Every few days we hear that another leading financial institution has written down billions more on subprime investments gone bad. Nearly every major financial institution, it turns out, had a hand in loans to low-credit borrowers–borrowers whose ability to pay often hinged on endlessly low interest rates or a strong housing market. How could this happen? How could nearly all the leading lights of the financial industry–the experts in assessing and managing risk–expose themselves to such massive losses? Or, as a Fortune cover crudely put it: “What were they smoking?”
A major part of the answer is: government bailout crack.
Cartoon by Cox and Forkum
For decades our government has had a semi-official policy that large financial institutions are too big to fail–and therefore must be bailed out when they risk insolvency–a policy that creates perverse incentives for them to take on far more risk than they otherwise would. “Too big to fail” is implemented through a network of government bodies that protect financial institutions from the long-term consequences of their decisions at taxpayer expense–a phenomenon we can observe right now.
Consider Countrywide, a major subprime money-loser just acquired by Bank of America. Private lenders have not been willing to grant Countrywide the $10s of billions it sought to keep afloat, given the company’s huge and difficult-to-measure subprime exposure. In a free market, bankruptcy would loom–but in our system, Countrywide and others can turn to the government-backed Federal Home Loan Banks for cash; these banks have lent Countrywide over $70 billion so far. According to the Wall Street Journal, these banks specialize in “providing funding where other creditors won’t go”–which they can do because of “a widespread belief the government would bail them out [with taxpayer money] in a crisis.”
Cash from Federal Home Loan Banks is just one of the many entrees the government provides on its bailout menu. Another option a failing bank has is to court bank depositors–who will not be scared away because their deposits are backed by the government’s Federal Deposit Insurance Corporation (FDIC). Countrywide and others have a huge potential pool of capital accessible to them if they take on the additional cost of offering depositors higher interest rates than their competitors’. On its Web site, Countrywide is actively chasing your dollars, boasting, “Can your bank match our CD rates?” The policy is working; American depositors have invested or kept $10s of billions of their savings in Countrywide’s coffers–despite regular headlines about the company’s perilous finances. Depositors know that no matter how reckless Countrywide is with their money, other taxpayers will be there to pay the company’s FDIC-backed commitments–just as they were there to bail out depositors in savings and loans in the 1980s.
Still another item on the bailout menu is provided by the Federal Reserve. Today and throughout history, when major financial institutions are losing money, the Fed uses its power to manipulate interest rates and the money supply so that banks can borrow cheaply–giving them easy money with which to paper over their old mistakes. Again, it is other taxpayers who pay–in this case, through inflation. Inflation depletes Americans’ hard-earned savings; the trend of skyrocketing housing and commodity prices we have witnessed during the last five years is just the latest and most obvious harm done by our government’s inflationary actions.
The combined effect of these and other bailout policies is to make risk-taking less risky for large financial institutions–because true failure is not an option.
If an institution can be bankrupted when its investments go bad, it is supremely clear to its managers and its creditors (its depositors, in the case of a bank) that they must be continuously diligent about risk. They have every incentive to thoroughly investigate long-term consequences–because enough money badly invested could mean the firm’s extinction.
However, when the long term loses its meaning, when institutions are told they can never fail, managers are given an incentive to put more capital at risk. If the investments go well in the short term, as subprime investments did for several years, the profit potential is huge. If they eventually fail, the downside is only so bad; the government will “do something” to keep the firms afloat.
And when these reckless investments do go well in the short term, they’re sure to be repeated. If one financial giant is reaping huge profits from subprime, other firms are pressured to follow along–or else risk losing investors, customers, or employees who want to be part of the exciting profit machine. The long-term result of “too big to fail” is a gradual and overall decline in responsible risk-taking–with periodic crises like the subprime debacle.
Any doctrine that encourages overly-risky investing, and punishes sound risk-taking is unfair and destructive. We need to phase out “too big to fail” and replace it with a free market in banking, which would reward sound long-term lending and borrowing practices and punish irresponsible ones. Otherwise, the next financial market fiasco is just a matter of time.
First published on March 18, 2008. Copyright