Companies Too Big to Fail or Too Big to Exist: Dilemma– Morton Fork, Hobson Choice, Darwin Rule…

Once you lose your freedom to fail, you also lose your freedom to succeed and you cease to be a free society. ~Jeb Hensarling

Too big to fail (TBTF) is a phrase used in regulatory economics and public policy and describes certain enterprises and institutions that are so large and so interconnected that their failure will be disastrous to the economy. Therefore, the federal government has a responsibility to support them when they face difficulty, so goes the logic.

Proponents of the theory believe that the importance of some institutions means they should become recipients of favorable financial and economic policies from governments or central banks. Some economists, such as, Nobel Laureate Paul Krugman hold that economy of scale in banks and in other businesses are worth preserving, so long as, they are well-regulated in proportion to their economic clout; therefore, the too big to fail status can be acceptable.

In addition, the global economic system must also deal with sovereign states (countries) that are too big to fail. Critics see the policy as flawed and large banks or other institutions should be left to fail, if their risk management is not effective. Critics, such as, Alan Greenspan, believe that such large organizations should be deliberately broken up: If they’re too big to fail, they’re too big.

In the article Too Big to Fail by Kimberly Amadeo writes:  The phrase too big to fail arose during the financial crisis to describe why the government needed to bailout some companies. Big banks, insurers…  improved their profitability by creating, then selling, complicated derivatives…

When economy was booming, they derived an unfair competitive advantage, took over smaller firms, and became even bigger. When their investments started going south, they knew the taxpayers would be forced to bail them out– or risk global economic collapse. An example is AIG, one of the world’s largest insurers. AIG was too big to fail because, if they went bankrupt it could trigger the bankruptcy of many other financial institutions…

Lehman Brothers, investment bank, was also too big to fail but the government refused bailout and it filed for bankruptcy, triggering a deep-drop in the stock market… The mortgage giants, Fannie Mae and Freddie Mac, were also too big to fail because they guaranteed 90% of all home mortgages.

The government guaranteed $100 million in their mortgages, in effect, returning them to government ownership. If Fannie and Freddie had gone bankrupt the housing market decline would have been much worse, since banks were not lending without their guarantees...

Enter the Dodd-Frank Wall Street Reform Act, which is the most comprehensive financial reform since the Glass-Steagall Act. It sought to regulate the financial markets and make another economic crisis less likely. It set-up the ‘Financial Stability Oversight Council’ to prevent any more banks from becoming too big to fail. How? It looks out for risks that affect the entire financial industry. It also oversees non-bank financial firms like hedge funds.

If any of these companies get too big, it can recommend they be regulated by the Federal Reserve, which can ask it to increase its reserve requirement. The Volcker Rule, another part of Dodd-Frank, also helps end too big to fail. It limits the amount of risk large banks can take. It prohibits them from trading in stocks, commodities or derivatives for their own profit, however, they can do so only on behalf of customers, or to offset business risk.

In the article “Big Banks: Now Even Too Bigger to Fail” by David J. Lynch writes:  Two years after the Obama administration vowed to eliminate the danger to the economy from financial institutions that are too big to fail; those same institutions, the nation’s largest banks are bigger than they were before the financial meltdown. Five banks: JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs– held more than $8.5 trillion in assets at the end of 2011, equal to 56% of the U.S. economy, according to the Federal Reserve, and that’s up from 43% five years earlier.

These banks, today, are about twice as large as they were a decade ago relative to the economy, meaning trouble at a major bank would leave the government with the same Hobson’s choice it faced earlier: let a big bank collapse and perhaps wreck the entire economy or inflame public ire with a costly bailout. ‘Many believe that nothing has changed, that too big to fail is fully intact, says Gary Stern. Giant institutions sheltered under an invisible government umbrella pose ‘a clear and present danger to the U.S. economy’.

This isn’t what the president had in mind two years ago when he vowed to prevent the further consolidation of the banking industry. The sprawling Dodd-Frank financial regulation bill that he signed in July 2010 was designed to avoid a repeat of the government’s frantic rescue of failing banks. Yet credit-rating companies Standard & Poor’s and Moody’s aren’t convinced that the too big to fail threat has been vanquished.

According to Richard Spillenkothen, former Fed’s director. ‘Probably the only way you can be 100% sure you’ve solved too big to fail,’ he says, ‘is by doing away with banks that are too big.’

In the articleToo Big to Fail – Too Big to Govern – Too Big to Manage.” by John W Rodat writes: The recent news that JP Morgan Chase had incurred a $2 billion trading loss reminds us again of the risks, to the rest of us, of organizations that are not only too big to fail, but too big and complex to be effectively managed.

