Post-Event Summary

According to Vern McKinley, research fellow at the Independent Institute and author of “Financing Failure: A Century of Bailouts,” the 2008 U.S. investment bank bailouts were the result of an inadequate understanding of banking history, hasty decision-making and hysterical rhetoric from the heads of banks and the U.S. Federal Reserve.

In a discussion on Monday at AEI, McKinley made the case that the contagion theory — which states that if one large bank fails it endangers others — is not born out in past financial crises. Historically, the failure of one major bank has not led other major banks to fail, nor is there reason to believe that banks that were bailed out would have pulled others down in a domino effect.

Jean Helwege of the University of South Carolina elaborated on McKinley’s thesis by arguing that the rationale used to explain the systemic risk posed by bank failures was illogical even without McKinley’s historical perspective —  the Fed’s selection of who to save and who to let fail was an arbitrary one.
Building on Helwege’s assertions, Alex Pollock of AEI suggested that, similar to Clausewitz’s fog of war, the fog of financial crisis clouds the judgment of those involved. Financial and government leaders felt motivated to take some sort of action during the bank failures because none wanted to be remembered for their inaction. Hence, new crises can be caused by a misreading of the crisis at hand.  

Phillip Swagel of AEI and the University of Maryland distanced himself from his fellow panelists by suggesting that contagious risk was a legitimate concern in the Federal bailout of American International Group (AIG). In particular, Swagel emphasized that AIG presented a unique risk distinct from other investment banks, and that the bailout was not simply a reaction to hysterical rhetoric.
--Harrison Dietzman

Event Description
As the values of mortgages and mortgage-backed securities plunged in late 2007 and early 2008, financial institutions that were holding these instruments gradually weakened. In March 2008, Bear Stearns — an investment bank that was heavily invested in the housing market —teetered on the edge of bankruptcy. In an emergency move, the Federal Reserve provided $30 billion in secured funding that enabled JP Morgan Chase, a commercial bank holding company, to acquire Bear. Six months later, Lehman Brothers, another investment bank, likewise struggled to fund itself, but this particular bank was not rescued. Its bankruptcy was followed by a major financial panic in which several commercial banks and the large insurance holding company American International Group (AIG) were rescued, and the U.S. Treasury Department fashioned a mechanism to stop a run on money market mutual funds. Why were Bear and AIG rescued while Lehman was allowed to fail? On what basis did officials in the Treasury Department, the Federal Deposit Insurance Corporation and the Fed make their intervention decisions? 

In a new book entitled “Financing Failure: A Century of Bailouts,” Vern McKinley provides the most detailed account yet of the government’s decision-making process during these momentous events.