America are examples of large banks that were subsumed by regionals. But then the regionals fell into the same trap. With “too big to fail” the really large banks have now been allowed to take over.

Crozet VA
Oct 8 2009 at 11:03am

Russ, thanks for another great interview – I now have a reason to look forward to Mondays. Thanks also to the people who commented before me – good stuff. However, in my opinion, no one has addressed directly the real problem here – the corruption of key members of Congress and key regulators. The formula for a Wall Street firm or large bank to insure it will be “bailed out” is really quite simple and inexpensive: you identify the handful of regulators and members of Congress you need to “buy” in order for your firm to be protected in a crisis. Fund their campaigns, do them some favors, give them some perks, basically make them indebted to you, and they will take care of you. When the time comes, these politicians and regulators will wave their hands and warn taxpayers that extreme measures are required to protect taxpayers from disaster. Then they will congratulate themselves for having the courage to make the tough decision to seize taxpayers’ money to bail out their corporate friends, and they will expect gratitude from voters for doing so.

These corrupt legislators and regulators rarely suffer any consequences. They divert attention away from themselves by calling for Congressional hearings and pointing the spotlight on CEO’s and CFO’s. These corporate executives know this is part of the game, so they come to Washington and let the politicians they purchased point fingers at them and demand answers in order to impress voters and escape blame.

Until the elected officials and regulators are held accountable for these financial disasters, this cycle will continue to repeat. When Mr. Stern talks about “preparation” he needs to expand the meaning of that process to the legislators and regulators. We need a process by which the role of legislators and regulators is scrutinized publicly and independently, and as Russ Roberts said, we need to change their incentives. This is where we need transparency. Let’s not kid ourselves, the largest banks control the politics of Washington, D.C. The regulators are working for the banks not the taxpayers. Russ Roberts hit the nail on the head when he said

“The politics are such that this too big too fail policy is a way to, on an ongoing basis, reward some very politically powerful people. What has in fact happened over the last 15 months is that the average American has sent hundreds of billions of dollars to some of the richest people on the face of the Earth. I think the more people understand it, the better chance the political incentives will change. If people don’t understand it, the political incentives are going to stay in place.”

Oct 8 2009 at 11:56am

I enjoyed this podcast a great deal. Stern kept saying “I wasn’t in the room when they were making these decisions…”

I’d love to hear (essentially) a response to this podcast from someone who WAS in at the Board of Governors in Washington last year. Randall Kroszner and Frederic Mishkin come to mind. Both are now academics that have recently left the board… I’d love to hear their take on “Too big to fail.” Especially Kroszner – because he left the board in January and was there all the way through AIG, Lehman, etc.

The board of governors required a supermajority 5/7 votes to fund these bailout measures. Since there was only 5 members on the board at the time, Kroszner and Mishkin had veto power over anything the Fed did. I wonder how they would respond to a moral hazard discussion or the failure to implement FDICIA.

Dr. Duru
Oct 8 2009 at 1:54pm

Another excellent discussion. Professor Roberts, you were correct in saying that this podcast would serve as a good educational follow-up to the last one on the failure of Bear Stearns.

I particularly liked the way you pointed out a signature message in all this: taxpayers sent many billions of dollars to bailout/assist/help some of the richest people on the planet.

I also understand now how adherence to this one principle of moral hazard can construct an entire financial system hopelessly trapped by systemic risk.

Oct 8 2009 at 11:22pm

It’s interesting the use of the populist idea that it is the poor average American paying all these taxes to help the rich. Am I wrong in my view that most libertarian’s view this as a myth? Wouldn’t it be more accurate to say that the majority of taxes are taken from wealthy people and corporations and have now been used to bail out many of those same people and institutions? There are wealthy people and institutions that probably did not benefit from this, in which case they could have used their economic/political clout to try and block this, granting it may be easier to get a government hand out than to prevent one.

