Too Big to Fail: A History

Too Big to Fail: A History

Big bailouts weren't unprecedented in 2008—but their numbers were.


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.

Following the WaMu seizure, several more subprime lenders were taken over by the FDIC and sold immediately, but conditions in the financial markets continued to worsen. Former FDIC Chairman Sheila Bair describes in her book Bull by the Horns how Treasury Secretary Timothy Geithner and other regulators were all too willing to throw subsidies at the largest banks. Indeed, Bair’s counterparts at the Fed and the Office of the Comptroller of the Currency had been hiding the severe problems affecting two even larger lenders, Wachovia and Citigroup, from the FDIC. Both banks were insolvent and Bair, for her part, pushed to have both banks taken over by the FDIC and broken up. But that was never really a possibility.

On September 29, 2008, the FDIC even issued a press release to the effect that “Citigroup Inc. will acquire the banking operations of Wachovia Corporation; Charlotte, North Carolina, in a transaction facilitated by the Federal Deposit Insurance Corporation and concurred with by the Board of Governors of the Federal Reserve and the Secretary of the Treasury in consultation with the President.” By this time, however, nobody in Washington wanted to see another large bank holding company forced into bankruptcy. That is precisely what would have happened had Well Fargo not arrived in the eleventh hour, trumped Citi’s bid for Wachovia, and bought the entire company.

In the months which followed, the Treasury was forced to injected tens of billions of dollars into Citigroup, an institution that had been used as a political club house by former Treasury Secretary Robert Rubin and his political minions, including Geithner, Larry Summers and even current Treasury Secretary Jack Lew. While Bair was rightly proud of the fact that the FDIC “forced stabilizing sales of Washington Mutual and Wachovia with no government support,” she could not prevent Geithner from bailing out Citi. Geithner’s old Goldman mentor Bob Rubin, along with the rest of the Citi board of directors, might have faced serious legal sanctions had Citi actually failed.

The tale of Lehman Brothers and the other failures that occurred before and after is a story of how a somewhat schizophrenic democracy called America navigates between free market discipline and renewal, on the one hand, and socialist convenience and cronyism, on the other. Irvine H. Sprague described the dichotomy nicely in his 2000 book Bailout: An Insider's Account of Bank Failures and Rescues:

During the high interest times in the 1970's and 1980's, the banks and the savings and loan associations were under heavy financial pressure. Hundreds of them failed. The Home Loan Bank Board permitted the savings and loan associations to treat goodwill as capital, thereby allowing them to remain open and to build up enormous losses that eventually cost the taxpayers billions of dollars. The Federal Deposit Insurance Corporation took a different approach. It closed the banks or sold them, all at no cost to the taxpayers.

In a number of articles and books, I have made the case that Paul Volcker is the father of “too big to fail.” His preference for bailouts begins with Penn Square Bank and moves forward to his tutoring of E. Gerald Corrigan, the former head of the Fed of New York and now at Goldman Sachs. Corrigan is the celebrated author of the "Banks Are Special" doctrine that underlies all bailouts. During his tenure at the Fed of New York, Corrigan cleaned up many financial messes created by the titans of Wall Street, then suddenly left amid whispers that he had fumbled the investigation of Banco Nazionale del Lavoro.

But if former Fed Chairman Volcker is the father, argues the film maker John Titus, “that makes Richard Nixon the grandfather since he bailed out Lockheed in 1971.” Writing before the subprime bust, Spague noted that there were four major corporate bailouts—Chrysler Corp, Lockheed, New York City and Conrail—and four bank rescues. Other than the 1984 rescue of Continental Illinois, most Americans would not recognize the other names.