The business of 'too big to fail'

Posted: Monday, September 28, 2009

The following editorial first appeared in the Anchorage Daily News:

One year ago on Sept. 15, the investment house Lehman Brothers collapsed, and the federal government refused to bail it out. The nation's financial system, already shaky from the near-bankruptcy of giant mortgage lenders Fannie Mae and Freddie Mac and the failure of the $400 billion investment house Bear Stearns, imploded. The financial shock waves pummeled the nation's economy, sending it to the edge of a new Great Depression. Trillions of dollars in federal bailouts and economic stimulus spending have pulled the nation's economy back from the brink.

But what have Congress and President Obama done to prevent a repeat financial disaster?

Not much. The bailout aid imposed some caps on huge bonuses and executive pay, and the Federal Reserve is working on rules to limit the rewards financial executives might reap for taking imprudent risks.

So far, that's about it.

The president gave a good speech on the subject recently, but Congress has made little progress on the reforms he seeks.

"The building blocks of this failure have not been changed," New York Times financial reporter Gretchen Morgenson said on the public radio program "Fresh Air." "A lot of what was business as usual continues to go on."

In part, that's because the president and Congress have been preoccupied with health care reform. But there's another, more disturbing factor at play, says Morgenson: Banks and financial institutions are spending tens of millions of dollars lobbying Congress to resist big changes.

The result?

Credit default swaps were the financial napalm that fueled the economic meltdown, but these complicated financial deals are still unregulated and still conducted in secret. The default swaps started as a potentially legitimate, but unregulated, form of insurance on financial transactions, but soon turned into little more than interlocking financial gambles, totaling trillions of dollars, that collapsed together when borrowers started defaulting.

Lenders are still free to make loans to people who obviously can't repay them, stuff those junk loans into packages that disguise how risky they are, and unload them onto unsuspecting buyers eager for high interest rates.

The conflict of interest at private agencies that rate the riskiness of financial investments has not been eliminated. (The investment issuer pays the rating agency for the rating and can go to a competitor if the rating is too low.) A recent proposal from the Securities and Exchange Commission helps a little, by effectively requiring investment issuers to disclose if they have gone shopping for a better rating.

Most important, the federal government has done nothing to protect taxpayers from a future round of trillion-dollar bailouts.

That's critical, because as necessary as all of last year's bailouts were, they send a dangerous message to the financial community. They say a company that grows "too big to fail" can continue seeking super-profits by making all kinds of risky investments, knowing that the federal government will have to bail it out to protect the economy, while executives who drove the company into the ground waltz off with huge bonuses.

The "too big to fail" question has been "completely ignored by the government," says New York Times reporter Morgenson.

Harvard Business School professor David A. Moss has a helpful proposal on this score. He says the government should publicly designate, in advance, any financial institution that is "too big to fail" and impose stricter financial oversight on it. Those companies would have to pay premiums for what amounts to government bailout insurance, similar to what the Federal Deposit Insurance Corp. now does with banks. This new "too big to fail" government insurance would set clear caps, in advance, on how much bailout aid it will supply.

Writing in the current issue of Harvard magazine, Moss notes that the Panic of 2008 was not an inevitable feature of a modern capitalist economy. Since the disaster of the Great Depression, the country had learned how to prevent the financial panics that periodically ravaged the American economy.

Thanks to financial laws and regulations passed in the 1930s, the nation went 50 years without a serious crisis in the financial system. Only when the government began deregulating the financial industry did serious trouble break out, with the savings-and-loan crisis of the 1980s.

For capitalism to work, those who make huge profits by taking huge risks have to suffer the consequences when they fail. If those well-rewarded risk-takers end up burning down their own houses, that's their problem - but it's the government's job to make sure that fire doesn't spread to innocent parties and the nation's entire economy.

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