If you really believe that the tax system is unfairly burdening the wealthy, as many libertarian’s seem to, then it is harder to see this as a large scale diversion of funds from “average” American’s to wealthy corporations. In this context couldn’t you also say that these people and companies have paid so much into our economy through taxation over the years that there is nothing all that wrong with using some of that money to help them out in the current economic difficulties? After all a lot of it is and will be their money.

Just playing evil’s advocate 🙂

Russ Roberts
Oct 9 2009 at 9:45am

AH Britton

The rich pay a disproportionate share of the income tax. Other taxes, such as the sales tax, the payroll tax (which is substantial and has a maximum contribution), and other taxes fall heavily on the middle and bottom of the income distribution.

Regardless of the fairness of the net effects of taxes and government largesse, the current system distorts the use of scarce capital and reduces our standard of living from what it otherwise could be.

David R
Oct 9 2009 at 10:55am

Gread podcast, thanks.

Comments re: 1. Long term costs of bailouts outwiegh short term costs of not-bailing out and 2. The Financial Political complex.

1. When Gary Stern said that he thought that the ‘probable costs of not bailing out were excessive relative to the lesson’s taught to creditors’ I’m not so sure he isnt making the same mistake of thinking that avoiding some pain now is now won’t more than offset by the cost of more later (as in, ‘the pain of cutting Lehman’s leverage in a boom is too much for stakeholders’). If his thesis is that the lessons of Continental Illinois, LTCM etc. were understood by creditors (‘we will be rescued by government’) then those rescues are a neccessary driver to the crisis we have just had… and the cost benefit of teaching the ‘no bail out’ lesson would have been well worth it. The history of bailouts also gives pause that next time will be worse, and that ‘we wont let this happen again’ is wishful thinking since a big impediment to ‘pain now’ is likely the ‘financial political complex’…

2. Eisenhower warned us of the ‘military industrial complex’, we should be much more concerned about the ‘financial political complex’.

All those ‘too big to fail’ institutions have direct connects to the political powers, whether by direct contributions, by contributions from those made fabulously wealthy taking annual bonuses while taking 80 year risks, by the well connected employees deliberately recruited to the institutions (family members, former elected officials, former regulators, well-connected consultants, etc. etc.).

He who pays the piper calls the tune, and the piper plays ‘bail out the creditors’. Yes, the Bond market (and its friends in high places) really can intimidate anyone. Can you get Bill Gross (PIMCO) on Econtalk to discuss that?

I do look forward to your essay Russ.

Scott S
Oct 14 2009 at 3:02pm

Stern provides a good history of the causes and effects of the moral hazard the government has developed over many years. But I think he runs the rails with his suggested solution. The “preparation” part (“Warning! You’re big boys now and we’re seriously not going to bail you out anymore!”) is fine. But his notion about replacing by-the-numbers regulators with smart, perceptive, insightful ones, empowered to make up rules as they go, sounds entirely wrong. Not only are we expecting unrealistic predictive ability from these mere mortals, but we’re now subtituting their risk/reward judgements for the business managers’ so entrusted. This is an insidious invasion into the private-sector’s resource allocation role and can only exacerbate favoritism, political wrangling and curruption. With his insight into human behaviour and incentives it’s surprising that wasn’t obvious to the guest.

Oct 21 2009 at 2:27am

I’m confused as to why LTCM wasn’t a warning to the banks that the government wasn’t going to bail them out?

All the big US bank counter parties were told they must pony up money to shore up LTCM because they were banks that recklessly loaned money to LTCM, and to others engaged in derivatives trading which was hidden from view and that if exposed would blow up the market, putting every bank at risk.

They were told that they must pony up cash to bailout LTCM because they, the banks were reckless and they needed to pay for their recklessness and the recklessness of their peers, and if they didn’t, the market would punish everyone to a far greater degree once everyone knew LTCM was going to be run by a government technocrat called a bankruptcy judge. And a bankruptcy judge could run LTCM for a long period of time, as long as a decade if necessary to unwind it in an orderly fashion to maximize returns to creditors.

