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Too Big to Fail or Too Big to Save? Fixing the System

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A year ago this week, when the world seemed to be falling apart, the US government took the bold and unusual step of pumping hundreds of billions of dollars into some of the country’s biggest banks in an effort to save them - and the global economy.

Now a year later, we're still trying to figure out if it was the right decision, how will we pay for it and how should we handle such a crisis in the future.

Robert Pozen is the author of Too Big to Save? How to Fix the U.S. Financial System and is my Guest Author with this post.

Guest Author Blog: Why Have We Bailed Out So Many Financial Institutions? by Robert Pozen.

Guest Author Blog
Guest Author Blog

Over the last year, the federal government has injected over $200 billion into approximately 600 financial institutions, and guaranteed over $300 billion of their troubled assets. Given the rapidly rising US budget deficit, what was the justification for such large bailouts, and what should be the rationale for bailouts in future financial crises?

In bailing out banks, federal officials have often invoked the rubric of “too big to fail.” But it seems impossible that 600 banks met this test. In my view, there are two valid definitions of “too big to fail:”

First, the US economy depends on the effective operation of the US payment system – the processing of checks, wires, etc. To protect the payment system, we should be prepared to bail out a handful of money center banks.

Second is the concept of “too interconnected” to fail. If the failure of a large financial institution would result in the insolvency of many other financial institutions, that is a reasonable basis for a bailout. For example, Fannie Mae and Freddie Mac were “too interconnected” to fail.

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Let us examine the recent 600 bailouts in light of these two criteria. In October of 2008, then Treasury Secretary Paulson effectively forced eight megabanks to accept $125 billion in federal capital.

Although several of these megabanks said they did not want or need the federal capital, Paulson insisted that they all accept in order to avoid stigmatizing the weaker ones.

By contrast, a senior analyst at Barclays Capital recently pointed out that investors attach little stigma to federal bailouts: “Indeed, the shares of banks that have accepted money from the Troubled Asset Relief Program (TARP) are actually trading better in some cases than those that have returned it.” (New York Times at B-9, September 22, 2009).

When a few big banks paid back their federal capital this spring, Treasury Secretary Geithner extended the deadline for small banks to apply for federal capital. Small banks are not critical to the payment system and are not too interconnected to fail. The federal government is contributing capital to small banks because they have been complaining loudly to Congress that they have been unfairly left out of the federal safety net.

The Crisis: 1 Year Later - A CNBC Special Report - See Complete Coverage
The Crisis: 1 Year Later - A CNBC Special Report - See Complete Coverage

Another politicized contribution of capital involved GMAC, the financing arm of General Motors. GMAC was permitted to become a bank holding company so it could receive $5 billion in federal capital under the TARP program. Of course, that program was supposed to rescue financial institutions, not auto companies. But Congress refused to pass legislation authorizing additional capital contributions to auto companies.

Like GMAC, American Express and Discover Financial were allowed to convert into bank holding companies in order to receive billions of dollars of federal capital. Although it would have been unfortunate if either credit card company had become insolvent, were they too big to fail? Since they serve a highly diversified base of merchants and customers, the bankruptcy of either credit card company would not have caused the failure of many other financial institutions. Indeed, other banks would quickly have taken on the business from the merchants and customers of the failed credit card company.

In addition, Goldman Sachs and Morgan Stanley were allowed to convert quickly into bank holding companies and subsequently received $10 billion each in federal capital. There is considerable evidence that the short term liquidity of these two broker dealers was under heavy pressure, but this problem was solved when they became banks that could borrow easily from the Federal Reserve. There is little evidence that either Goldman Sachs or Morgan Stanley needed a large infusion of federal capital in order to survive.

By contrast, when Lehman Brothers asked to become a bank holding company to deal with the heavy pressures on its short term liquidity, this request was rejected by the federal regulators. Why? We don’t know. Similarly, why did the federal regulators decide to bail out Bear Stearns but not Lehman Brothers, which was twice as large? Although many have speculated on the answer, again we really don’t know.

In order to put some discipline into the process of bailing out financial institutions, Congress should pass a statute requiring the Secretary of the Treasury to explain in writing the rationale for every federal bailout. That explanation should contain an analysis of the costs and benefits of the bailout, which should be approved by the Chairman of the FDIC and the Federal Reserve. This explanation should be reviewed in light of the subsequent facts by the General Accounting Office, which should issue a public report on its findings. Only with such a procedure will we understand the criteria actually used in applying the vague doctrine of “too big to fail,” and begin to hold accountable federal officials for spending billions of dollars on bank bailouts.

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Robert Pozen
Robert Pozen

Robert Pozen is Chair of MFS Investment Management, which manages over $150 billion in assets. He previously was Vice-Chair of Fidelity Investments. He currently is a senior lecturer at Harvard Business School.

He has published numerous articles in the Wall Street Journal, the New York Times, and the London Financial Times. He has served in senior positions at public entities such as the SEC and the State of Massachusetts.

He was a member of the President's Commission to Strengthen Social Security, and Chairman of the SEC's Advisory Committee on Financial reporting.

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Email me at bullishonbooks@cnbc.comAnd follow me on Twitter @BullishonBooks