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May 07, 2009

Banks that are too big to fail might just be too big.

By Alan Stoga

Lehman Brothers failed on Sept. 15, 2008. In the conventional wisdom, that event turned a long-simmering crisis into a catastrophe that still grips the economy and the markets.
However, in hindsight, Lehman’s death might have been the best thing that could have happened to the rest of the big banks who were then struggling with the subprime mess. It scared Washington into saving them, at a cost of hundreds of billions of taxpayer dollars.
Now, the government is saying that the worst has passed, and the big banks will survive. Last week, the Federal Reserve said (PDF) that nine of the biggest banks have enough capital even if the economy worsens. The other ten need to raise $75 billion, according to the Fed—and, in the scale of banking numbers, that’s not considered much of a problem.
What could be a problem is the credibility of the so-called “stress tests” on which the government rests its assessment. Unlike typical regulatory bank inspections, these tests were designed to be made public, and to reassure, not scare the markets.
In other words, the Fed may have pulled its punches. The Wall Street Journal is reporting that the regulators “significantly scaled back the size of the capital hole” after the banks objected to the conclusions of the stress tests, and that four banks managed to reduce the Fed’s “capital needed” number by a total of $40 billion.
A former top Treasury official, who did not want to be identified, insisted that the tests were “reverse engineered” to produce results that would allow the Fed and Treasury to declare victory.
At least for the time being, the markets are willing to believe. Banking stocks are rising and investment bankers like Daniel Alpert of New York’s Westwood Capital seem willing to look forward. “My big concern at this point is not the solvency of the banks,” he says. Rather, it is “whether the banks will have enough capital to go out and take risks.”
That’s the vicious circle: if the banks don’t take risks, the economy won’t recover. But if the economy doesn’t recover, the banks—and Washington—could again be surprised.
If that happens, the price tag could rise well beyond the billions of government money already committed to keeping the big banks going. Simon Johnson, former IMF research director, warns that “we’ve gotten into the position of subsidizing a big, politically powerful sector of the economy.”
The result, says Harvard University’s Jeffrey Miron, is that “we’re stuck in this business for a very long time.”

Too Big to Fail

It’s not just the huge amounts of money committed post-Lehman to keep the big banks alive, but the two principles that have driven Washington’s approach to the crisis that may shape the future.
The first is that some banking institutions are simply too big to fail. As Martin Baily, a former chairman of the Council of Economic Advisers under President Clinton, told the Senate Banking Committee last week, “the disorderly failure of another major financial institution would…threaten economic recovery.”
The second is that, regardless of how much taxpayer money was made available to a weak bank, the government would not take control. The Treasury—backed first by President Bush and then by President Obama—said it did not want to run a bank, regardless how much of it the government owned.
In practice, that meant that neither the institutions, nor the management of the biggest banks would pay a price if things went badly. “It says that if you make excessively risky decisions, someone’s going to come in and pay for those,” says Miron.
That was probably music to the ears of the Bank of America, Citigroup and other very large banks. The American banks were looking at what the IMF now estimates (PDF) to be $1.6 trillion in write-downs between 2007–2010. In normal circumstances, or in other industries, that would almost certainly have been a death knell for at least a few of them.
Or, as Sen. Bob Menendez of New Jersey said last week: “If we’ve gotten to a point where an institution is too big to fail, haven’t we already failed?

Follow the Money

The conventional answer is that the market shock that followed Lehman’s demise proved that letting a big bank fail was simply too risky. Alpert points out that the network of relationships and transactions among big banks means that one failure could ripple through the system, pulling down other banks as well. “There’s no question that size matters: one big failure could be disastrous,” he says.
Another possibility is that Washington is simply too much a creature of Wall Street to even imagine any policy approach that challenged the viability of the biggest banks. Simon Johnson, a professor at MIT, thinks too many elected officials accept that “what’s good for Wall Street is good for the country.”
He also points out that there is a revolving door between government and Wall Street: “Goldman Sachs and the government are now pretty interchangeable in terms of ideas and policy proposals.”
However, the extraordinary policy choice not just to save the big banks, but to refuse to take control might be more than just the accidental confluence of bankers and government officials.
The “pay to play” atmosphere of contemporary Washington has been well documented. Indeed, President Obama made it one of the focal points of his campaign. Money matters, and bankers have big wallets.
Since 2004, banks, securities firms and their personnel have spent almost $1 billion in lobbying and federal campaign contributions, according to FLYP’s analysis of data collected by the Center for Responsive Politics.
Bill Buzenberg, executive director of the Center for Public Integrity, thinks “too big to fail” doesn’t capture the reality of Washington. “Many of these institutions are too politically connected to fail,” he says. Buzenberg recently authored a study that identified the 25 biggest issuers of subprime mortgages and linked most of them to the “too big to fail” banks that have now been rescued.
He calls it “a kind of legalized corruption.” Political contributions and lobbying contributed to a lack of regulation, and the lack of regulation produced the banking crisis.
He might have added: to the solution as well.

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And what happened to all those billions and billions of assets that the banks once had? That we the taxpayers are now being asked to replace? Most of them, I’d bet, have been hustled offshore to countries like the cayman islands and switzerland where they can be safely hidden from US Taxes. I think Obama is right to go after Americans who use these off-shore tax havens and get them to pay up. I expect that some of the names we find using those tax dodge hideouts will be no surprise to Americans, and will include some of the nation’s loudest critics of the Obama administration and some of the most vocal advocates of deregulation.

Jay Magoo
May 14, 2009