Every few days we hear that another leading financial institution
has written down billions more on subprime investments gone bad. Nearly
every major financial institution, it turns out, had a hand in loans to
low-credit borrowers--borrowers whose ability to pay often hinged on
endlessly low interest rates or a strong housing market. How could this
happen? How could nearly all the leading lights of the financial
industry--the experts in assessing and managing risk--expose themselves
to such massive losses? Or, as a Fortune cover crudely put it: "What were they smoking?"
A major part of the answer is: government bailout crack.
For decades our government has had a semi-official policy that large
financial institutions are too big to fail--and therefore must be
bailed out when they risk insolvency--a policy that creates perverse
incentives for them to take on far more risk than they otherwise would.
"Too big to fail" is implemented through a network of government bodies
that protect financial institutions from the long-term consequences of
their decisions at taxpayer expense--a phenomenon we can observe right
Consider Countrywide, a major subprime money-loser just acquired by
Bank of America. Private lenders have not been willing to grant
Countrywide the $10s of billions it sought to keep afloat, given the
company's huge and difficult-to-measure subprime exposure. In a free
market, bankruptcy would loom--but in our system, Countrywide and
others can turn to the government-backed Federal Home Loan Banks for
cash; these banks have lent Countrywide over $70 billion so far. According to the Wall Street Journal,
these banks specialize in "providing funding where other creditors
won't go"--which they can do because of "a widespread belief the
government would bail them out [with taxpayer money] in a crisis."
Cash from Federal Home Loan Banks is just one of the many entrees
the government provides on its bailout menu. Another option a failing
bank has is to court bank depositors--who will not be scared away
because their deposits are backed by the government's Federal Deposit
Insurance Corporation (FDIC). Countrywide and others have a huge
potential pool of capital accessible to them if they take on the
additional cost of offering depositors higher interest rates than their
competitors'. On its Web site, Countrywide is actively chasing your
dollars, boasting, "Can your bank match our CD rates?" The policy is
working; American depositors have invested or kept $10s of billions of
their savings in Countrywide's coffers--despite regular headlines about
the company's perilous finances. Depositors know that no matter how
reckless Countrywide is with their money, other taxpayers will be there
to pay the company's FDIC-backed commitments--just as they were there
to bail out depositors in savings and loans in the 1980s.
Still another item on the bailout menu is provided by the Federal
Reserve. Today and throughout history, when major financial
institutions are losing money, the Fed uses its power to manipulate
interest rates and the money supply so that banks can borrow
cheaply--giving them easy money with which to paper over their old
mistakes. Again, it is other taxpayers who pay--in this case, through
inflation. Inflation depletes Americans' hard-earned savings; the trend
of skyrocketing housing and commodity prices we have witnessed during
the last five years is just the latest and most obvious harm done by
our government's inflationary actions.
The combined effect of these and other bailout policies is to make
risk-taking less risky for large financial institutions--because true
failure is not an option.
If an institution can be bankrupted when its investments go bad, it
is supremely clear to its managers and its creditors (its depositors,
in the case of a bank) that they must be continuously diligent about
risk. They have every incentive to thoroughly investigate long-term
consequences--because enough money badly invested could mean the firm's
However, when the long term loses its meaning, when institutions are
told they can never fail, managers are given an incentive to put more
capital at risk. If the investments go well in the short term, as
subprime investments did for several years, the profit potential is
huge. If they eventually fail, the downside is only so bad; the
government will "do something" to keep the firms afloat.
And when these reckless investments do go well in the short term,
they're sure to be repeated. If one financial giant is reaping huge
profits from subprime, other firms are pressured to follow along--or
else risk losing investors, customers, or employees who want to be part
of the exciting profit machine. The long-term result of "too big to
fail" is a gradual and overall decline in responsible risk-taking--with
periodic crises like the subprime debacle.
Any doctrine that encourages overly-risky investing, and punishes
sound risk-taking is unfair and destructive. We need to phase out "too
big to fail" and replace it with a free market in banking, which would
reward sound long-term lending and borrowing practices and punish
irresponsible ones. Otherwise, the next financial market fiasco is just
a matter of time.