Too Big to Fail
Introduction
Bail-outs of lending institutions by governments, central banks or other institutions can end up creating moral hazard and encouraging risky lending in the future. Financial bail-outs guaranteed by a lender of last resort can change incentives concerning risky decisions.
Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. But frequent bail-outs may lead lending institutions that are "too big to fail," or systemically important to the entire financial system, to take on more risky loans believing that they will not have to carry the full burden of losses (Kuttner).
Bear Stearns was one of the United States’ top five investment banks, but the bank’s liquidity was badly hurt by the subprime mortgage crisis in the late summer and fall of 2007, and they were nearing bankruptcy. If the bank were to fail, there would likely be a massive liquidity shock to the entire financial system that may last for a long time, so the federal government stepped in acting as the lender of last resort and provided Bear Stearns with enough money to temporarily stay afloat. They essentially had the attitude that Bear Stearns was “too big to fail.”
Fannie Mae and Freddie Mac purchase mortgages in a secondary market, and each is so large that, together, they own almost half of all mortgages in the United States. Obviously, if they were to go bankrupt, there would be a massive disturbance within the mortgage market and in financial markets in general.
Lehman Brothers, like Bear Stearns, was one of the country’s top five investment banks until it too began to have liquidity issues due to a plethora of bad assets. The government had recently bailed out Bear Stearns, Fannie Mae and Freddie Mac, so they were beginning to see limits to how far they could go with spending taxpayer money to save these massive institutions. As a result, Lehman Brothers failed, and this failure delivered a shock to financial markets.
After Lehman’s failure, the federal government took on a stronger version of the too big to fail attitude and became willing to bail out these massive institutions no matter what it took. Lehman Brothers was the last major corporation that Ben Bernanke and the federal government would deny.
Bail-outs of lending institutions by governments, central banks or other institutions can end up creating moral hazard and encouraging risky lending in the future. Financial bail-outs guaranteed by a lender of last resort can change incentives concerning risky decisions.
Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. But frequent bail-outs may lead lending institutions that are "too big to fail," or systemically important to the entire financial system, to take on more risky loans believing that they will not have to carry the full burden of losses (Kuttner).
Bear Stearns was one of the United States’ top five investment banks, but the bank’s liquidity was badly hurt by the subprime mortgage crisis in the late summer and fall of 2007, and they were nearing bankruptcy. If the bank were to fail, there would likely be a massive liquidity shock to the entire financial system that may last for a long time, so the federal government stepped in acting as the lender of last resort and provided Bear Stearns with enough money to temporarily stay afloat. They essentially had the attitude that Bear Stearns was “too big to fail.”
Fannie Mae and Freddie Mac purchase mortgages in a secondary market, and each is so large that, together, they own almost half of all mortgages in the United States. Obviously, if they were to go bankrupt, there would be a massive disturbance within the mortgage market and in financial markets in general.
Lehman Brothers, like Bear Stearns, was one of the country’s top five investment banks until it too began to have liquidity issues due to a plethora of bad assets. The government had recently bailed out Bear Stearns, Fannie Mae and Freddie Mac, so they were beginning to see limits to how far they could go with spending taxpayer money to save these massive institutions. As a result, Lehman Brothers failed, and this failure delivered a shock to financial markets.
After Lehman’s failure, the federal government took on a stronger version of the too big to fail attitude and became willing to bail out these massive institutions no matter what it took. Lehman Brothers was the last major corporation that Ben Bernanke and the federal government would deny.
Bear Stearns
Bernanke as a student of the Great Depression felt the pressure to do what was necessary to avoid a systemic collapse of the financial system. This led to the controversial bail-out of the investment bank, Bear Stearns.
While the Fed’s initial injection of liquidity had eased the markets but not eliminated the uncertainty about future funding and help firm confidence in borrowing and trading with one another. In March 2008, the Federal Reserve sought to rescue the investment bank Bear Stearns.
