To bail or not to bail?


Eoin Martin asks how one juggles the $85 billion question of whether to let a financial institution fail or not.

When Lehman Brothers filed for bankruptcy on Monday 15th September, US Treasury officials said they had wanted to draw a line in the sand. Having saved Bear Stearns, Fannie Mae and Freddie Mac with government money, Hank Paulson, the Treasury Secretary, had decided to let a big bank fail.

The sand is a fine place to draw a line if you don’t mind it being washed away in no time. Just 36 hours after Paulson told journalists in the White House that he never considered putting tax-payers’ dollars on the line for Lehman, the Federal Reserve effectively did just that to the tune of $85 billion for ailing insurer AIG.
Why the sudden change of mind? Despite the apparent irrationality, both the decisions to let Lehman fail and to bail out AIG were sensible and brave.

The sand is a fine place to draw a line if you don’t mind it being washed away in no time

The question is, how do financial regulators decide when to save a bank and when to let one fail and why does it matter? It matters because banks are not like ordinary businesses. If they fail, they tend to cause other banks and businesses to fail too, sometimes spreading almost uncontrollable contagion throughout the financial system.

In simple terms, the fear is that if banks think regulators will always step in to save the day, they will be encouraged to take larger risks than would otherwise be the case. This is known as moral hazard.
Regulators need banks to worry that their help cannot be taken for granted. This requires a cool head and careful timing or it can go badly wrong. By sending too many mixed signals, the British government arguably hastened the demise of Northern Rock last year.

In March 2008, the smallest of the five New York investment banks, Bear Stearns, was bought at a knock-down price by JPMorgan Chase to prevent it becoming insolvent. The deal was supported by the Federal Reserve Bank of New York with a loan of $29 billion for the company’s more risky assets. This was not a bail-out as such but without putting public money at risk, the deal would not have happened.

Even though Bear Stearns itself was comparatively small, the case for saving it was based on the fact that it was the counterparty to almost $10 trillion (yes trillion) worth of derivatives. Nobody was sure what would happen if the bank suddenly disappeared but the thought was sufficiently terrifying to be worth preventing.
This is an example of the concept that some banks are too big to fail. This was also the logic behind the US Treasury takeover of the two government-sponsored mortgage companies Fannie Mae and Freddie Mac a fortnight ago. The amount of debt held by those companies and the damage their collapse would have caused to an already weakened property market was unthinkable to US authorities.

Regulators don’t like the “too big to fail” theory for obvious reasons. They fear it gives risk-taking bankers a feeling of invincibility. If this was dangerous a decade ago, it is catastrophically so now due to the proliferation of immensely complex financial derivatives. These instruments are designed to spread risk however they can also have the effect, in layman’s terms, of putting risk everywhere.

Last week, the financial crisis took its most deadly twist yet. A second investment bank, Lehman Brothers was spirally towards collapse. Naturally the Fed and the Treasury hoped a buyer could be found. Bank of America and Barclays were the only possibilities. Neither was willing to take such a gamble unless the risks were underwritten by the tax payer.

Hank Paulson didn’t lift a finger. It was a well-judged move. Lehman like Bear Stearns was a counterparty to a lot of credit default swaps although not to quite the same extent. The likelihood that its collapse will damage the financial system extensively is real and already evident.

Despite this, the Treasury signalled that it intended to stop the rot. Loose regulation and sharp practice on Wall Street are much to blame for the current crisis and further encouragement of this would ultimately be detrimental.

Regulators need banks to worry that their help cannot be taken for granted

A second justification was that sooner or later the Treasury and the Fed risked running out of money. It took over $200 billion to save Fannie Mae and Freddie Mac. It was not sustainable for federal agencies to engage in bail-outs on that scale at intervals of only nine days.

What then was the explanation for saving AIG, America’s largest insurance company? No doubt regulators baulked at the idea but the answer is that AIG really was just too big to fail. Unusually for an insurer, it was much bigger than a bank by virtue of the fact that it had insured vast amounts of debt using derivatives.
When an insurer fails, its policy holders often have to bear their losses themselves. In this case, that meant thousands of institutions bearing hundreds of billions of dollars. The results would have been cataclysmic.
Hank Paulson was still concerned about moral hazard and rightly so. The strategy the US authorities have adopted is tough but sensible. The government took more than 79% of AIG. They also got rid of the management and took first preference on the assets. That punishes the risk takers and is the best the deal the tax payer can hope to get.

Looking at Hank Paulson and Ben Bernanke, Mervyn King, the Governor of the Bank of England, and Alistair Darling, the Chancellor of the Exchequer, may be wondering how they managed to get the comparatively minor kerfuffle at Northern Rock so badly wrong.

More likely they’re hoping they will not have to bail out any more banks in their careers. If last week showed anything, and in fact it showed many things, it was that you could write a rule book one day and throw it out the next.