The lesson in 1998, which should have been fresh in the minds of the bankers as they bought debt that made the LTCM debt look as safe as US Treasuries. was they would be expected to bailout whoever ended up being too big to fail.

But perhaps the real lesson every bank learned was that they must be so highly leveraged that when the crisis hits, they are like LTCM, and all the other banks will be told to bail them out.

So I think the moral hazard lesson was that you must not be the one who has the sound balance sheet with lots of capital assets in a banking crisis.

If you have a strong balance sheet, you will be required to bailout those who took the risks and created the crisis, because if you don’t bail them out, you will be dragged down with them, because you can never have sufficient capital reserves in a real climate of fear causing everyone to make runs on all the banks.

Clearly you must never be in the position of being more sound than your competitors when a crisis occurs, and since you can never know when a crsis will occur, you must always be at risk of failure if one bank will fail so you are not expected to bail anyone out, but not the one bank that is most at risk of failing so you are forced out of business.

Oct 21 2009 at 2:43am

BTW, I find it odd that the discussion doesn’t mention the role of OTC derivatives that aren’t public and thus can’t be examined from the outside, especially when derivatives serve as insurance to protect against falls in market prices of any arbitrary financial instrument.

LTCM’s entire business was built on derivatives arbitrage structured so they couldn’t lose more that $15M a day, but in the crisis they were losing $350M a day, according to Frontline’s report. And AIG’s failure was caused by a very small unit of a huge very sound business which like LTCM engaged in derivatives arbitrage.

