2
Did Creditors Expect to Get Rescued?
Was it reasonable for either investors or their creditors to expect government rescue?1 While there were government bailouts of Lockheed and Chrysler in the 1970s, the recent history of rescuing large, troubled financial institutions began in 1984, when Continental Illinois, then one of the top ten banks in the United States, was rescued before it could fail. The story of its collapse sounds all too familiar—investments that Continental Illinois had made with borrowed money turned out to be riskier than the market had anticipated. This caused what was effectively a run on the bank, and Continental Illinois found itself unable to cover its debts with new loans.
In the government rescue, the government took on $4.5 billion of bad loans and received an 80 percent equity share in the bank. Only 10 percent of the bank’s deposits were insured, but every depositor was covered in the rescue.2 Eventually, equity holders were wiped out.
In congressional testimony after the rescue, the Comptroller of the Currency implied that there were no attractive alternatives to such rescues if the 10 or 11 largest banks in the United States experienced similar problems.3 The rescue of Continental Illinois and the subsequent congressional testimony sent a signal to the poker players and those that lend to them that lenders might be rescued.
Continental Illinois was just the largest and most dramatic example of a bank failure where creditors were spared any pain. Irvine Sprague, in his 1986 book Bailout, noted, “Of the fifty largest bank failures in history, forty-six—including the top twenty—were handled either through a pure bailout or an FDIC assisted transaction where no depositor or creditor, insured or uninsured, lost a penny.”4
The 50 largest failures up to that time all took place in the 1970s and 1980s. As the savings and loan (S&L) crisis unfolded during the 1980s, government repeatedly sent the same message: lenders and creditors would get all their money back. Between 1979 and 1989, 1,100 commercial banks failed. Out of all of their deposits, 99.7 percent, insured or uninsured, were reimbursed by policy decisions.5
The next event that provided information to the poker players was the collapse of Drexel Burnham in 1990.6 Drexel Burnham lobbied the government for a guarantee of its bad assets that would allow a suitor to find the company attractive. But Drexel went bankrupt with no direct help from the government. The failure to rescue Drexel put some threat of loss back into the system, but maybe not very much—Drexel Burnham was a political pariah. The firm and its employees had numerous convictions for securities fraud and other violations.
In 1995, there was another rescue, not of a financial institution, but of a country—Mexico. The United States orchestrated a $50 billion rescue of the Mexican government, but as in the case of Continental Illinois, it was really a rescue of the creditors, those who had bought Mexican bonds and who faced large losses if Mexico were to default. As Charles Parker details in his 2005 study, Wall Street investment banks had strong interests in Mexico’s financial health (because of future underwriting fees) and held a significant number of Mexican bonds and securities.7 Despite opposition from Main Street and numerous politicians, policy makers put together the rescue in the name of avoiding a financial crisis. Ultimately, the US Treasury got its money back and even made a modest profit, causing some to deem the rescue a success. It was a success in fiscal terms. But it encouraged lenders to finance risky bets without fear of the consequences.
Willem Buiter, then an economics professor at the University of Cambridge, now the chief economist at CitiGroup, was quoted at the time saying,
This is not a great incentive for efficient operations of financial markets, because people do not have to weigh carefully risk against return. They’re given a one-way bet, with the U.S. Treasury and the international community underwriting the default risk. That makes for lazy private investors who don’t have to do their homework figuring out what the risks are.8
Or to put it a little more informally, all profit and no loss make Jack a dull boy.
The next major relevant event on Wall Street was the 1998 collapse of Long-Term Capital Management (LTCM), a highly leveraged private hedge fund.9 When its investments soured, its access to liquidity dried up and it faced insolvency. There was a fear that the death of LTCM would take down many of its creditors.
The president of the Federal Reserve Bank of New York, William McDonough, convened a meeting of the major creditors—Bankers Trust, Barclays, Bear Stearns, Chase Manhattan, Credit Suisse, First Boston, Deutsche Bank, Goldman Sachs, J. P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Parabas, Solomon Smith Barney, Société Générale, and UBS. The meeting was “voluntary,” as was ultimately the participation in the rescue that the Fed orchestrated.
Most of the creditors agreed to put up $300 million apiece. Lehman Brothers put up $100 million. Bear Stearns contributed nothing. Altogether, they raised $3.625 billion. In return, the creditors received 90 percent of the firm. Ultimately, LTCM died. While creditors were damaged, the losses were much smaller than they would have been in a bankruptcy. No government money was involved. Yet the rescue of LTCM did send a signal that the government would try to prevent bankruptcy and creditor losses.
