Too Big to Fail: A History
There has been a great deal of discussion concerning the fifth anniversary of the failure of Lehman Brothers. Just about anyone who knows anything about the event believes that allowing the giant securities firm to fail was a bad idea, a negative event that made the Great Recession that followed the subprime debt bust even worse. At the same time, most Americans oppose the idea of bailing out large banks.
No society which does not allow for economic failure can truly call itself free. Thus, any discussion of Lehman Brothers raises questions about the American political system which are as old as the Republic itself.
The hard reality is that the financial collapse of Lehman Brothers was necessary and inevitable, even beneficial. The largest bankruptcy in U.S. history shattered the comfortable illusion that American regulators were in control of the financial markets. But it also accelerated a political process whereby bailouts for big banks and corporations—what we call “too big to fail”—are more likely than ever before. Members of Congress solemnly declare the need to make future bailouts impossible. Yet nothing which has followed since the subprime bust in terms of new laws and regulation alters the political trajectory whereby public bailouts of large private banks and companies are still viewed as the path of least resistance.
The first thing to observe about the failure of Lehman Brothers was that it was hardly the only failure in that fateful year and before. New Century Financial, American Home Mortgage and Countrywide Financial had either failed or been acquired in fire sales in 2007. Bank of America officially agreed to acquire Countrywide in January of 2008, but the smaller firm had been doomed since at least 2006. Despite this fact, regulators still did not appreciate the scope of the growing crisis even as the symptoms of contagion appeared around the periphery of the financial world.
Three months later, Bear Stearns collapsed into the arms of the Federal Reserve Bank of New York. By April of that year, my old employer was sold to JPMorgan Chase for a fraction of its valuation. A large primary dealer in U.S. government bonds disappeared. But the firestorm was just beginning. By July 2008, the Federal Deposit Insurance Corp had taken over IndyMac, one of the largest banks ever resolved by the deposit insurance agency. Funding for all of the financial community was drying up fast, forcing securities dealers large and small to run for cover. Secret discussions began to orchestrate the sale of several large broker dealers to commercial banks, but the management of Lehman Brothers refused to take any of these final opportunities.
By early September, the stage was set for full blown contagion. Mortgage giants Fannie Mae and Freddie Mac were taken over by the U.S. government, illustrating the degree to which the growing dysfunction in the mortgage markets had worked its way up the credit risk food chain, from subprime lenders like New Century to subprime debt shops such as Bear Stearns to government-guaranteed mortgage agencies backed with the full faith and credit of the U.S. Treasury. Like the recent flooding in Colorado, the liquidity running away from Wall Street destroyed everything in its path.
By September 15, as Lehman Brothers filed for bankruptcy protection, Bank of America agreed to acquire Merrill Lynch for $50 billion. This was the second major primary dealer acquired by Bank America in less than a year. The next day, American International Group (AIG) accepted an $85 billion bailout by the Federal Reserve and the U.S. Treasury in return for a 79.9% equity stake in the crippled life insurer. As part of the government bailout of AIG, all of the firm’s counterparties such as Goldman Sachs were made whole, 100 cents on the dollar, for funds owed them by AIG.
The following week, the two remaining independent broker dealers, Goldman Sachs and Morgan Stanley, became bank holding companies, a move meant to at least partly alleviate the funding problems that affected all of Wall Street. But only a few days later, the second shoe dropped with the FDIC seizure of Washington Mutual. While all of the events which had occurred up to that point were indeed horrific, the failure of a large federally insured depository nearly caused the U.S. financial system to seize up on that fateful day. Its bank branches and assets were sold to JPMorgan Chase in the biggest U.S. bank failure in history, but the parent company filed bankruptcy that day.
The rescue of AIG, the failure of Washington Mututal and the bankruptcy filing by the parent company, changed the financial and political equation of the subprime crisis. It was one thing for large non-bank mortgage companies and even broker dealers to fail and be acquired by other like firms. But when the Treasury had to rescue AIG and then the FDIC and other government agencies started to take down large federally insured banks of the size of Washington Mutual, the willingness of America’s political class to follow the dictates of market forces evaporated. Not only had the failure of WaMu caused significant losses to bond investors in the parent company, but yet another primary dealer of U.S. government securities had disappeared.