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There is substantial evidence that the cause of the financial crisis was nothing more complicated than a buildup of weak and high-risk mortgages in the U.S. financial system--mostly the result of U.S. government policy to expand homeownership. Too little regulation was not a major factor. Under these circumstances, substantial changes in U.S. government housing policy--particularly with respect to Fannie Mae and Freddie Mac--would have been the most effective way to prevent a recurrence of a financial crisis. Yet the debate over financial regulation in Congress became a contest between those who want the government to have more control of the financial system and those who want it to have less. Considering the legislation that came out of both houses, the United States is well on its way to taking down the most innovative and successful financial system the world has ever known. This happened because an erroneous idea--that large, nonbank financial institutions are too "interconnected" to fail--initially adopted by the Bush administration as the rationale for the rescue of Bear Stearns, evolved into the narrative for explaining the chaos that followed Lehman's collapse. With this narrative generally accepted, the Obama administration's regulatory plan inevitably followed.Key points in this Outlook:
- The idea that large, nonbank financial institutions are "interconnected" and will cause a systemic breakdown if they fail began as a policy rationale for the rescue of Bear Stearns and evolved into the dominant narrative for explaining the chaos after the collapse of Lehman Brothers.
- With this conceptual underpinning, it was inevitable that the Obama administration would propose a regulatory plan designed to prevent the failure of large, nonbank financial institutions and to provide for an orderly resolution in the event of failure.
- However, Bear Stearns was solvent when it was rescued, and its failure would not have caused a systemic breakdown.
- The moral hazard created by the rescue of Bear was responsible for the chaos that followed Lehman's failure.
In his bestselling book The Big Short, Michael Lewis begins his description of the derivatives market with this quote from Leo Tolstoy:
The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.
Although Lewis did not cite it for this purpose, Tolstoy's remark is a perfect description of the power of narrative in the modern day. Once a narrative about a public issue becomes accepted, it is virtually impossible to change; facts that support it are reported by the media, but contrary facts are ignored. So it has been with the notion that large, nonbank financial institutions like Bear Stearns, Lehman Brothers, and American International Group (AIG) cannot be allowed to fail--that is, declare ordinary bankruptcy--because their "interconnections" with other financial institutions will drag the others down. There is literally no evidence for this notion other than government statements that it is so, yet the claim--first advanced to justify the rescue of Bear Stearns--has evolved into the conceptual foundation for the regulatory regime developed by the Obama administration, passed by the House of Representatives, and now adopted in the Senate. This Outlook is about how this narrative was formed and how it has influenced policy even though it has no basis in fact.
Original Sin: The Rescue of Bear Stearns
The narrative's roots are entwined with the rescue of Bear Stearns, which involved a government-assisted sale of the company to JP Morgan Chase in March 2008. In recent public testimony before the Financial Crisis Inquiry Commission (FCIC), Christopher Cox, chairman of the Securities and Exchange Commission (SEC) in 2008, noted that during the week prior to its rescue, Bear--with over 10 percent capital under the Basel II standards that the SEC applied--was solvent and well capitalized. Bear's top management testified in the same hearing that while the firm had lost money in the last quarter of 2007, it would have reported a profit in the first quarter of 2008 if it had not been taken over. These claims need not be taken entirely at face value. It is possible that the firm's capital had been eroded by the time it was rescued on March 14, and the firm certainly would have been worth more as a going concern than as a bankrupt entity. It is also possible that the management's view about Bear's profitability in the first quarter was overly optimistic. The FCIC's own investigation found that Bear was legally solvent--its assets exceeded its liabilities--at the end of its first fiscal quarter in 2008 (which ended in February). But even if we discount these statements, it is unlikely that the market would have suffered a systemic breakdown if Bear Stearns had been allowed to fail. The firm clearly was not a hollow shell; its creditors would have recovered much, if not all, of their advances in the bankruptcy proceeding. What is more, most of Bear's short-term creditors had advanced their funds under repurchase, or "repo," agreements--a form of collateralized borrowing that the firm had begun to emphasize several years before because it was thought to be more stable than unsecured borrowing. The repo lenders would have been able to recover most, if not all, of their losses by selling the collateral underlying the repos.
In testimony before the FCIC, Bear's management officials said they were baffled by the creditor and counterparty run (withdrawals of funds or refusals to renew even secured financing) that the firm suffered in the week that began on March 10, 2008. The most they could offer was that the firm had simply lost the confidence of the market. This explanation would not justify a rescue by the government, and indeed neither the firm's management nor Cox--speaking as a former member of Congress rather than SEC chair--thought the firm (the smallest of the big five investment banks) should have been considered too big to fail or otherwise systemically significant.