In addition to all of these public and dramatic interventions by the Fed and the Treasury, there were many examples of regulatory forbearance—where government regulators suspended compliance with capital requirements. There were also the seemingly systematic efforts by the Federal Reserve beginning in 1987 and continuing throughout the Greenspan and Bernanke eras to use monetary policy to keep asset prices (equities and housing, in particular) bubbling along.10 All of these actions reduced investors’ and creditors’ worries of losses.11
That brings us to the current mess that began in March 2008. There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placed them into conservatorship, and is honoring their debts and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks.
Each case seems different. But there is a pattern. Each time, the stockholders in these firms were either wiped out or saw their investments reduced to a trivial fraction of what they were before. The bondholders and lenders were left untouched. In every case other than that of Lehman Brothers and Washington Mutual, bondholders and lenders received everything they were promised: 100 cents on the dollar. Many of the poker players—and almost all of those who financed the poker players—lived to fight another day. It’s the same story as Continental Illinois, Mexico, and LTCM—a complete rescue of creditors and lenders.
The most important and much-discussed exception to the rescue pattern was Lehman. Its creditors had to go through the uncertainty, delay, and the likely losses of bankruptcy. The balance sheet at Lehman looked a lot like the balance sheet at Bear Stearns—lots of subprime securities and lots of leverage. What should executives at Lehman have done in the wake of Bear Stearns’s collapse? What would you do if you were part of the executive team at Lehman and you had seen your storied competitor disappear? The death of Bear Stearns should have been a wake-up call. But the rescue of Bear’s creditors let Lehman keep playing the same game as before.
If Bear had been left to die, there would have been pressure on Lehman to raise capital, get rid of the junk on its balance sheet, and clean up its act. There were a variety of problems with this strategy: Lehman might have found it hard to raise capital. It might have found that the junk on its balance sheet was worth very little, and it might not have been worth it for the company to clean up its act. What Lehman actually did, though, is unclear. It appears to have raised some extra cash and sold off some assets. But it remained highly leveraged, still at least 25–1 in the summer of 2008.12 How did it keep borrowing at all given the collapse of Bear Stearns?
One of Lehman’s lenders was the Reserve Primary money market fund. It held $785 million of Lehman Brothers commercial paper when Lehman collapsed. When Lehman entered bankruptcy, those holdings were deemed to be worthless, and Reserve Primary broke the buck, lowering its net asset value to 97 cents. Money market funds are considered extremely safe investments in that their net asset value normally remains constant at $1, but on that day, Reserve Primary’s fund holders suffered a capital loss. What was a money market fund doing investing in Lehman Brothers debt in the aftermath of the Bear Stearns debacle? Didn’t Reserve’s executives know Lehman’s balance sheet looked a lot like Bear’s? Surely they did. Presumably they assumed that the government would treat Lehman like Bear. It seems they expected a rescue in the worst-case scenario.
They weren’t alone. When Bear collapsed, Lehman’s credit default swaps spiked, but then fell steadily after Bear’s creditors were rescued, through mid-May (figure 1), even as the price of Lehman’s stock fell steadily after January.13 This suggests that investors expected Lehman to be rescued, as Bear was, in the case of a Lehman collapse.14 Many economists have blamed the government’s failure to rescue Lehman as the cause of the panic that ensued.15 But why would Lehman’s failure cause a panic? What was the new information that investors reacted to? After the failure of Bear Stearns, many speculated that Lehman was next. It was well known that Lehman’s balance sheet was highly leveraged with assets similar to Bear’s.16 The government’s refusal to rescue Lehman, or at least its creditors, caused the financial market to shudder, not because of any direct consequences of a Lehman bankruptcy but because it signaled that the implicit policy of rescuing creditors might not continue.
The new information in the Lehman collapse was that future creditors might indeed be at risk and that the party might be over. That conclusion was quickly reversed with the rescue of AIG and others. But it sure sobered up the drinkers for a while.
Did this history of government rescuing creditors and lenders encourage the recklessness of the lenders who financed the bad bets that led to the financial crisis of 2008?
Figure 1. The Annual Cost to Buy Protection against Default on $10 Million of Lehman Debt for Five Years
Source: Phoenix Partners Group.
For the GSEs’ creditors, the answer is almost certainly yes. Fannie Mae and Freddie Mac’s counterparties expected the US government to stand behind Fannie and Freddie, which of course it ultimately did. This belief allowed Fannie and Freddie to borrow at rates near those of the Treasury.
