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The ‘Too Big to Fail’ Problem

Now that Freddie Mac and Fannie Mae have joined the “too big to fail” club, isn’t it high time we started thinking about how to avoid allowing companies and other quasi-private agencies to get into these problems in the first place? It seems that over the past few decades, the Federal government has pretty much given carte blanche for any large corporation to ignore sane business principles as long as their revenues are high enough. I’m not an economist, but I can’t hope avoid the thought that this history of bailouts does, in some perverse way, incentivize risky behavior by ensuring that there are no real consequences for your risks–as long as your failures are big enough.

Having read various responses to the recent financial and mortgage industry bailouts, it seems like the most common policy suggestions regarding bailouts are these:

1) Stop bailing companies out.
2) More regulations for the industry in which the bailouts occur.
3) Punish executives after a bailout–remove them from their positions, etc.
4) Nationalize or partially nationalize (ie own a large of stock) of the company being bailed out.

Personally, I’m inclined towards #1, as I don’t see why the government should step in and stop a business from failing. However, the odds of bailouts actually stopping are pretty much zero, as one consequence of democracy is that government has to be seen “doing something” in response to a crisis, even if the best response is for the government to ignore it.

Clearly, then, there’s some consensus that there needs to be some harsher consequences for future bailouts. Of these, the most likely to occur are probably #2 and #3, as thankfully there’s not a lot of political will for the government to control businesses in this country.

The problem is that both of those responses to the problem don’t seem to be likely to keep bailouts from happening in the future. For one, bailouts cross industries, so more regulation in one industry isn’t going to really affect a bailout in another. Also, as we can see from the past few decades in business, it’s clear that monumental failure as a high-profile corporate executive doesn’t actually seem to hinder one’s job prospects, unless that failure includes prison time. Additionally, the prospect of just losing executives might not be enough to change a corporate culture as a whole. After all, if the company survives, what does the Board care if they have to find a new CEO and CFO?

So having thought about this for a bit, the idea I think ought to be thrown around out there is this: if we have to bail a company out because it’s “too big to fail”, then the consequence a company should face for that bailout is to ensure that it doesn’t become “too big” again. In other words, if the federal government bails out a company, it ought to require that the company break itself up, preferably into at least three companies. That way, the company suffers consequences, but at least portions of that company will come under new leadership, and a secondary failure of one of the new companies is less likely to cripple the industry and economy as a whole.

Not being an economist, I’m sure somebody’s already thought of this, and there’s no doubt that there’s going to be some refinements here, but a mandatory breakup of a bailed out company seems to be the best way to disincentivize too-risky behavior without the risk of over-regulation.

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About Alex Knapp
Alex Knapp writes about pretty much everything under the sun, including politics, art, religion, philosophy, sports, music, culture, and science.

Comments

  1. Dave Schuler says:

    In other words, if the federal government bails out a company, it ought to require that the company break itself up, preferably into at least three companies

    While I’m inclined to think this is a good idea, I think the matter is somewhat more complicated, particularly in the cases of FNMA and FHLMC.

    In the general case U. S. companies are increasingly competing against large foreign competitors, sometimes with monopolies in their home countries, sometimes wholly or partially owned by foreign governments. While I like the idea of more smaller companies I’m not sure it’s prudent to chop up American companies (even failing American companies) so that they can be crushed by overseas competitors.

    In the specific cases of Fannie Mae (FNMA) and Freddie Mac (FHLMC) these GSE’s have the power to borrow against the Treasury at preferred rates. I’m not sure that a lot more organizations with that power are a great idea.

    As with lots of other things I think the underlying issue is one of incentives. The managers at these two GSE’s have incentives to act in ways in which nobody imagined when the two institutions were created and I think that needs to be changed.

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  2. Bithead says:

    How about the federal government not regulating who gets loans, and who gets preferential traeatment? Let’s admit that most of the IndyMac business for examles was because they, under Government pressure, issued loans to people who really couldn’t afford them.

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  3. Dave Schuler says:

    Is anybody talking about the federal government bailing IndyMac out? I haven’t heard that.

    Fannie Mae and Freddie Mac are very different cases from IndyMac. IndyMac’s a private mortgage banking company. Fannie Mae and Freddie Mac are government/private hybrids. Fannie Mae used to be a government department, pure and simple.

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  4. Michael says:

    How about if the government bought a controlling interest in the companies (going from smallest shares to larger), then liquidated their assets and shut them down?