Why, then, did the government rescue Bear Stearns? The unprecedented nature of the action and its implications for moral hazard in the future certainly required a robust rationale. Federal Reserve Board of Governors minutes from March 14, 2008--just before the rescue--record the Board's agreement that "given the fragile condition of the financial markets at the time, the prominent position of Bear Stearns in those markets, and the expected contagion that would result from the immediate failure of Bear Stearns," the Fed should extend a loan to JP Morgan, which would eventually be passed along to Bear Stearns. An idea similar to contagion--that Bear was too "interconnected" to fail--first appeared in the media in a Wall Street Journal article on March 17, 2008, and was loosely attributed to unnamed "government officials." According to the article, "Officials have been scrambling to come up with new tools because the old ones aren't suited for this 21st-century crisis, in which financial innovation has rendered many institutions not 'too big to fail' but 'too interconnected to be allowed to fail suddenly.'" Thereafter, the idea that Bear was too interconnected to fail was used regularly by Bush administration and Fed officials to justify their rescue, and it appeared dozens of times in media stories. The most complete statement of the "interconnectedness" theory was contained in Federal Reserve chairman Ben S. Bernanke's prepared testimony to the Senate Banking Committee on April 3, 2008:
Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets. The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company's failure could also have cast doubt on the financial positions of some of Bear Stearns' thousands of counterparties and perhaps of companies with similar businesses.
Part of this statement cannot be challenged; there is no question that financial institutions are interconnected. That is how a financial system performs its function; through these interconnections, money is transferred from a place where it is not being used efficiently to a place where it will be. The real question, however, is whether this interconnectedness is so substantial that the failure of one such institution will bring down others--whether, in Bernanke's words, Bear's failure could "have cast doubt on the financial positions of some of Bear Stearns' thousands of counterparties." If so, then its interconnectedness would have had significant implications for the financial system as a whole.
But if Bear was indeed solvent at the time--something the Fed and Treasury must have known from discussions with the SEC--it is highly implausible that its failure would have dragged down its counterparties. If a firm is solvent, all its creditors will be paid in due course. Although Bear had become illiquid when many counterparties withdrew their financing, bankruptcy is designed for firms that are solvent but illiquid; it provides temporary protection and allows a creditor panic to subside while the firm marshals its resources and makes arrangements for orderly payment. That is what Bear would have been able to do if it had been allowed to file for bankruptcy. Its rescue short-circuited that process, and thus we will never know whether Bear's filing would have brought about the systemic event that Bernanke feared by dragging down its counterparties.
What Lehman's Failure Demonstrated
However, a partial but persuasive answer to whether Bear's bankruptcy filing would have caused a systemic disruption is provided by the failure of Lehman Brothers that occurred six months later. Unlike Bear, Lehman was likely not solvent, and it had certainly become illiquid by the time it filed for bankruptcy. Nevertheless, despite all the market turmoil that followed Lehman's bankruptcy filing, there was only one case of a Lehman counterparty or creditor failing because of Lehman's inability to meet its financial obligations. That case was the Reserve Fund, a money-market fund that held a substantial amount of Lehman's commercial paper. The Reserve Fund's losses caused it to "break the buck"--in other words, it failed to maintain a $1 per share redemption value--and triggered runs at other money-market funds where investors felt they might be at risk of a similar loss. The threat to "thousands of counterparties" that Bernanke envisioned occurring if Bear had not been rescued never materialized after Lehman filed for bankruptcy.
Even Lehman's credit default swap (CDS) obligations, and the CDSs written specifically on Lehman by others, did not cause any substantial disruption in the CDS market when Lehman collapsed. Within a month after the bankruptcy, all of the CDSs specifically written on Lehman were settled through the exchange of approximately $6 billion among hundreds of counterparties, and while Lehman had over nine hundred thousand derivatives contracts outstanding at the time it filed for bankruptcy, these did not give rise to any known insolvency among those of its counterparties that were protected by a Lehman CDS. In cases where Lehman's derivatives counter-parties suffered losses, the counterparties filed appropriate claims in the Lehman bankruptcy proceeding, which are being adjudicated in the ordinary course. In other words, Lehman--a larger firm than Bear and one that had more "interconnections"--had no significant effect in dragging down its counterparties. This suggests that the rationale given for Bear's rescue--its extensive "interconnections"--was erroneous. If Lehman's interconnections did not drag down its counterparties, Bear's certainly would not have done so.