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Podcast Episode Highlights
0:36Intro. [Recording date: September 25, 2009.] Book life-changing; written 2004; fundamental questions of the financial crisis. Why would a firm like Bear Stearns or Lehman Brothers take so much risk? Why would they be so leveraged, put themselves in a position where a bad quarter would kill their firm? Yes, there have been bailouts in the past, but they were partial; punished equity-holders. Should induce some prudence. But punishing equity holders while bailing out bond holders and creditors has some subtle incentives that are not so obvious. Start with modern history of bank bailouts in the last 25 years. What has happened and what form? Continental Illinois, forefather in modern times. At the time, highly regarded commercial bank, highly regarded. Failed because of energy-related exposures throughout the country. Creditors, large and small, and even beyond the creditors were protected by the Federal government and didn't suffer any losses. Reason for that protection: policy-makers' concerns about contagion or spillover effects, meaning the concern was that problems at Continental would affect other financial institutions, other markets, and the performance of the economy in terms of output and employment. Decision made to try to limit the damage. They were the 7th or 8th largest bank in the United States at the time, though listeners today have never heard of them. Very large bank, 5000 counterparties, connected with other creditors, borrowers, and lenders. Had borrowed a lot of money from community banks around the country, who had exposure to Continental in excess of their capital. Would have cascaded. Wasn't the only problem, but part of it. Congressional testimony after episode, Comptroller of the Currency indicated there were 11 banks he considered too big to fail. Message received by creditors. Moral hazard: normal prudence for a creditor is that you don't want your borrower to go bankrupt so you can be repaid for your loan. Creditors don't get any upside--collect interest, expect to get principal back; no matter how well the firm does you won't do any better than that. Compare with equity holders. Imposing losses on equity holders doesn't do any good in terms of moral hazard. Seems counter-intuitive. They don't want to lose their equity. Depends on how diversified the equity holder is. If you are a large institutional investor owning equity in lots of different companies around country or globe, don't have a large exposure to any one company. If one goes bankrupt, it doesn't have a large effect on your performance. Contrast to a community bank that is family owned--lots of incentive to be prudent. Can't say the same for equity holders of large institutions where equity is broadly held. Deep insight: bond holders, creditors, and equity holders. Tend to think of the equity holders as group standing on the side reminding firm not to be too risky. High-risk stock adds zest to their portfolios; risk versus return. Don't get above normal returns without above normal risk; diversify portfolios.
8:57The management themselves are stockholders, often. Surely they don't want to be wiped out. Correct. That's where we get back to the moral hazard issue. Not excessively greedy; rather were responding to the incentives they confronted. Creditors expect to be protected, so they have no incentive to worry about the risks the company is taking, which is another way of saying that risk-taking is mispriced. It's priced too low, and when something is priced too low, too much of it will be taken on. That's what happened in some of the high-profile cases in the last couple of years. Some large institutions avoided the problems--didn't go out of business or require bailouts, but did suffer declines in equity values for the present time. Conversation with Paul Romer: salary. Downside risk--don't want their equity to be wiped out. But they usually can't cash in their equity. When they lose hundreds of millions when their stocks fell, comforted by the fact that they couldn't have cashed that out when they were high; and secondly, they made large sums of money in salary along the way; and they did sell some of their stock in the good times. Diversified the rest of their assets; making $10-20 million a year and using that to diversify into safer assets. Not stupid; not greedy. Prudent with their own money. Strange to believe that people are more greedy in the first decade of the 21st century than they were ten or thirty or forty years ago.
12:18History: Continental Illinois's creditors and bondholders avoided direct losses, though can assume the value of the bonds went down when the company got into trouble; once the bailout announced, bonds returned to face value. Equity holders were close to wiped out, or at least not coddled by the government. 1984, one event. Testimony by office of Comptroller of the Currency makes imprudent remark--not just this one company--we'd bail out all eleven. What happens going forward? There was another banking crisis in the late 1980s, early 1990s; many savings and loans institutions did fail and a lot of people lost money. Also episodes of forbearance when some large financial institutions had you marked their balance sheet to market would have been seen to be insolvent. Wasn't done; given time to recover, which they did. Creditors surely understood what was going on; served to reinforce the notion that if you were a creditor of a systemically important financial institution you were likely to be protected directly or indirectly. Next high-profile episode was Long Term Capital Management (LTCM)--different kind of fish, but creditors drew the same conclusion. During the period between 1984 and 1998 (LTCM crisis) many banks went broke. The FDIC covered almost every dollar of depositors' money even when it exceeded the limits the FDIC had promised to guarantee. Changed in 1991 with FDICIA legislation. Government had to engage in least-cost resolution of banks that became insolvent--idea was to impose losses on creditors. Following FDICIA, putting LTCM aside, the FDIC did pursue that policy. Also in FDICIA an out that said to the regulators that you could avoid least-cost resolution if you thought there could be significant systemic adverse consequences from pursuing it. A lot of people thought FDICIA dealt with the too-big-to-fail problem. Because of the loopholes, it didn't deal with it, and what happened in the Continental Illinois case. Have to have agreement among the FDIC, the Board of Governors of the Federal Reserve, the President, and the Secretary of the Treasury in order to exercise the loophole that you are not going to pursue least-cost resolution. But those were the people involved in the decision to bail out the creditors of Continental Illinois. So, FDICIA was just formalizing what was past practice. But in the interim there were some crises paid by creditors in that period. Don't mention the Savings and Loan crisis, Mexican crisis, or other international crises before 1998. Any role in perception of creditors? No significant separate effects. In the wake of FDICIA some creditors did lose money--but all were creditors of relatively small financial institutions. FDICIA never tested; when tested, found wanting. Alan Meltzer, recent podcast: why wasn't FDICIA used in the current crisis? Told Hank Paulson to use it; Paulson said he asked the banks and they were against it. Of course they were against it--it removes their management! People shouldn't have kidded themselves about the prospective effectiveness of FDICIA. Have to prepare for a crisis in advance. Preparation is not easy, but essential.
20:39LTCM, 1998. They were a hedge fund; podcast with William Cohan. They were not a bank, not FDIC or SIPC insured--just a hedge fund that was highly leveraged, meaning they had borrowed a lot of the money they had used to make their bets with. No government money was explicitly put in. Federal Reserve Bank of New York convened a lot of large Wall Street counterparties and persuaded them to put in enough funds so that LTCM's positions could be unwound in an orderly way. They did have exposures around the world to lots of counterparties so had they been unable to honor their commitments, they would have had global implications. Also concerns about fire sales of assets--similar concern. If LTCM had to liquidate its positions in short order it would put a lot of downward pressure on asset prices which would impair the conditions of those other firms. That argument used a lot; used now to talk about why mark-to-market is part of the problem. The argument is that if they sell quickly, firms that hold similar assets will have to re-price them on their books; their capital cushion will no longer meet capital requirements, so they will have to start unwinding their positions. Cascade. Gets too much mileage out of the "quickly" part. Suppose they had to sell them slowly. The problem isn't the speed--it's that the assets aren't worth very much. Step back; ask the reaction of creditors to LTCM, reinforcing--even though no government money, when they called that meeting it wasn't so voluntary. What is next event important in reputational effects? Between early 1990s and recent crisis was mostly a period of tranquility in financial markets. Two other episodes: 1991 when Drexel Burnham went out of business--government let them go; wound them down in an orderly way. "Tequila crisis" in the early 1990s--a lot of banks had lent them money--U.S. government anxious not to see those bills--the Mexican obligations to the U.S. banks--go unpaid. Forbearance: some of those international exposures was part of the reason it was practiced. Forbearance is when you look at a financial institution, value its assets relative to its liabilities; if you are rigorous you might find the institution is insolvent; forbearance is when you are more generous in how you do the evaluations, which gives institution more time. Subtle: creditors, when they saw the government not enforcing those standards as rigorously as they normally would, saw that the government was trying to help them avoid bankruptcy. Creditors very sophisticated; some were even counting on it when they initiated their exposure to these organizations.
28:17Puzzle about claim, besides example of Drexel. If the claim is that because of the reduced risk to creditors, these institutions became more risky, why did it take so long for it to blow up? Trying to predict in advance what will set off a financial crisis virtually impossible. Some people claim that they knew residential housing was in trouble, but calling the timing--that it would begin in August of 2007 as opposed to August of some other year--nobody really got all of that right and if they did, couldn't repeat that. Institution like Fannie Mae was inherently dysfunctional. As close as you could get to believing that the government would bail them out; bad set of incentives; had their own regulator; takes a while for that process to get corrupted. Couldn't have said when, but not unreasonable to suggest that it was unstable and would eventually blow up. Lots of regulators testified before Congress before the crisis; but no desire to do anything about it. Incentives: If I'm leveraged, say a 2 to 1 ratio between my investments and my capital, so half of what I have invested are my own and the other half are borrowed. Low level of leverage--huge cushion. If they fall very far, my lenders and creditors feel