    That way the government takes a smaller loss, punishes the largest shareholders and board members most (making them more concerned about the CEO on their next investment), gives competitors in the industry (maybe limited to US competitors) access to cheap assets, and basically says that no company is “too big to fail” because the government will force a less-painful shutdown before they reach that point.

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  5. Tlaloc says:

    I’m amenable to the concept.

    Then again I think the USG should break up walmart on the grounds that it represents a national security threat to the country, so take it for what it is worth.

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  6. Dave Schuler says:

    How about if the government bought a controlling interest in the companies (going from smallest shares to larger), then liquidated their assets and shut them down?

    We’re not going to liquidate and close Fannie Mae and Freddie Mac. Again, they’re public/private hybrids. We might return to them to departmental status but they’ll never be eliminated.

    The function that the agencies perform, ensuring continued liquidity, is still necessary.

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  7. Alex Knapp says:

    Dave,

    I realize that the FMs have some more complicated issues surrounding them. Bearing in mind my lack of expertise, my thought on the FMs is to break them up and disallow any entity ever having those preferred rates again.

    Michael,

    How about if the government bought a controlling interest in the companies (going from smallest shares to larger), then liquidated their assets and shut them down?

    That’s an interesting thought–kind of like a forced bankruptcy?

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  8. Michael says:

    That’s an interesting thought–kind of like a forced bankruptcy?

    More or less, only it would take place before the company got to the point of having to go Chapter 7, when presumably their asset/debt ratio will not have hit rock bottom yet.

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  9. Michael says:

    The function that the agencies perform, ensuring continued liquidity, is still necessary.

    Is there nobody else in the industry who provides that function?

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  10. anjin-san says:

    Let’s admit that most of the IndyMac business for examles was because they, under Government pressure, issued loans to people who really couldn’t afford them

    Let’s admit that this is a massive oversimplification of a complex issue. During the peak of the real estate boom, I was tending bar on Sat. nights at a local jazz club. Ever weekend, the bar was packed with mortgage brokers. They talked quite a bit about how much money they were making, laughed a lot about the ridiculous “stated income” claims many borrowers were making, and drank a great deal of single malt scotch.

    Not once did I hear one of them say, “Damn government is forcing me to write loans that we both know are going to fail”.

    Did government play a role in the crisis? Probably. Did greed? Absolutely.

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  11. Steve Plunk says:

    anjin-san makes the point this is a complicated issue and we are trying to simplify it in a way that can’t be done. Fannie Mae, Feddie Mac, Indymac, these sound so alike but are so very different. We should also avoid trying to draw all corporations into this.

    Bithead makes the point that government was heavilty involved in Indymac’s business and of course it was a partner in the other two. It has been acknowledged that politics played a part in management of FNMA and FHLMC. It also is true lenders were pressured into lending to less credit worthy groups while things were booming. The way I see it if the federal government screwed it up then they should bail ’em out. It’s called responsibility for one’s actions.

    Again, we can’t draw any conclusions about corporations in general from these problems. No one is suggesting we bail out one of the Dow industrials. These are unique businesses failing.

    So address the four points in Alex’s post.

    1. We should only bail out companies when the government is culpable to the problem.

    2. Regulation is likely part of the problem to begin with so additional regulation makes no sense.

    3. You can’t punish executives for failing at business unless they broke the law. Besides, the board of directors is who should be responsible yet they are ignored.

    4. Nationalizing any business has a poor track record of success. We’re not commies.

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  12. legion says:

    My main problem with this sort of bailout – admittedly less with this specific instance of the FM’s & more with the previous Wall Street bailouts – is that it’s inherently anti-capitalistic. I’m no economist, but I thought the whole point was that good businesses, that make good decisions, tend to grow; while bad businesses, that make poor decisions, fail & clear the way for new businesses. Government bailouts, especially highly-selective bailouts, double-especially gov’t bailouts for the largest, poorest-run concerns – sounds to me more like old Soviet-era central-gov’t-controlled Communism. And we all know how well that turned out…

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  13. anjin-san says:

    Regulation is likely part of the problem to begin with so additional regulation makes no sense

    Or perhaps intelligent regulation needs to take the place of some that was not properly though out.

    There is also the issue of due diligence responsibilities on the part of lenders. If someone is about to do something stupid, such as sign for a loan he probably will not be able to repay, a professional has a responsibility to tell him so. If a client insists on being stupid, thats his lookout, but clearly a lot of what was going on was brokers with visions of big paydays in mind telling unqualified borrowers they had nothing to worry about.

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  14. John425 says:

    steveplunk’s point #3: “You can’t punish executives for failing at business unless they broke the law. Besides, the board of directors is who should be responsible yet they are ignored.”

    Where the hell is fiduciary responsibility in these Boards? Too busy listening to newly-minted MBAs whose idea of long term is 4 months?

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  15. Anon says:

    For what it’s worth, here‘s Jim Lindgren’s take on the IndyMac failure and Schumer’s role.

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  16. Bithead says:

    “Damn government is forcing me to write loans that we both know are going to fail”.

    That’s because they didn’t own the company. But, they knew. Face it; They didn’t start writing such loans until recently, and that because the government demanded it.

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  17. Michael says:

    They didn’t start writing such loans until recently, and that because the government demanded it.

    [citation needed]

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  18. Bithead says:

    [citation needed]

    Really? What rock have you been under?

    Fine, if you wanna play that game just this once. Let’s look at the HUD site.

    Subprime Lending

    Subprime loans play a significant role in today’s mortgage lending market, making homeownership possible for many families who have blemished credit histories or who otherwise fail to qualify for prime, conventional loans. A recent HUD analysis, based on HMDA and related data, shows that the number of home purchase subprime applications increased from 327,644 in 1997 to 783,921 in 2000.

    And what was it that caused that shift?

    HUD is committed to increasing homeownership opportunities for all Americans. HUD is engaged in a special effort to boost the minority homeownership rate since the rate for black and Hispanic Americans lags behind that of others.

    And in the doing, what happened, of course is to be seen as non-discriminatory, banks were forced to weigh such factors as credit history and ability to pay, less in their overall evaluation of creditors. All without counting the cost. But as even HUD admits:

    Many have questioned why minorities appear to be over-represented in the subprime lending market. Studies reveal that even in upper-income African-American neighborhoods one is one-and-a-half times as likely to have a subprime loan than persons in low-income white neighborhoods. In neighborhoods where Hispanics comprise at least 80 percent of the population, they were 1.5 times as likely than the nation as a whole to have a subprime mortgage loan.
    ….
    Some allege this disparity to be attributed to subprime lenders purposefully marketing to African-American communities-what some have called reverse redlining

    And I’m one of the ones making that charge.
    Are you getting all of this?

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  19. anjin-san says:

    Are you getting all of this?

    HUD. Hmmm, part of the executive branch. OK, one more massive screwup by the Bush admin. Thanks for straightening it out.

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  20. anjin-san says:

    And if, as you are arguing HUD caused the problem, how is that the fault of liberals, who you keep blaming for the problem. Are those wacky liberals using their mind-control rays again?

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  21. Michael says:

    Are you getting all of this?

    Here’s what you’ve stated, please correct me if I’m wrong:

    1.) There was in increase in subprime loans between 1997 and 2000

    2.) HUD encouraged increasing home ownership by minorities.

    3.) Lenders targeting subprime loans minorities at minorities more than they did to whites.

    Okay, I’m with you so far. But what I’m missing is the piece that links #2 as a cause of #3, to get:

    4.) The government demanded that lenders give out subprime loans.

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  22. Michael says:

    Anjin-san,
    I don’t believe Bit has blamed liberals for HUD’s decisions, so you’re being prematurely defensive there. Also, blaming the Executive branch doesn’t prove Bit wrong, it in fact supports his argument that HUD is at fault.

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  23. Bithead says:

    HUD is only part of the problem, and is used as an example, And an easy source of documentation of the overall governmental push not as a target of original fault.

    (Background, check this)

    Also, while those I quoted mentioned race or ethnicity as an issue, race aqnd ethnicity are not the point. The point is that the people being loaned money to, simply were not qualified to take on loans. They were given loans so as to be seen as an ‘Equal Opportunity Lender”. It seems from a statistical POV fair enough to suggest that there were and are more minorities unqaulified for loans on a percentage basis than there are for other groups. the rates of Black home ownership, as an example is now listed at being around 49%. That’s quite an increase since even the 1980s, which saw black home ownership skyrocketing. I like the way that’s going, don’t misunderstand me.

    I wonder, however, how many of the sub-prime loans which have gone belly-up, were issued over the objections of their credit record and other traditional qualifications for loans, simply because of their minority status?

    A loss on a bad loan, after all, is cheaper in the short run, than a discrimination lawsuit. That alone, even absent new laws will certainly create the conditions we have now.

    Add to that, laws such as the Community Reinvestment Act, passed originally back in 77, (democrat congress, Jimmy Carter White House) and amended in 1995 (Clinton). It was these amendments to the CRA which created most of the trouble we have now, by allowing sub-primes to be secularized. That, in combo with the other factors I mentioned, created our current situation.

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  24. Michael says:

    I wonder, however, how many of the sub-prime loans which have gone belly-up, were issued over the objections of their credit record and other traditional qualifications for loans, simply because of their minority status?

    Yes, but wouldn’t you agree that this scenario falls under the category of “unintended consequences”? HUD didn’t say to give minorities sub-prime loans, it just failed to anticipate that this route was the easiest way lenders could reach HUD’s official goal of increasing minority home ownership.

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  25. Bithead says:

    Yes, but wouldn’t you agree that this scenario falls under the category of “unintended consequences”?

    Most disasters do fall into that line… or any accident for that matter where safety guidlines are ignored for one expediency or another.

    I should have mentioned that a fair amount of sub-prime loans… something on the order of 35-36% if I remember rightly, that are curretly out, are in the ahnds of real-estate speculators. That said, I can’t find how the failures from each group of sub-prime borrowers breaks down, just now, and I’d be interested to see it… and the trends of each over time… IOW, what was the trigger?

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  26. anjin-san says:

    Anjin-san,
    I don’t believe Bit has blamed liberals for HUD’s decisions, so you’re being prematurely defensive there. Also, blaming the Executive branch doesn’t prove Bit wrong, it in fact supports his argument that HUD is at fault.

    This discussion goes back over several threads…

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  27. anjin-san says:

    So far it seems clear that the government played a part in creating an environment conducive to the sub prime mess. What I am not seeing is the element of the government forcing lenders to make loans that were doomed to failure.

    It seems more like the government opened the door and the lenders happily went through it, making a great deal of money in the process…

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  28. Bithead says:

    What I am not seeing is the element of the government forcing lenders to make loans that were doomed to failure.

    That’s because you’re operating under the illusion that there was no business reason to redline certain areas of town…. reasons that were not at all racist.

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  29. anjin-san says:

    That’s because you’re operating under the illusion that there was no business reason to redline certain areas of town…. reasons that were not at all racist.

    No, thats because I am still not seeing an actual mechanism for “forcing”. How were lenders “forced”
    Under what penalty? Would they be taken to jail if they did not make these loans? You need to support your charge with something beyond vague statements…

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  30. Bithead says:

    (Shrug) You’re not looking.
    How to get additional minority loans out, as the law I cited (and as modified in 95) without taking added risks on bad loans? What I’m suggesting is that as of the late 70’s when Carter force CRA down our gullet, racism wasn’t the issue with minorities not getting loans. Ability to pay was. That was also true in 95 when Clinton modified it.

    I suggest a serious look at CRA and it’s ramifications before proceding.

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  31. anjin-san says:

    (Shrug) You’re not looking.

    Well, I am kinda busy this week. But I notice that you have not been able, amongst all your typing, to produce a single sentence that documents how lenders were forced to make loans they knew would fail. Were feds holding guns to the heads of the lenders while they wrote the loans?

    Forced is a strong word. Encouraged, enabled, that is one thing, forced is quite another. But this is hardly the first thing you have not been able to produce facts to support your arguments now, is it?

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  32. Bithead says:

    ‘Encoruaged’ at the point of a discrimination lawsuit?

    Come on. You’re just ducking, now. As soon as they were enabled, they were forced to act that way, or have large numbers of lawsuits headed their way.

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  33. Michael says:

    ‘Encoruaged’ at the point of a discrimination lawsuit?

    Come on. You’re just ducking, now. As soon as they were enabled, they were forced to act that way, or have large numbers of lawsuits headed their way.

    Then they should have taken it to court first and argued that there was no way to fulfill it’s requirement.

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  34. Bithead says:

    Bring them to court at whose expense?
    And given that they’d be viewed as being discriminatory…(Think the left wouldn’t so label them, as when CRA was first written? You know better…) at what cost in terms of image, and thereby what overall cost to the busienss?

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  35. Michael says:

    And given that they’d be viewed as being discriminatory…(Think the left wouldn’t so label them, as when CRA was first written? You know better…) at what cost in terms of image, and thereby what overall cost to the busienss?

    Well now that’s a PR problem, not a legal problem. They could spin it as “protecting the poor” if they were creative.

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