Lehman's Role in Creating the Financial Crisis
The turmoil and freeze-up in lending that followed Lehman's bankruptcy was unprecedented and frightening to all observers. However, there is a substantial likelihood that the moral hazard created by the rescue of Bear was the reason Lehman's bankruptcy precipitated a crisis. A review of the CDS spreads on Lehman shows that they moved within a relatively narrow range as Lehman's condition continued to weaken through the summer and into the fall of 2008. It was not until just before the fateful weekend of September 13-14, 2008, that the spreads blew out, indicating that despite Lehman's deteriorating condition, those who were seeking to protect themselves against Lehman's failure were finding ready counterparties in the CDS market. This suggests strongly that the market was expecting a rescue until the very last minute, which would be entirely rational; no sensible person could have imagined that the U.S. government would rescue Bear but not Lehman. Lehman was much larger, more interconnected, and a major player in the CDS market--one of the markets where interconnections were supposed to be most troublesome. If, as government officials were arguing, Bear's interconnections were really the basis for Bear's rescue, it would have been completely irresponsible for officials to have allowed Lehman to fail. Indeed, it would not be surprising to learn that the managers of the Reserve Fund decided to hold the fund's Lehman commercial paper because they expected that Lehman would also be rescued and they could then avoid a loss on the paper's reduced value. This conclusion would be consistent with the CDS market's judgment about the likelihood of a government rescue for Lehman. Thus, when Lehman filed for bankruptcy, the markets were shocked. The result--hoarding cash and freezing lending--was the rational response to a sudden realization that the world's governments were not going to rescue all large firms. Now it was necessary to know the financial condition of all counterparties and to hold cash in case depositors and other funding sources were to withdraw funds or cut off lending. This produced the freeze-up in lending that most people now regard as the financial crisis.
In addition, the rescue of Bear probably made it more difficult to find a buyer for Lehman. After Bear, it was rational for Lehman's management to expect a rescue, and that would have reduced their interest in selling the firm or diluting the stockholders; it would also have kept the firm's selling price higher than it might otherwise have been. Potential buyers, like the Korean Development Bank or Barclays Bank, would likely have expected some U.S. government support, just as JP Morgan Chase had received in buying Bear. When this was not offered, it is likely that they backed away from the acquisition to put pressure on U.S. officials to come forward with financial assistance. Like other market participants, it was probably difficult for potential acquirers to believe that the U.S. government would have rescued Bear because it was supposedly too interconnected with others in the financial system, but would be willing to allow Lehman to fail.
These are all the likely consequences of the moral hazard created by the rescue of Bear, which increasingly--with the passage of time--seems to be the central policy error in the U.S. government's response to the financial-market weakness that was coming to light in early 2008. Thus, the rescue of Bear--which was probably unnecessary in the first place--reduced Lehman's incentive to want or to find a buyer, reduced the incentives of potential acquirers to make offers for Lehman without government support, and caused a catastrophic freeze-up in the market when it became clear that the U.S. government would not carry out with Lehman the logical implications of its claim that Bear was too interconnected to be allowed to fail.
The Bear Rescue Narrative Evolves
Nevertheless, by the time Lehman filed its bankruptcy petition in the fall of 2008, the idea that Bear had to be rescued because of its "interconnectedness" was the unquestioned explanation for the actions of the Treasury and Fed, regularly used by members of the Bush administration and repeated in virtually every media account of the Bear rescue. Given this acceptance, and recalling the Tolstoy observation, it is not surprising that the turmoil following Lehman's bankruptcy was not examined for what it showed about the rescue of Bear; nor was Bear's rescue examined for what it likely contributed to the turmoil that occurred after Lehman's collapse. Instead, the post-Lehman chaos was interpreted as confirmation that Lehman as well as Bear should have been rescued. This is characteristic of narratives. Once they are established, subsequent events that are thought to confirm the narrative are reported in the media, while those that challenge the narrative are ignored or explained away. Thus, one commentator saw interconnectedness as the cause of the post-Lehman chaos even though it was largely imaginary:
For many, the lesson of Lehman Brothers is that a financial firm had to fail in order to demonstrate how interconnected the entire financial system was, often at levels that even top U.S. market players and government officials could not have foreseen. . . . However painful Lehman's financial and economy effects was on the market [sic] experts said the bankruptcy provided the political will necessary to begin serious discussions about the country's need for a financial super regulator.
Through interpretations like this, the explanation for why Bear was rescued evolved into a conclusion with far greater policy significance; under the new interpretation of Lehman, all large financial firms--because of their purported interconnectedness--were inherently a danger to financial-system stability. This provided a rationale for extensive government regulation, since regulation was believed (again, without much evidence) to be effective in reducing the likelihood of a financial institution's failure and thus the chances of another financial crisis. Writing in the Journal of Credit Risk, one commentator made this connection explicit: "This crisis--and the cases of firms like Lehman Brothers and AIG has made clear that certain large, interconnected firms and markets need to be under a more consistent and more conservative regulatory regime. It is not enough to address the potential insolvency of individual institutions--we must also ensure the stability of the system itself."
