Too big to fail is a phrase used to describe a company that's so entwined in the global economy that its failure would be catastrophic. Big doesn't refer to the size of the company, but rather its involvement across multiple economies.
Former President George W. Bush's administration popularized "too big to fail" during the 2008 financial crisis. The administration used the phrase to describe why it had to bail out some financial companies to avoid worldwide economic collapse.
The firms in need of rescue were 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. These banks were so heavily invested in these derivatives that they became too big to fail.
Banks That Became Too Big to Fail
The first bank that was too big to fail was Bear Stearns. Bear Stearns was a small but very well-known investment bank that was heavily invested in mortgage-backed securities. When the mortgage securities market collapsed, the Federal Reserve lent $30 billion to JPMorgan Chase & Co. (JPM.N) to buy the Bear Stearns, to alleviate concerns that confidence in other banks would be destroyed.
Citigroup, another financial industry giant, had also involved itself in the mortgage security madness. Lehman Brothers' investment bank was also affected by the crisis. When Treasury Secretary Hank Paulson said no to bailing out the bank, it filed for bankruptcy. That same day, the Dow dropped 504 points.
By Wednesday, the financial markets panicked; this threatened the overnight lending needed to keep businesses running. The problem had escalated beyond the control boundaries of monetary policy. The only option seen by financial industry leaders was a $700 billion bailout to recapitalize the major banks.
Bank of America, Morgan Stanley, Goldman Sachs, and JP Morgan were also headlining as they were experiencing losses from the collapsing securities values.
Firms That Were Rescued
After receiving a $25 billion injection, Citigroup received a $20 billion cash infusion from the Treasury. In return, the government received $27 billion of preferred shares yielding an 8% annual return. It also received warrants to buy no more than 5% of Citi's common shares at $10 per share.
The investment banks Goldman Sachs and Morgan Stanley were bailed out by the Federal Reserve (the Fed), which allowed them to become bank holding companies—meaning they were now being regulated by the government.
What this meant is that they could borrow from the Fed's discount window, and take advantage of the Fed's other guarantee programs intended for retail banks. With the collapse of these investment banks, the era of ultra-successful investment banking was over.
Fannie Mae and Freddie Mac Mortgage Companies
Federal agencies, including the mortgage giants Fannie Mae and Freddie Mac, guaranteed 90% of all new home mortgages made in 2009. They purchased mortgages from banks and created securities from them. In the process, investors flocked to these securities due to the high return.
Home loans were given to people who could not afford them (sub-prime loans), which then were sold as securities. Investors spent thousands of dollars on these securities when the housing bubble burst due to a massive number of mortgage defaults.
The U.S. Treasury underwrote $100 billion in their mortgages, in effect returning them to government ownership. If Fannie and Freddie had gone bankrupt, the housing market would have collapsed.
AIG Insurance Company
The American International Group (AIG) was one of the world's largest insurance companies. Most of its business was traditional insurance products. When the company delved into credit default swaps, it began taking enormous risks.
These swaps insured the mortgage securities purchased by investors, in an attempt to reduce the risk of the securities if the borrowers defaulted. 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 reduce stress on the global economy. In return, the government received 79.9% 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 under the Systematically Significant Failing Institution Program.
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.
Preventing Banks From Becoming Too Big to Fail
The Dodd-Frank Wall Street Reform Act (Dodd-Frank) was the most comprehensive financial reform since the Glass-Steagall Act of 1933 (repealed in 1999, which set the framework for the investment banking crises). 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? The council 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 then ask it to increase its reserve requirement (the amount of cash or deposits financial institutions are required to keep with the Federal Reserve Banks).
The Volcker Rule, another part of Dodd-Frank, also helps keep banks from becoming 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.