From January 2000 through mid-2003, the spreads of Fannie Mae and Freddie Mac bonds vs. Treasuries—the rate at which Fannie and Freddie could borrow money compared to the US government—were low and falling. Those spreads stayed low and steady through early 2007. Between 2000 and fall 2008 when Fannie and Freddie were essentially nationalized, the rate on Fannie and Freddie’s five-year debt over and above Treasuries was almost always less than 1 percent. From 2003 through 2006, it was about a third of a percentage point.17 Yet between 2000 and 2007, as I show below, Fannie and Freddie were acquiring riskier and riskier loans, which ultimately led to their death. Why didn’t lenders to Fannie and Freddie require a bigger premium as Fannie and Freddie took on more risk?
The answer is that they saw lending to the GSEs as no riskier than lending money to the US government. Not quite the same, of course. GSEs do not have quite the same credit risk as the US government. There was a chance that the government would let Fannie or Freddie go bankrupt. That’s why the premium rose in 2007, but even then, it was still under 1 percent through September 2008.18
The unprecedented expansion of Fannie and Freddie’s activities even as their portfolio became riskier helped create the housing bubble. This eventually led to their demise and conservatorship, the polite name for what is really nationalization. The government has already paid out over $100 billion on Fannie and Freddie’s behalf, with a much higher bill likely to come in the future.19
But what about the lenders to the commercial banks and the investment banks? Yes, the government bailed out all the lenders other than those that lent to Lehman and Washington Mutual. Yes, many institutions that had made bad bets survived instead of going bankrupt. But did this reality and all the rescues of the 1980s and 1990s really affect the behavior of lenders in advance of the rescues?
We can’t know with certainty. No banker will step forward and say that past bailouts and the “Greenspan put” caused him to be less prudent and made him feel good about lending money to Bear Stearns. No executive at Bear Stearns will say that he reassured nervous lenders by telling them that the government would step in. And Goldman Sachs continues to claim that it is part of a “virtuous cycle” of raising capital and creating wealth and jobs, that it converted into a bank holding company to “restore confidence in the financial system as a whole,” and that the rescue of AIG had no effect on its bottom line.20 (Right. And I’m going to be the starting point guard for the Boston Celtics next year.)
While direct evidence is unlikely, the indirect evidence relies on how people generally behave in situations of uncertainty. When expected costs are lowered, people behave more recklessly. When football players make a tackle, they don’t consciously think about the helmet protecting them, but safer football equipment encourages more violence on the field. Few people think that it’s okay to drive faster on a rainy night when they have seatbelts, airbags, and antilock brakes, but that is how they behave.21 Not all motivations are direct and conscious.22
There is even some evidence of conscious expectations of rescue, though it is necessarily anecdotal. Andrew Haldane, the executive director of Financial Stability of the Bank of England, tells this story about stress-testing, simulations that banks conduct to examine worst-case scenarios for interest rates, the state of the economy, and so on, to make sure they have enough capital to survive:
A few years ago, ahead of the present crisis, the Bank of England and the FSA [Financial Services Authority] commenced a series of seminars with financial firms, exploring their stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests. A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia—disappointing, but perhaps unsurprising? Or network externalities—we understood how difficult these were to capture?
No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.
All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mis-managing their risks?
Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue.23
The only difference between this scenario in the United Kingdom and the one in the United States is that, in the United States, the Fed came to the rescue, and the executives, for the most part, kept their bonuses.
NOTES
1. The policy of government bailout is usually called “too big to fail.” But government occasionally lets large financial institutions fail. As I show below, the government almost always makes sure that creditors get all the money they were promised. The rescue of creditors is what creates excessive leverage and removes the incentive of the one group—creditors—with the natural incentive to monitor recklessness.
2. See Robert L. Hetzel, “Too Big to Fail: Origins, Consequences, and Outlook,” Economic Review (Nov./Dec. 1991), http://www.richmondfed.org/publications/research/economic_review/1991/er770601.cfm.
3. C. T. Conover, testimony before the House Subcommittee on Financial Institutions Supervision, Regulation and Insurance of the Committee on Banking, Finance, and Urban Affairs, Inquiry into Continental Illinois Corp. and Continental Illinois National Bank, 98th Cong., 2nd sess., 1984, http://fraser.stlouisfed.org/historicaldocs/678/download/63823/house_cinb1984.pdf.
