The Next Financial Crisis: What Will the Market 'Expect'?

In signing the Dodd-Frank Financial Reform Act President Obama claimed to much applause, “And finally, because of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes. (Applause.)  There will be no more tax-funded bailouts — period. (Applause.)  If a large financial institution should ever fail, this reform gives us the ability to wind it down without endangering the broader economy.  And there will be new rules to make clear that no firm is somehow protected because it is ‘too big to fail,’ so we don’t have another AIG.”

Yet there is a deep irony in the 2400 pages of the Dodd-Frank Financial Reform legislation: No serious person believes that it will prevent the next financial crisis and, despite bravado to the contrary, no one really believes that when that financial crisis hits that massive bailouts of financial institutions will not be forthcoming.  Indeed, from Sherrod Brown and Elizabeth Warren on the left to Jeb Hensarling and House Republicans on the right, there is a bipartisan consensus that bailouts are here to stay and that the bailout culture is here to stay.  And, perhaps even more important (as will be discussed momentarily), “markets” appear to agree that TBTF is here to stay, creating a capital markets subsidy of some $83 billion for the largest banks (a contested figure).  Indeed, by entrenching “Too-Big-to-Fail” (TBTF) and “systemic risk” as the operating assumptions of the American financial system, the long term impact of Dodd-Frank will likely make TBTF banks even bigger and the cozy relationships between Wall Street and Congress closer still.

Why—despite bravado to the contrary by the architects of the legislation—is there such a broad belief that Dodd-Frank doesn’t end bailouts?  Because, as Vern McKinley shows in his book Financing Failure: A Century of Bailouts, the ubiquity of bank bailouts during the past century in the United States is matched only by the empty promises of politicians that they will eliminate and prohibit future bailouts.  But McKinley shows that not only is there “nothing new under the sun” when it comes to the relationship between financial crises and bailouts, the foreseeability and size of bailouts have grown over time even as the institutional constraints on bailouts and the documented rationales for them have weakened.

McKinley provides a perspective that is unique among the books that I have read about the financial crisis.  Unlike works of pure journalism, McKinley situates the most recent financial crisis and bailouts within a historical pattern; unlike scholarly work, McKinley draws upon extensive information drawn from Freedom of Information Act requests and other primary research to provide direct evidence of the thought-processes of those acting during the financial crisis.  Throughout he weaves in the direct comments gleaned from the published memoirs and reporting on the government’s response to the financial crisis.  The book presents a real-time glimpse inside the corridors of power as government officials muddled their way through the financial crisis and its aftermath.

And the picture that McKinley presents is both depressing and realistic.  He shows government officials simultaneously consumed by panic, arrogance, and ignorance, bumbling frantically and repeatedly, producing responses that not only failed to accomplish their stated goals but actually producing counterproductive results, with George W. Bush’s Secretary of the Treasury Henry Paulson coming off as Washington’s chief Keystone Cop.

Although Paulson self-righteously insisted during the crisis that “There is no playbook for responding to turmoil we have never faced” (p. 299), McKinley shows that this more accurately reflects Paulson’s ignorance of history than the novelty of the questions he confronted.  And while Ben Bernanke (unlike Paulson) at least had some intellectual knowledge of past financial crises, he systematically misunderstood the historical analogies to the most recent crisis.  As a result of these historical blind spots, both leaders (and later Congress and the White House) failed to understand the actual causes of the crisis to which they were responding.  As a result they undermined the effectiveness of their own interventions while sowing the seeds of the next, and invariably larger, financial crisis.

What is a “bailout” and why are bailouts bad?  McKinley argues that a “bailout” of an insolvent institution is the corruption of an arguably sound idea, going back to the Nineteenth-century British economist Walter Bagehot, that a central bank may be a useful institution to preserve the soundness of the financial system in a time of panic.  But Bagehot’s core distinction was between what today would be called illiquid versus insolvent institutions.  It is crucially important that the distinction be preserved—saving an improvident and mismanaged failed institution from its day of reckoning undermines incentives for prudent operation, weakens public confidence in the financial system by propping up failed institutions, provides unfair economic advantages to the disadvantage of responsible banks, risks taxpayer dollars, and typically produces larger losses in the end than would have otherwise been the case (as evidenced most strongly by the savings and loan crisis of the 1980s).

The real concern is to protect the operations of solvent institutions confronting a bank run because of loss of public confidence in the banking system and the uncertainty whether a particular bank is also insolvent.  Similarly, the purpose of deposit insurance is to provide confidence that depositors will be made whole in the event of a failure, thereby relieving the ordinary depositor of the risk of leaving their deposits in a particular institution.

The role of a central bank, therefore, is not to provide capital to insolvent banks during a time of crisis, but to provide capital to solvent but illiquid banks.  So—to state the glaringly obvious point widely ignored throughout the financial crisis—if Citibank is insolvent, the Federal Reserve should not lend to Citibank to prop it up.  Instead, it should lend to banks other than Citibank that are solvent, but which could suffer a confidence-induced bank run if Citibank were to fail.  A bailout occurs, therefore, when the Federal Reserve or Treasury provides funds to insolvent institutions, thereby propping them up, with all the negative consequences that entails.

As McKinley demonstrates, this failure to remain focused on the central justification for government intervention in crisis periods has led to increasing numbers and cost of bailouts in each succeeding financial crisis.  Bailout programs began with the New Deal, which provided bailouts to rural and small-town banks in the 1930s.  Indeed, the peculiar institutional structure of the Federal Reserve, organized around multiple semi-private regional Federal Reserve banks sprinkled throughout the country, reflects the focus of the era that the purpose of the Fed was to preserve banking stability throughout the country rather than being beholden to the New York Wall Street community (as it is today).  Unlike the most recent crisis, where Fed and Treasury officials cooked up strained stories that it was necessary to bail out Wall Street in order to save Main Street, the Fed’s founders at least recognized that the best way to protect Main Street was by protecting, well, banks on Main Street, rather than allowing small banks to fail while bailing out big, politically connected banks.

Unfortunately, the seeds of future bailouts, and particularly the ability of the Federal Reserve to bailout out non-banks, were also sown during the New Deal.  The Emergency Relief and Construction Act of 1932 added Section 13(3) to the Federal Reserve’s portfolio of powers, permitting the Federal Reserve “in unusual and exigent circumstances” to lend directly to “individuals, partnerships, and corporations,” rather than just depository institutions. (p. 59).  Wary of the potential for abuse of this provision by the Federal Reserve and special-interest pleaders, however, the new powers were hemmed in by numerous restrictions that limited the ability of non-banks to tap the Fed’s largesse, resulting in a very limited use of the power during the New Deal.  But as McKinley ominously notes, “This power to lend would remain dormant for more than seventy years.” (p. 59).

The template for bailouts changed dramatically with the bailout of Continental Illinois in the 1980s.  Unlike earlier bailouts, Continental Illinois was manifestly insolvent (not illiquid) and manifestly incompetently run and a poster child for market discipline.  Continental Illinois, however, provides the first apparent bailout based on the amorphous concept of “systemic risk”—that it is appropriate to bailout an insolvent institution to fend off the “contagion” effect for others.  Astonishingly, however, at the time there was almost no hard evidence as to what the supposedly negative systemic effect would have been of allowing Continental Illinois to fail.  Congressional hearings after the fact discovered that not only did the FDIC have almost no information to ground its decisions, much of the slap-dash information it did have later turned out to be inaccurate and inconsistent with the theory that the bank was systemically important.  This lack of information was especially striking in that Continental Illinois’s fragility had been known for years, yet the FDIC was still ill-prepared when the bank eventually became insolvent.  The federal government ultimately lost $1.1 billion on Continental. Moreover, many of the institutions that were protected by the bailout of Continental Illinois later failed themselves anyway (usually at higher cost than if they had failed at that time).

Ironically, the unprincipled and seat-of-the-pants style of the Continental Illinois bailout provided the template for the 2008 bailouts of banks, investment banks, AIG, and the auto makers.  In particular, as McKinley observes, the congressional hearings on Continental record the first apparent use of the term “too big to fail” in justifying the FDIC’s bailout.  (p. 87).  This intellectual transformation in turn produced a political transformation, “the slow transformation of [the open bank assistance program] from a program that predominantly resolved small banks at a zero cost to the FDIC to a program that resolved large banks at a great cost to the FDIC.” (p. 90).

After Continental Illinois, McKinley observes there was a period of retrenchment, most notably the commitment of the SEC not to bail out Drexel, Burnham, Lambert when it failed in the 1980s. (p. 100).  Although large and interconnected by standards of the time, Drexel’s failure had little contagion effect in the markets.

The story culminates in the bailouts in the latest financial crisis.  The second half of the book is concerned largely with this latest round of bailouts, illustrating the recurrent pattern of seat-of-the-pants and panicked decision-making based on incomplete or even no information whatsoever.  Moreover, McKinley demonstrates the problem of moral hazard that is endemic in the evolution of bailouts over time, as firms such as Lehman Brothers, used the threat of their own messy failure to play a sort of game of chicken with the government.

Perhaps most chilling in McKinley’s account is the precedent that the most recent bailouts set for the future.  Paulson created a sort of self-fulfilling prophecy that eventually forced his own hand into bailing out the large financial institutions.  As McKinley shows from extensive quotes from Paulson’s own memoir (pp. 270-75), the driving motivation for Paulson was the belief that he had to provide bailouts because “the market” expected him to provide bailouts.  Thus, meeting “the market’s” expectations for bailouts was the only way to instill confidence in the market.

But why had “the market” come to expect bailouts?  Enter the government’s bailout of Bear Stearns, even though it had little basis for doing so.  So, it followed, surely the government would bail out even larger institutions.  Moreover, everyone was aware of the underlying public choice dynamics that McKinley characterizes as the “not on my watch” phenomenon—that every politician has an incentive to bail out today while ignoring the long-term consequences of propping up insolvent institutions and the moral hazard that perpetuate the bailout culture.  Moreover, as McKinley wryly notes, “There are a number of problems with [Paulson’s] vision of the market, not the least of which is that ‘the market’ as he defines it perpetually wanted government policy to direct resources its way.” (p. 273).  Despite all this, there is no evidence that the bailouts even had their intended effect of preserving “market” confidence, as shown for example, by the nearly identical market response to AIG’s bail out compared to the decision not to bail out Lehman. (p. 179).

And so we begin where we started—if Paulson’s rationale is carried forward, the crucial variable for future bailouts is whether “the market” expects bailouts.  And why would “the market” expect bailouts?  Because market actors know that politicians will always be tempted to bail out first and come up with rationalizations after.  Thus, the self-fulfilling logic of bailouts perpetuates itself and becomes larger with every iteration.  Too big to fail is here to stay.