Financing Failure: A Century of Bailouts

Published by EH.Net (April 2012)

Vern McKinley, Financing Failure: A Century of Bailouts. Oakland, CA: Independent Institute, 2011. xvi + 381 pp. $17 (paperback), ISBN: 978-1-59813-053-9.

Reviewed for EH.Net by Roy C. Smith, Stern School of Business, New York University.

This book looks deeply into the extensive history of financial bailouts in the United States, mainly focusing on the 1930s, the 1980s and the 2000s, and concludes that although there is little evidence to justify them, they continue to be repeated when financial crises appear.? The author, a Research Fellow at the Independent Institute and a consultant to central banks and financial institutions, has brought to light many details from the 2007-2008 crisis from previously undisclosed documents obtained from the Freedom of Information Act (including some suits initiated by himself), and from scouring the abundant crisis literature that has since appeared.

A ?bailout? is defined as any sort of intervention by a government entity, which is done preemptively to prevent a failure of a financial institution, and consequently benefits depositors, creditors or investors. Government officials have always justified bailouts, however distasteful, as being necessary to prevent ?disorderly failures? that could collapse the larger financial system and impose far greater cost to the economy than the cost of the assistance. Bailouts not only create moral hazard, they also interfere with free market allocation of financial resources to achieve optimal results.

McKinley observes that after the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933 requiring banks to pay into an insurance fund that would compensate depositors in the event of a failure, and to close banks deemed to be insolvent, government involvement in banks has expanded enormously. In 1974, the concept of ?Open Bank Assistance? (OBA) in which the Federal Reserve, the FDIC and other regulators could ?prop up? banks in trouble was initiated with the bailout of uninsured depositors and creditors of Franklin National Bank, the twentieth largest bank in the U.S. There were fifteen more OBA interventions until Continental Illinois, the seventh largest bank, was similarly bailed out in 1984. The now familiar terms ?too-big-to-fail? and ?systemic risk? seem to date from that event.

Many banking observers and academics thought the Continental Illinois intervention, which occurred when Paul Volcker was Chairman of the Federal Reserve, was sound and necessary policy that contained a serious, decade-long crisis involving dozens of large banks. Uninsured depositors and creditors were protected, but shareholders often were wiped out, managements changed, or mergers forced on reluctant boards. The industry recovered without transferring its difficulty to the general economy, which continued to enjoy healthy economic growth throughout the 1980s and 1990s.

In 1990, Drexel Burnham, a large securities firm, filed for bankruptcy, having received no assistance from the government. But a year later, section 13(3) of the Federal Reserve Act (the ?unusual and exigent circumstances? clause) was amended to allow the Fed to make loans under such conditions to broker-dealers.

By 2008, Ben Bernanke had taken over the Fed, and together with Treasury Secretary Hank Paulson and Tim Geithner, then President of the Federal Reserve Bank of New York, authorized the unusual and exigent guarantee of $40 billion of mortgage backed securities so JP Morgan could acquire Bear Stearns, the fifth largest investment bank. This event McKinley refers to as ?the original sin,? because he believes it was based on the false premise that the liquidity crisis Bear Stearns was facing would spread to its trading counterparties and threaten the whole system. McKinley believes the matter was mishandled, alternative approaches were not considered carefully enough, and the officials involved exaggerated the consequences of Bear Stearns? failure in justifying their actions. The bailout, however, served to increase the market?s confidence that investment banks larger than Bear Stearns (i.e., Lehman) would also be assisted if necessary.

Six months later, over a Gotterdammerung weekend, Fannie Mae and Freddie Mac were taken into ?conservatorship,? Lehman was allowed to fail but AIG was rescued, and Merrill Lynch was merged into Bank of America, already wobbly from its exposures to Countrywide.? These events, especially the surprise over Lehman, drove the markets into a paroxysm that lasted for months and slammed the economy into a deep recession.

Subsequently, and urgently, Goldman Sachs and Morgan Stanley were converted into bank holding companies and the Troubled Assets Relief Program (TARP) was used to provide infusions of equity into more than 300 banks. Citigroup and Bank of America were given double doses of TARP money to prevent their collapse, and inexplicably, Wachovia was steered into a merger with a very shaky Citigroup, though Wells Fargo later trumped the deal. Though creditors and stockholders of Lehman and Washington Mutual received no assistance, these other interventions, together with an equivalent instance of bank rescues by European governments, constituted the most extensive use of bailouts in financial history.? Altogether $1.8 trillion of write-offs occurred at global financial institutions from 2007-2010, and $1.6 trillion of replacement capital was raised, much of it from government sources. Many financial markets seized up entirely in the turmoil that surrounded these events. The Fed alone extended nearly $8 trillion in interventions to calm the markets and return them to normal.

Without these bailout actions, all the responsible officials claim, a nuclear meltdown of our financial system surely would have occurred.? For them, things certainly looked different at the beginning of the crisis than afterwards.

McKinley?s findings persuade him that banking failures often follow periods of lax or incompetent regulation, and that the process of providing bailouts is the result of overly urgent, ?seat of the pants? management efforts by the same regulators who allowed the conditions creating the failures to develop. He believes that bailouts are not particularly political because administrations of both parties have provided them.

The dilemma of bailouts is that the only thing worse than bailing out an entity deemed too-big-to-fail is not doing so and letting the economy go up in smoke. As unpopular as bailouts are, the political realm recognizes that failure to act can be more damaging that acting. This is the real reason that governments do them, and will again in the future. But they would do very well to read McKinley?s book first.

Roy C. Smith is Kenneth Langone Professor of Entrepreneurship and Finance, NYU Stern School of Business and author of Paper Fortunes: The Modern Wall Street, Where It?s Been and Where It?s Going (2010).

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