very good because they know I can compensate them. If I live in a world of too big to fail and if my creditors believe I'm likely to be bailed out, don't I have a natural incentive to increase that leverage as much as possible? The other people are comfortable; and I will increase my rate of return on my asset base, with riskier and riskier bets. True? Yes, but would emphasize the incentives or motivations of the creditors. Recognizing that they will be covered by the taxpayer, that's where the misplacing of risk comes in. They are willing to lend money to permit this company to lend out. Lack of market discipline. Creditors' expectations--as long as they are what they are, the problem will persist. One of the outcomes of the last couple of years is to more deeply embed creditors' expectations that they will be bailed out. What would a firm's optimal level of leverage be in a case of too big to fail? Puzzling why a firm would, like Bear Stearns or Lehman, be leveraged 30, 40, 50 to 1--putting in a dollar or two for every hundred being borrowed? When you do that, you put the existence of the firm at risk. What are they getting in return? Opportunity to make much larger bets, and will take riskier debts. These firms could borrow cheaply and saw investment opportunities. Given how cheaply they could borrow, they felt they would be well compensated for the risks they were taking on the assets they were acquiring. A lot of these companies survived; their stock didn't go to zero; had big return as their competitors were destroyed. Worst part of story--why could they borrow at such low rates of interest when they were putting those lenders at such risk? Standard answer is they just expecting housing prices to keep going up. Alternative answer is: they were lending to each other. So, their likelihood of being bailed out than if it were the Chinese lending to Fannie Mae. Except for Lehman Brothers, their bets turned out to be right.
37:42Lehman Brothers: why were they left to twist in the wind and not bailed out? No effective means to deal with Lehman Bros. Private sector acquirers backed away; senior management at Lehman may have misjudged the situation and was asking too much. Not on the scene. May also have been a view that in the wake of Bear Stearns that Lehman Brothers's creditors had had ample opportunity to adjust their exposures if they were concerned; and if they didn't, that's too bad and they should bear some losses. People have used Lehman Brothers as a marker for the real onset of the deepening financial crisis, but Lehman Brothers gets too much blame and AIG not enough. AIG was a triple-A rated institution with exposures around the world and no effective comprehensive supervision and really did come out of the blue. Didn't know about AIG but knew they were big and would be lots of trouble if they were permitted to fail. When Bear Stearns died in March of 2008, married off to J.P. Morgan Chase; creditors, lenders, and others taken care of, but stockholders' investment went down drastically. Between March and September two things happened that have not gotten enough attention: Lehman becomes a lot more leveraged. Lehman has similar assets to Bear Stearns, and yet can continue borrowing money, which suggests strongly that people thought they would be taken care of. More dramatic: money market fund Reserve Primary--first money market fund--lends Lehman hundreds of millions of dollars during this period, and when Lehman goes bankrupt, has to "break the buck"--lower their asset value from $1 to $.97, which sent tremendous shock waves through the financial world. Even money market funds may be taking on too much risk. But why would they do that? Answer, per Arnold Kling and James Stewart in the New Yorker: they figured there was a decent chance they'd get bailed out when Lehman went bankrupt. Friend running a money market fund before Continental was bailed out--knew it was shaky--buying Continental certificates of deposit (CDs). A lot is a probability game; friend said he was willing to buy 1-mo. or 2-mo. CDs because they may fail but not in the next month or two. Worked out because Continental creditors were bailed out. Even if you think the institution may not last, there is a timing dimension. Even in the case of Bear Stearns the plug gets pulled on them when people in the repo market say they won't lend any more. Why didn't they just say the government would bail them out? Why stop lending? Did a risk/reward calculation and said maybe the government would bail them out, but didn't want to be there to find out.
44:40Reaction when you put this hypothesis forward. Same issue: saying that history and empirical evidence suggest that there is a moral hazard problem is met with response that equity holders still have a risk. Lots of pushback, skepticism; practitioners don't like it. Less skepticism now than when book came out. There were a lot of people who thought that FDICIA addressed the problem and the book was just wrong. There are people who believe it's just not good public policy to impose losses on creditors of large financial institutions. Don't know what underlies that view--they must feel that it's potentially too disruptive. Third thing: the best thing to do is to make supervision and regulation sufficiently effective that you can prevent these episodes going forward. Given incentives we confront, that's not possible. We should make supervision effective but we shouldn't kid ourselves. The track record suggests it's not going to be sufficient. Arnold Kling paper: stiffened capital requirements, think there will be fewer systemic losses, but there is a political dynamic. Argument made by many is that we have to recreate Fannie and Freddie but this time we'll just have different restrictions so they won't get out of control.