4. Irvine Sprague, Bailout: An Insider’s Account of Bank Failures and Rescues (New York: Basic Books, 1986), p. 242.
5. Stern and Feldman, Too Big to Fail, 12. They do not provide data on what proportion of these deposits were uninsured.
6. See “Predator’s Fall: Drexel Burnham Lambert,” Time, February 26, 1990, http://www.time.com/time/magazine/article/0.9171,969468,00.html.
7. Charles W. Parker III, “International Investor Influence in the 1994–1995 Mexican Peso Crisis,” working paper, Columbia International Affairs Online, Columbia University, 2005, http://www.ciaonet.org/wps/cid096/ (login required).
8. Willem Buiter quoted by Carl Gewirtz in “Mexico: Why Save Speculators?” New York Times, February 2, 1995, http://www.nytimes.com/1995/02/02/business/worldbusiness/02iht-bail.html?scp=13&sq=tesobonos%20mexico%20bailout&st=cse.
9. See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000).
10. Nell Henderson, “Backstopping the Economy Too Well?” Washington Post, June 30, 2005, http://www.washingtonpost.com/wp-dyn/content/article/2005/06/29/AR2005062902841.html.
11. See Barry Ritholtz, Bailout Nation (New York: Wiley, 2009), and the following podcast with Ritholtz: Library of Economics and Liberty, “Ritholtz on Bailouts, the Fed, and the Crisis,” http://www.econtalk.org/archives/2010/03/ritholtz_on_bai.html.
12. Investopedia, “Case Study: The Collapse of Lehman Brothers,” http://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp?viewed=1.
13. Buying a credit default swap on Lehman was insurance against Lehman defaulting on its promises. The fact that the price fell between March and May in the aftermath of Bear’s collapse means that it was cheaper to buy that insurance. Evidently traders believed that Lehman was unlikely to go bankrupt.
14. See Liz Rappaport and Carrick Mollenkamp, “Lehman’s Bonds Find Stability,” Wall Street Journal, June 13, 2008, http://online.wsj.com/article/SB121331446000169869.html. They wrote, “The tempered reaction in the bond markets underscores investors’ conviction the Federal Reserve won’t let a major U.S. securities dealer collapse and that Lehman Brothers may be ripe for a takeover. In March, when Bear Stearns was collapsing, protection on Lehman’s bonds cost more than twice as much as it does now.” A nice description of how credit default swaps worked and some levels they traded at for various firms at different times is available at http://www.briefing.com/GeneralContent/Investor/Active/ArticlePopup/ArticlePopup.aspx?Articleld=NS20080912145604TankingStock.
15. One prominent exception is John Taylor, who argues that it was Paulson’s panic and apocalyptic threats of disaster that spooked the markets, not Lehman going bankrupt. See John Taylor, Getting off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Stanford, CA: Hoover Institution Press, 2009).
16. “Lehman Next to Be Squeezed?” Sydney Morning Herald, March 15, 2008, http://www.smh.com.au/business/lehman-next-to-be-squeezed-20080315-1zme.html.
17. See Figure 7 in James R. Barth, Tong Li, and Triphon Phumiwasana, “The U.S. Financial Crisis: Credit Crunch and Yield Spreads,” http://www.apeaweb.org/confer/bei08/papers/blp.pdf.
18. In other words, even as Fannie and Freddie were near death, they were still able to borrow at rates only 1 percent above the rates the US government was offering on Treasuries.
19. See Congressional Budget Office, “CBO’s Budgetary Treatment of Fannie Mae and Freddie Mac,” background paper, January 2010, pp. 7–8, http://www.cbo.gov/ftpdocs/108xx/doc10878/01-13-FannieFreddie.pdf.
20. John Arlidge, “I’m Doing ‘God’s Work.’ Meet Mr. Goldman Sachs,” Sunday Times, November 8, 2009, http://www.timesonline.co.uk/tol/news/world/us_and_americas/article6907681.ece?token=null&offset=0&page=1.
21. The Peltzman effect, named for Sam Peltzman’s innovative work on automobile safety regulation, is a form of moral hazard. Clive Thompson, “Bicycle Helmets Put You at Risk,” New York Times, December 10, 2006, offers a fascinating example of subconscious effects. This study finds that drivers drive closer to cyclists when they are wearing a helmet. Wearing a helmet increases the chance of being hit by a car.
22. See the posts at Macroeconomic Resilience, http://www.macroresilience.com, for Hayekian arguments on how moral hazard selects for risk-taking, particularly in the presence of principal–agent problems.
23. Andrew Haldane, “Why Banks Failed the Stress Test,” Marcus-Evans Conference on Stress-Testing, February 9–10, 2009, pp. 12–13, http://www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf.