Missing the Point With “Too Big to Fail”

If you’ve been paying much attention to financial and quasi-financial news, you’ve probably been bombarded on numerous occasions with the phrase “too big too fail.”  Matter of fact, I just started reading Andrew Ross Sorkin’s book by the same name which is really pretty damn interesting and worth checking out if you’re at all interested in the mortgage crisis.  Sorkin’s book is beside the point, however.  At some point in time, it was decided by the politicians, regulators, and the media that the size of the financial institutions are to blame for the melting down of the economy.  Supposedly, banks like Citigroup, JP Morgan, Wells Fargo, Bank of America, and related financial firms like Goldman Sachs and AIG are so large that their very existences put the rest of the financial system at risk.  We can’t let them fail due to the cascading turmoil which would likely infect the other, smaller institutions and eventually the entire economy.  It’s like the banking version of H1N1.

Without a doubt, these massive companies play an integral role in the American financial landscape.  I would hate to see one of them fail.  Banks provide much of the infrastructure for the business transactions which occurr every second of everyday.  Because they’re so important, the federal government stands behind them with the FDIC and the extremely powerful Federal Reserve.  If, perhaps, the bulk of depositors of any commercial bank were to decide one day to withdraw their funds for whatever reason, the bank in question could not cover them without the help of the Federal Reserve.  As everyone knows, a bank’s not just an elaborate-looking safe.  It must take the funds deposited there and loan them to others (businesses, individuals, municipalities, etc.) in order to be profitable.  That’s sort of banking at it’s most basic level.  Banking, however, has evolved – some might prefer the term devolved – over the years.

In order to boost profitability, banks decided to deal in some riskier assets.  That’s where all the bad mortgages, many of them bundled together by other firms, come into play.  Based on the foolish assumption that housing values only went up, institutions loaned money to anyone with a pulse and aspirations of owning a home.  I suppose some banks originated some of these mortgages themselves and kept them on their books.  In many cases, firms made these risky debt obligations, packaged them up with some others, and sold them off.  Now you’ve got all this crap floating around.  However, since home prices are skyrocketing, the “bubble” mentality takes over.  Everybody wants a piece of the action, so they decide to buy some mortgages.  Worse yet, financial institutions are using them as collateral to borrow against.  Even worse, some firms are selling insurance (think AIG) in case of defaults.  The insurance, or credit defaults swaps (CDS), aren’t necessarily a bad thing except that A) AIG and others didn’t know what the hell they were insuring and B) insurance providers didn’t possess the assets necessary to cover them should a large portion go bad.  As we all know, house values did go down and many people couldn’t cover their mortgage payments and defaulted.

Why did I go through this very basic rehash of what happened  in the U.S. banking system over the past couple of years?  Well, it’s because all of this floating “crap” was/is the problem.  Funny thing too, the government played an integral role in promoting home ownership for people who weren’t creditworthy.  Another funny thing, they’re still doing it even after they had to completely take over what were once known as government sponsored mortgage accumulators, Fannie and Freddie.  This time they’re utilizing the FHA.  Maybe, the massive banking supermarkets are too large.  I really don’t know, but let’s not pretend their sizes are root of the problem.  If we had more small banks, but they all decided to take on risky mortgage backed securties, we’d still be in the midst of a collossal mess.

In other words, we need to deal with what these large banks are holding.  We need to decide the proper, least risky way to value the assets they do hold.  We need to decide if the promotion of home ownership is a government reponsibility.  Computer scientists use the phrase:  “garbage in, garbage out.”  You can compel financial institutions to write mortgages to people who can’t possibly pay them back under normal circumstances.  You can even use government sponsored entitites to provide a market for these bad loans, but eventually the chickens come home to roost.  And even if the chickens defaulted on their mortgage and have to roost elsewhere, someone’s eventually going to be holding a worthless piece of paper.

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