48:51Solutions to Too Big to Fail itself. What might we do to encourage more prudence on the part of creditors than now? Have to find a way to credibly put creditors of these systemic institutions at risk of loss. Can't simply say we're not going to bail you out--not credible. Preparation--very important. The reason policy-makers intervene is because of concern about spillovers. Preparation means identifying and taking steps to limit those spillover effects. Analytical question; a lot of that information is already available. Where do these institutions have exposures? Are those exposures prudent? In some cases, don't have to do anything. If it fails, you can impose losses on the creditors because you've prepared--you've done the analysis and satisfied yourself that the spillovers are manageable. In cases where you are concerned, have to use authority to reduce the chances of those spillovers. Don't want to reduce to zero--don't want a world where nobody has exposures to each other, but they can be reduced. Should be done in tranquil, sound times, not in the middle of a crisis. Two problems. Appealing, good to add transparency, but if you have a policy that says if we think you are not too systemically connected, we're going to let the chips fall where they may, you create an incentive to become more connected. Some people say Lehman's mistake was they weren't connected enough--they blew it, they should have been taking riskier bets with more people. Other side of the process: Has to be ongoing work; authorities have to be prepared to intervene. How do you keep that from being an ad hoc process that is prone to rent-seeking? Would you make them sell stuff? Head of the monitoring process will be intervening in financial institutions on an ongoing basis. Always devils in the details. Until proposal implemented won't know its strengths or weaknesses. Doesn't mean policy is random. If implemented in a consistent way, financial institutions will understand the rules and will adjust, perhaps pretty quickly. Proposal has the weakness of not having been tried; but the things that have been tried haven't worked. About the first point--idea that we should put in positions of authority people who by reputation or statements they've made at their hearings that they were plausibly people who wouldn't bail out large institutions. Suppose Gary Stern is made head of this new body in charge of systemic risk. You're a pretty credible guy--book, appeared on EconTalk, reputation. Is it imaginable that you would keep your reputation as opposed to bowing to the political pressures? That's why preparation is so important. Can't ask anybody if a financial crisis comes out of the blue without preparation that you should let a large institution go to teach the creditors a lesson. That may not pass a cost-benefit test. Cost may be too large to the economy relative to the lesson taught to the creditors. If the guy who gets to make this decision is sitting there and knows they have acted to limit spillover effects earlier, then easier to decide to not bail out the creditors, because the costs are much reduced. If you communicate to the creditors in advance, get better pricing the marketplace. Potential to set up a virtuous circle. Any traction for that idea? Not as much as might be hoped. Don't know the variety of other proposals that are around. Some proposals make sense--higher capital requirements, higher insurance premiums, greater holdings of liquid assets for systemic institutions; but by themselves they don't get to the moral hazard problem. Too big to fail policy rewards some politically powerful people. What has in fact happened over the last 15 months is that Americans have sent hundreds of billions of dollars to some of the richest people on earth.
59:54Naive question: What if we had done nothing? What is best case for those interventions? Can't do counterfactual; speculative. Had Bear Stearns been let to fail, consequences would be severe; but can't quantify them. Would be looking at a much weaker economy with more dire prospects. Could be wrong. History gives one pause about inadequate responses. Federal Reserve balance sheet currently has between $6-8 billion in mortgage backed securities that had been issued by Fannie and Freddie. They bought up old ones and have been buying new ones as Fannie and Freddie have issued them, channeling money into mortgage markets to keep interest rates low--trying to keep the price of housing supported so there won't be a fall in existing loans. They are not marked to market--not quite worth what the Fed says they are. What are the implications for inflation as things return to normalcy? Dominant there is the macro objective. Economy entered recession at end of 2007, lasted probably till a couple of months ago; broad and deep by many metrics. When short-term interest rates hit zero, had to look for other ways to have a macro effect. Want to try to operate in deep markets and not operate in corporate credit where you end up picking and choosing among quality. Balance sheet and inflation--exaggerated. One, while there is a strong relationship between money and inflation in the long run, you have to emphasize the long run--probably five or ten years if you look at the evidence. What happens to the Fed's balance sheet during a year or two unless it persists. That gets to the second point: the Fed and all Central Banks have a challenge about when to start tightening and how much. Challenge after any recession or period of accommodation or ease. Inflation performance of U.S. and global economies since the 1980s has been period of low or diminishing inflation over time. History gives you at least some modicum of confidence that they may get it right.