In mid-June 2007, Bear Stearns announced that two of its hedge funds that invested heavily in subprime MBS were not doing well. The securities were estimated to have lost 28% of their value since the beginning of the year (“CRS Report for Congress”).
In March 2008, the Federal Reserve Bank of New York provided an emergency loan to try to avert a sudden collapse of the company. The company could not be saved, however, and was sold to JPMorgan Chase for as low as ten dollars per share, a price far below the 52-week high of $133.20 per share, traded before the crisis, although not as low as the two dollars per share originally agreed upon by Bear Stearns and JP Morgan Chase.
The Federal Reserve Bank of New York stepped in with a 28-day loan through JPMorgan Chase. And arranged a necessary takeover; shares purchase by JPMorgan Chase initially set at $2 per share, but later increased to $10 per share to appease shareholders and ensure the deal would be accepted, combined with a $29 billion loan from the Federal Reserve, and with JPMorgan Chase taking on the first $1 billion of losses to Bear Stearns. The actions averted a financial system crisis that might have resulted otherwise (Berman, Kelly, Sidel).
While the Fed’s initial injection of liquidity had eased the markets but not eliminated the uncertainty about future funding and help firm confidence in borrowing and trading with one another. In March 2008, the Federal Reserve sought to rescue the investment bank Bear Stearns.
In mid-June 2007, Bear Stearns announced that two of its hedge funds that invested heavily in subprime MBS were not doing well. The securities were estimated to have lost 28% of their value since the beginning of the year (“CRS Report for Congress”).
In March 2008, the Federal Reserve Bank of New York provided an emergency loan to try to avert a sudden collapse of the company. The company could not be saved, however, and was sold to JPMorgan Chase for as low as ten dollars per share, a price far below the 52-week high of $133.20 per share, traded before the crisis, although not as low as the two dollars per share originally agreed upon by Bear Stearns and JP Morgan Chase.
The Federal Reserve Bank of New York stepped in with a 28-day loan through JPMorgan Chase. And arranged a necessary takeover; shares purchase by JPMorgan Chase initially set at $2 per share, but later increased to $10 per share to appease shareholders and ensure the deal would be accepted, combined with a $29 billion loan from the Federal Reserve, and with JPMorgan Chase taking on the first $1 billion of losses to Bear Stearns. The actions averted a financial system crisis that might have resulted otherwise (Berman, Kelly, Sidel).
Fannie Mae & Freddie Mac
Fannie Mae and Freddie Mac are two government-sponsored enterprises (GSE) that buy mortgages from banks, a process known as buying on the secondary market. They then package these into mortgage-backed securities, and resell them to investors on Wall Street. The collapse of the housing market brought light onto the mortgage back security market.
In the first government bail-out of the financial crisis, the Federal government stepped in an effort to restore trust by promising to bail-out bad loans and keep the housing slump from getting worse.
In July 2008, Congress approved a bailout plan Fannie Mae and Freddie Mac. The plan allowed the U.S. Treasury Department to guarantee as much as $25 billion in loans held by the two corporations, who hold or guarantee more than $5 trillion, or half, of the nation's mortgages. Wall Street's recent fears that these loans will default have caused Fannie's and Freddie's shares to tumble, making it more difficult for the private companies to raise additional capital themselves (Paulson).
In July 2008, Congress approved a bailout plan Fannie Mae and Freddie Mac. The plan allowed the U.S. Treasury Department to guarantee as much as $25 billion in loans held by the two corporations, who hold or guarantee more than $5 trillion, or half, of the nation's mortgages. Wall Street's recent fears that these loans will default have caused Fannie's and Freddie's shares to tumble, making it more difficult for the private companies to raise additional capital themselves (Paulson).
Lehman Brothers
Lehman Brothers, like Bear Stearns, Fannie Mae and Freddie Mac, had a lot of bad home loans, and they were near the point of having to declare bankruptcy in early September of 2008. Bear Stearns, Fannie Mae and Freddie Mac had already been bailed out by the federal government, and Lehman essentially wanted a similar sort of bailout.
