What Too Big to Fail Means
Can a Company Really Be Too Big to Fail?
Too big to fail is a company that's so essential to the global economy that its failure would be catastrophic. Big doesn't refer to the size of the company. Instead, it means it's so interconnected with the global economy that its failure would be a big event.
The Bush administration popularized this phrase during the 2008 financial crisis. It describes why it must bail out some companies to avoid economic collapse. These included financial firms that had relied on derivatives to gain a competitive advantage when the economy was booming. When the housing market collapsed, their investments threatened to bankrupt them. That's when they became too big to fail.
Examples of Too Big to Fail Banks
The first bank that was too big to fail was Bear Stearns. On March 2008 the Federal Reserve lent $30 billion to JPMorgan Chase to buy the failing investment bank. Bear was a small bank but very well-known. The Fed worried that Bear's failure would destroy confidence in other banks.
Lehman Brothers was an investment bank. It wasn't a big company, but the impact of its bankruptcy was alarming. In 2008, Treasury Secretary Hank Paulson said no to its bailout. It filed for bankruptcy. On the following Monday, the Dow dropped 350 points. By Wednesday, financial markets panicked. That threatened the overnight lending needed to keep businesses running. The problem was beyond what monetary policy could do. That meant a $700 billion bailout was necessary to recapitalize the major banks.
Citigroup received a $20 billion cash infusion from Treasury. In return, the government received $27 billion of preferred shares yielding 8 percent annual return. It also received warrants to buy no more than 5 percent of Citi's common shares at $10 per share.
The investment banks Goldman Sachs and Morgan Stanley were also too big to fail. The Fed bailed them out by allowing them to become commercial banks. That meant they could borrow from the Fed's discount window. They could take advantage of the Fed's other guarantee programs intended for retail banks. That ended the era of investment banking made famous by the movie, "Wall Street." The 1980s mantra, "Greed is good," was now seen in its true colors. Wall Street greed led to taxpayer and homeowner pain.
Fannie and Freddie Mortgage Companies
The mortgage giants, Fannie Mae and Freddie Mac, were really too big to fail. That's because they guaranteed 90 percent of all home mortgages by the end of 2008. Treasury underwrote $100 million in their mortgages, in effect returning them to government ownership. If Fannie and Freddie had gone bankrupt, the housing market would have collapsed. That's because banks would not lend without government guarantees.
AIG Insurance Company
The American International Group was one of the world's largest insurers. Most of its business was traditional insurance products. When it got into credit default swaps, it got into trouble. These swaps insured the assets that supported corporate debt and mortgages. If AIG went bankrupt, it would trigger the failure of the financial institutions that bought these swaps.
AIG's swaps against subprime mortgages pushed it to the brink of bankruptcy. As the mortgages tied to the swaps defaulted, AIG was forced to raise millions in capital. As stockholders got wind of the situation, they sold their shares, making it even harder for AIG to cover the swaps. Even though AIG had more than enough assets to cover the swaps, it couldn't sell them before the swaps came due. That left it without the cash to pay the swap insurance.
The Federal Reserve provided an $85 billion, two-year loan to AIG to further stress on the global economy. In return, the government received 79.9 percent of AIG's equity and the right to replace management. It also received veto power over all important decisions, including asset sales and payment of dividends. In October 2008, the Fed hired Edward Liddy as CEO and Chairman to manage the company.
The plan was for the Fed to break up AIG and sell off the pieces to repay the loan. But the stock market plunge in October made that impossible. Potential buyers needed any excess cash for their balance sheets. The Treasury Department purchased $40 billion in AIG preferred shares from its Capital Repurchase Plan. The Fed bought $52.5 billion in mortgage-backed securities. The funds allowed AIG to retire its credit default swaps rationally, saving it and much of the financial industry from collapse. The AIG Bailout became one of the largest financial rescues in U.S. history.
Ending Too Big to Fail
The Dodd-Frank Wall Street Reform Act was 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. The Fed 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 profit. They can only do so on behalf of their customers or to offset business risk.