Professor Simon Johnson, economist, puts it in simple terms:  The lessons from JP Morgan’s losses are simple. Such banks have become too large and complex for management to control. The breakdown in governance is profound. Conventional regulation will not protect either the economy or society because regulators have even less information and what information they do have is even more delayed than in the organizations they presume to regulate. 

The only effective solution is to reduce the size and perhaps the complexity of organizations that are so interlinked with the economy and society that the economy and society cannot afford to let them fail. According to Johnson; while information processing capabilities have grown to an extraordinary degree over recent decades, they have still not kept up with the growth in the size and complexity of large financial institutions. When too big to manage meets too big to fail; disaster – or another bailout – is inevitable.

In the article If It’s Too Big to Fail – Is It Too Big to Exist?” by Eric Dash writes: Nearly a century ago, the jurist Louis Brandeis railed against what he called the ‘curse of bigness’. He warned that banks, railroads and steel companies had grown so huge that they were lordingit over the nation’s economic and political life. ‘Size, we are told, is not a crime,’ Brandeis wrote. ‘But size may, at least, become noxious by reason of the means through which it is attained, or the uses to which it is put.’ Brandeis worried that the corporate giants of his day would imperil democracy through concentrated economic power.

His essays, published in 1914 under the title, ‘Other People’s Money and How the Bankers Use It’, helped drum up support for the creation of the Federal Reserve System, antitrust laws, and trust busting.  Devotees of economic Darwinism insist that corporate size, and its accompanying economies of scale, brings progress and benefit to consumers.

But how big is too big to fail? And how would you measure it anyway? In the case of big organizations, policy makers argue that interconnection of modern finance, as much as the size of the players, is the real issue. Frederic S. Mishkin, former Fed director, said; ‘there could be no turning back on too big to fail. You can’t put that genie in the bottle again. We are going to have to deal with it’.

In the article Too Big to Fail or Too Big to Change by Chad Johnson, Bernstein Litowitz Berger & Grossmann LLP write:  Pundits have criticized the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) as capitulating to the interests of big finance; citing the characterizations of SEC settlements as mere slaps on the wrist and the DOJ’s failure to convict a single executive responsible for creating the great recession despite significant evidence of misconduct. 

While the SEC has reached several settlements in connection with misconduct related to the financial meltdown, those settlements have been characterized as cheap, hollow, bloodless, and merely cosmetic, as noted by John C. Coffee, law professor. The relative lack of prosecutions stemming from this financial meltdown stands in sharp contrast to the government’s response to past corporate malfeasance.

The criminal cases arising from the ‘Savings and Loan’ scandals of the 1980s and 1990s, where some of the biggest kingpins– including Charles Keating of ‘Lincoln Savings & Loan’ and roughly 3,800 other bankers– were thrown behind bars, as well as, the Enron and WorldCom accounting debacles in the early 2000s where Jeffrey Skilling, Kenneth Lay and Bernard Ebbers were jailed, demonstrated that executives would be held accountable for their crimes.

As David Einhorn, hedge fund manager, told The New York Times; ‘since there have been almost no big prosecutions, there’s very little evidence that the government has stopped bad actors from behaving badly.’ Simply put, without forcing executives to answer for their misconduct, no amount of financial reform will restore public trust in government or the markets…

Too big to fail (TBTF) has no clear guidelines and thus any large organization can claim; it’s vital to the health of the economy, because its failure would have a domino effect on suppliers. For example, large oil companies going out of business would have a terrible impact on supplies of gasoline and heating fuel…

Big pharma that produce antibiotics and vaccines… which are essential and an interruption in their supply could have catastrophic consequences, from a public health point of view… According to Michael Heberling; TBTF is problematic, because it indirectly influences how companies are managed. If there is a real, or implied, government safety-net, management might be inclined to take on more risk for greater profit… Expecting a government bailout if things go wrong creates an incentive for a company to take on risk and enjoy the associated increase in return’, said Gregory Mankiw.

According to Thomas Sowell, ‘the hybrid public-and-private nature of these activities amounts to privatizing profit and socializing risk since taxpayers get stuck with the tab when high-risk finances don’t work out.’

In other words, it is a travesty to say or imply that current crisis stems from market failure. The most troubling aspect of ever-increasing number of government bailouts is the subtle change overtaking the entire country.

The mindset of companies and individuals today is shifting away from self-responsibility. We blame everyone else for our mistakes and look to others (the taxpayer) to come to the rescue. When it comes to handouts and bailouts the government is no longer simply on the slippery slope– it’s in free-fall. Every bailout makes it harder to say no when the next TBTF request comes forward…

If you put all your eggs into one basket, you better watch that basket. ~Mark Twain