In the past six months the US government, partly through the agency of the
Federal Reserve and JP Morgan Chase, has rescued no fewer than four major
financial institutions - Bear Stearns, Fannie Mae, Freddie Mac and American
International Group (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
and Company, 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,
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 had been established over a century and had the finest
political and financial connections. (A former Baring partner was 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 19th 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 19th century.
The US continued to follow the principle of no bank bailouts, including through
the Great Depression, until the first major bailout by the Federal Deposit
Insurance Corporation, 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 Federal Reserve.
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 US$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, 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 American
International Group (AIG). AIG was first 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 be 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 (now 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 that 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.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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