Hot Issue: Too Big to Fail

In recent years in Washington, politicians of both major political parties have supported policies that make the American taxpayer the ultimate backstop for failing private sector firms. Rather than allowing entrepreneurs and companies to succeed or fail based on their success at serving the needs of their customers, Congress and the Executive Branch have decided that certain entities are ‘too big to fail’. They have ensured that tax money is available to allow these firms to survive and even prosper. But rejection of a policy centuries old – one that requires firms to succeed or fail based on their performance against competitors in the market – is fraught with problems:

• It encourages risky behavior by firms which recognize that the government will ultimately bear the cost of failure
• it discourages innovation by giving private actors another way to succeed
• it poorly serves consumers who benefit from competition
• it wastes taxpayer dollars supporting companies that consumers do not patronize

The most obvious beneficiaries of taxpayer largesse have been several government sponsored enterprises: FNMA and FMAC. ‘Fannie’ and ‘Freddie’ were created to expand credit for home purchases and allow more Americans to afford homes. But policymakers eventually forced the agencies to dilute their credit requirements, with disastrous results:

Starting in 1993, political forces pushed Fannie and Freddie to loosen their once strict loan purchasing requirements. By 1996, regulations required that 40% of all Fannie and Freddie-bought loans must come from individuals with below median incomes. In 1995, Fannie and Freddie began buying subprime securities originally bought and bundled by private firms. One of these firms was Countrywide Financial who, thanks to their status as Fannie Mae’s biggest customer, delivered investors a 23,000% return between 1985 and 2003. By 2004, Fannie and Freddie were purchasing $175 billion worth of subprime securities per year from Countrywide and their brethren… a 44% share of the entire market. There are other factors that helped contribute to the 2008 financial crisis, but Fannie and Freddie’s use of their “too big to fail” status to create and grow the subprime security market was essential.

Having created a housing bubble by irrationally extending credit, policymakers in Washington now decided not to allow that bubble to collapse. The Federal government seized control of Fannie and Freddie in 2008. By July of 2009, Uncle Sam had poured nearly $90 billion into the two GSEs. By May, 2010, the two lenders had received more than $125 billion in taxpayer money, and were requesting nearly $20 billion more – with an end to losses nowhere in sight. The Congressional Budget Office estimates that losses to taxpayers will ultimately total about $370 billion.

As the government extended a blank check to these housing lenders, in the hopes of forestalling a dramatic correction in housing prices, it simultaneously bailed out a number of entirely private-sector companies. These bailouts were implemented through the Troubled Asset Relief Program, which passed Congress and was signed into law by President Bush, on October 3, 2008. Much as in the case of the Fannie/Freddie takeover, the goal of the TARP was to prevent economic collapse. As Secretary Paulson said at the time “the clogging of our financial markets has the potential to have significant effects on our financial system and our economy.”

The beneficiaries of the Troubled Asset Relief Program eventually grew to include many large Wall Street firms – among them Citigroup, Bank of America, AIG (American International Group), JPMorgan Chase, Wells Fargo, General Motors, Goldman Sachs, Morgan Stanley, PNC Financial Services Group, U.S. Bancorp, GMAC Financial Services, Chrysler, Capital One Financial, Regions Financial Corporation, American Express, Bank of New York Mellon Corp, State Street Corporation, and Discover Financial.

While the financial firms that received taxpayer funds through the TARP are expected to pay those funds back in full, General Motors and Chrysler present a different case. The federal government committed more than $50 billion to the two auto companies in 2009, but it’s not clear how much progress has been made toward re-establishing those companies as successful private entities.

In the case of General Motors for example, the firm is now misleading taxpayers with the claim that it has paid back its federal loans ‘in full, and ahead of schedule.’ But the claim is dubious. While GM has returned $6.7 billion in TARP funds, those funds are derived from a separate escrow account, also made available under TARP.  In other words, GM is using taxpayer-supported money to pay back the taxpayers. Further, GM is simultaneously applying to the Department of Energy for a separate $10 billion loan intended to help automakers meet CAFE standards. This loan would come at a lower interest rate than the one GM has ‘repaid.’ Also, GM skates around the question of the federal government’s controlling share in the firm. The company further ignores that Uncle Sam was originally expected to begin selling off GM shares in 2010 – a plan that is now on hold. Chrysler and GM continue to operate far below capacity, and suffer from significant competitive challenges. According to the Congressional Budget Office, the ongoing experiment in taxpayer-ownership of car companies is likely to cost approximately $35 billion.

Several years into the ‘bailout era,’ there’s little evidence that the bailouts have helped economic growth. Polls show that the American people now firmly oppose the TARP, and the idea that some firms are ‘too big to fail.’ And politicians in Washington clearly demonstrate that they recognize the public wish by promising to end it. Nevertheless, Congress has been poised to make bailout authority permanent, and to eliminate the need for Congress to take a vote on it again:

The Dodd bill provides for a $50 billion fund, collected in advance from large financial firms, that will be used for the resolution process. In other words, the creditors of any company that is resolved under the Dodd bill have a chance to be bailed out. That’s what these outside funds are for. But if the creditors are to take most of the losses—as they did in Lehman—a fund isn’t necessary.

Which system is more likely to eliminate the moral hazard of too big to fail? In a bankruptcy, as in the Lehman case, the creditors learned that when they lend to weak companies they have to be careful. The Dodd bill would teach the opposite lesson. As Sen. Richard Shelby (R., Ala.) wrote in a March 25 letter to Treasury Secretary Tim Geithner, the Dodd bill “reinforces the expectation that the government stands ready to intervene on behalf of large and politically connected financial institutions at the expense of Main Street firms and the American taxpayer. Therefore, the bill institutionalizes ‘too big to fail.’”

Mr. Shelby is right on target.

Congress is expected to consider the Dodd bill by June, 2010. Congressional leaders have consented to delete authority for permanent bailouts before final passage. But the fact that it was proposed initially shows clearly that many in Washington continue to believe bailouts are necessary and appropriate. That culture has to change.