Henry Paulson, the secretary of the treasury, did not want to spend more taxpayer dollars on bailing out yet another massive bank so he tried desperately to find a buyer for Lehman Brothers. He tried to urge other large banks to buy Lehman Brothers with the argument that an outside takeover was necessary to prevent the financial system from entering a state of complete panic. No banks were willing to step up and take over such a massive problem, so the only remaining possibility was a federal bailout.
Lehman was denied. On September 14, 2008 Lehman Brothers declared bankruptcy. The bailout would have cost the federal government somewhere between $60 billion and $90 billion. The lender of last resort did not lend in a time of desperation.
Many people thought that Paulson was simply trying to draw the line for how far he would go with the massive bailouts with the attitude that allowing banks to fail is a necessary part of maintaining the integrity of the financial system, but that has since been denied. In reality, it is still rather unclear as to what the true rationale was for Lehman’s denial. The denial is especially questionable because two days later the government did bail out AIG.
Lehman’s collapse added fuel to and already existing panic, and many people consider it a massive mistake to have let Lehman fail.
*This and further information available in Wessel: 2009
Henry Paulson, the secretary of the treasury, did not want to spend more taxpayer dollars on bailing out yet another massive bank so he tried desperately to find a buyer for Lehman Brothers. He tried to urge other large banks to buy Lehman Brothers with the argument that an outside takeover was necessary to prevent the financial system from entering a state of complete panic. No banks were willing to step up and take over such a massive problem, so the only remaining possibility was a federal bailout.
Lehman was denied. On September 14, 2008 Lehman Brothers declared bankruptcy. The bailout would have cost the federal government somewhere between $60 billion and $90 billion. The lender of last resort did not lend in a time of desperation.
Many people thought that Paulson was simply trying to draw the line for how far he would go with the massive bailouts with the attitude that allowing banks to fail is a necessary part of maintaining the integrity of the financial system, but that has since been denied. In reality, it is still rather unclear as to what the true rationale was for Lehman’s denial. The denial is especially questionable because two days later the government did bail out AIG.
Lehman’s collapse added fuel to and already existing panic, and many people consider it a massive mistake to have let Lehman fail.
*This and further information available in Wessel: 2009
AIG
Unlike Bear Stearns, Fannie Mae, Freddie Mac and Lehman, AIG is an insurance company, not a bank. AIG was, however, taking part in activities similar to those that caused the precarious financial stability of the banks.
They basically had a hedge fund that was trading credit default swaps and pooling them to securitize them much like the investment banks were doing with the subprime home loans. This hedge fund started to fail to the point where all of AIG was threatened. AIG was America’s largest insurance company, and if they were to fail, a panic would have resulted that would have made the panic over Lehman’s failure look miniscule.
Only two days after Lehman Brothers declared bankruptcy, the federal government paid $85 billion to bail out insurer AIG. There was already an overwhelming feeling of panic in the financial markets, and the failure of this insurance giant only two days after the bankruptcy of Lehman could have potentially threatened long term financial stability on a global level. Ben Bernanke, the chairman of the Federal Reserve Bank’s board of governors, is a student of the Great Depression, and after seeing how Lehman’s failure affected the global economy, he essentially had no choice but to take on a “too big to fail” attitude. This attitude has persisted, as the federal government’s loan to AIG is now up to over $180 billion.
*This and further information available in Wessel: 2009
Key Terms
· Bail-out: a large loan when a company or bank is nearing bankruptcy
· Moral hazard: an incentive to engage in very risky lending because of the knowledge that the loan is essentially insured by an outside entity
· Hedge fund: an investment fund limited to certain investors
· Moral hazard: an incentive to engage in very risky lending because of the knowledge that the loan is essentially insured by an outside entity
· Hedge fund: an investment fund limited to certain investors
