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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.
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.
Peter J. Wallison, AEI
Vern McKinley, Independent Institute
Jean Helwege, University of South Carolina
Alex J. Pollock, AEI
Phillip Swagel, AEI and University of Maryland
Peter J. Wallison, AEI
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Jean Helwege holds the J. Henry Fellers Professorship of Business Administration at the Darla Moore School of Business, University of South Carolina. Before joining the Finance Department in 2010, she held academic positions at Penn State, the University of Arizona and Ohio State University. She also worked as an economist in the Federal Reserve System from 1988 to 1998. She has written more than 20 scholarly articles for publications including the Journal of Finance, Review of Financial Studies, Journal of Financial Economics, Journal of Financial Quantitative Analysis, Journal of Financial Intermediation, Financial Management and the Journal of Fixed Income. From 2005 to 2007, she served as associate editor of the Review of Financial Studies. Her research interests include corporate bonds and empirical corporate finance.
Vern McKinley is a research fellow at the Independent Institute and author of the institute’s new book “Financing Failure: A Century of Bailouts.” From 1985 to 1999, he worked with the Federal Reserve’s board of governors, Federal Deposit Insurance Corporation, Resolution Trust Corporation and Department of the Treasury’s Office of Thrift Supervision. Since 1999, McKinley has served as a legal adviser and regulatory policy expert for governments of several countries on financial-sector issues. He has completed policy work for both the American Enterprise Institute and the Cato Institute and served as an alumni council member of the Fund for American Studies. McKinley has been credited with correctly predicting in 1997 that the structure of Fannie Mae and Freddie Mac would one day lead to the meltdown of the two institutions. He has brought four Freedom of Information Act (United States) suits against the Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve and Federal Housing Finance Agency to compel release of details on the bailouts, represented in the cases by Judicial Watch. McKinley has also testified before the U.S. Congressional Subcommittee on Commercial and Administrative Law on issues related to U.S. consumer bankruptcy policy.
Alex J. Pollock joined AEI in 2004 after thirty-five years in banking. He was president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 to 2004. He is the author of numerous articles on financial systems and the organizer of the “Deflating Bubble” series of AEI conferences. In 2007, he developed a one-page mortgage form to help borrowers understand their mortgage obligations. At AEI, he focuses on financial policy issues, including housing finance, government-sponsored enterprises, retirement finance, corporate governance, accounting standards and the banking system. He is a director of the CME Group, the Great Lakes Higher Education Corporation and the International Union for Housing Finance, and the chairman of the board of the Great Books Foundation.
Phillip Swagel, an economist and academic, was assistant secretary for economic policy at the Treasury Department from 2006 to 2009, where he was responsible for analysis on a wide range of economic issues, including policies relating to the financial crisis and the Troubled Asset Relief Program. He has also served as chief of staff and senior economist at the White House Council of Economic Advisers and as an economist at the Federal Reserve Board and the International Monetary Fund. He is concurrently a professor of international economics at the University of Maryland's School of Public Policy and previously taught at Northwestern University, the University of Chicago’s Booth School of Business and Georgetown University. Swagel works on both domestic and international economic issues at AEI. His research topics include financial markets reform, international trade policy and the role of China in the global economy.
Peter J. Wallison, a codirector of AEI’s program on financial policy studies, researches banking, insurance and securities regulation. As general counsel of the U.S. Treasury Department, he had a significant role in the development of the Reagan administration’s proposals for the deregulation of the financial services industry. He also served as White House counsel to President Ronald Reagan and is the author of “Ronald Reagan: The Power of Conviction and the Success of His Presidency”(Westview Press, 2002). His other books include “Competitive Equity: A Better Way to Organize Mutual Funds” (2007); “Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks” (2004); “The GAAP Gap: Corporate Disclosure in the Internet Age” (2000); and “Optional Federal Chartering and Regulation of Insurance Companies” (2000). He also writes for AEI’s Financial Services Outlook series.