That is exactly the approach the Obama administration adopted upon taking office. Through use of the interconnectedness idea, it became possible for the administration to propose a comprehensive system of regulation for the largest nonbank financial firms, going far beyond any regulatory regime ever envisioned in the past. This extensive regulation was justified by arguing that if one of these large firms were to fail it could--like Lehman--cause instability in the financial system, just as Bernanke had argued that the failure of Bear Stearns could have undermined the financial condition of "thousands" of its counterparties. The fact that this never occurred when Lehman failed was ignored. For example, in a statement on September 15, 2009, the anniversary of Lehman's bankruptcy, President Barack Obama stated:
While holding the Federal Reserve fully accountable for regulation of the largest, most interconnected firms . . . we'll also require these financial firms to meet stronger capital and liquidity requirements and observe greater constraints on their risky behavior. That's one of the lessons of the past year. The only way to avoid a crisis of this magnitude is to ensure that large firms can't take risks that threaten our entire financial system, and to make sure they have the resources to weather even the worst of economic storms.
This statement says it all: interconnected financial firms require regulation or they will, by taking risks, bring down the financial system again. Similar declarations--implicating interconnectedness in the financial crisis--were made in the white paper the administration issued in June 2009 as a prelude to the introduction of its regulatory legislation, and thereafter by Treasury Secretary Timothy F. Geithner, presidential adviser Paul Volcker, and many others in the administration and Congress. The beauty of it was that they could make these statements without fear of contradiction because the underlying idea--that large firms were so interconnected that the failure of one would bring down others--had now become not only an explanation for the rescue of Bear, but also, because of the chaos that followed Lehman's bankruptcy, the accepted narrative for what caused the financial crisis itself.
As Tolstoy observed, even intelligent people, once they have accepted an idea, cannot be persuaded to reexamine their position. That is the power of a narrative.
Peter J. Wallison (email@example.com) is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.
1. See Peter J. Wallison, "Deregulation and the Financial Crisis: Another Urban Myth," AEI Financial Services Outlook (October 2009), available at www.aei.org/outlook/100089; and Peter J. Wallison, "Cause and Effect: Government Policies and the Financial Crisis," Critical Review 21, no. 2-3 (June 2009): 365-76, available at www.aei.org/article/101071.
2. Michael Lewis, The Big Short: Inside the Doomsday Machine (New York: W. W. Norton, 2010), ix.
3. Financial Crisis Inquiry Commission, The Shadow Banking System--Day 1, 111th Cong., 2d. sess., May 5, 2010, available at www.fcic.gov/hearings/05-05-2010.php (accessed May 20, 2010).
6. Minutes of the Board of Governors of the Federal Reserve System, March 14, 2008, quoted in Greg Robb, "Bear Stearns Too Interconnected to Fail, Fed Says," MarketWatch, June 27, 2008, available at www.marketwatch.com/story/fed-believed-bear-stearns-was-too-interconnected-to-fail (accessed May 19, 2010) (emphasis added).
7. Robin Sidel, Dennis K. Berman, and Kate Kelly, "J.P. Morgan Buys Bear in Fire Sale, as Fed Widens Credit to Avert Crisis," Wall Street Journal, March 17, 2008 (emphasis added).
8. See Federal Reserve chairman Ben S. Bernanke: "Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets," and Robert Steel, undersecretary of the Treasury for domestic finance: "The failure of a firm at that time that was so connected to so many corners of our markets would have caused financial disruptions beyond Wall Street," quoted in Associated Press, "Quotes from Bear Stearns Hearing," FoxNews.com, April 3, 2008, available at www.foxnews.com/wires/2008Apr03/0,4670,Congress BearStearnsQuotes,00.html (accessed May 19, 2010). See also Michael M. Grynbaum, "Paulson Urges Americans to be Patient on the Economy," New York Times, July 23, 2008; "'Too Big to Fail' Is Too Expensive by Half," ChiefExecutive.net, November/ December 2009, available at www.chiefexecutive.net/ ME2/ dirmod.asp?sid=&nm=&type=Publishing&mod=Publications%3A%3AArticle&mid=8F3A7027421841978F18BE895F87F791&tier=4&id=FA948EDD2F744208935FAE67A5001184 (accessed May 19, 2010); Jeffrey E. Garten, "Yet Another Domino Falls," Newsweek, July 28, 2008; and Gretchen Morgenson, "Do You Have Any Reforms in Size XL?" New York Times, April 23, 2010.
9. See, for example, John Waggoner and David J. Lynch, "Red Flags in Bear Stearns' Collapse," USA Today, March 19, 2008; and Matthew Goldstein, "Bear Stearns' Big Bailout," Bloomberg Businessweek, March 14, 2008, available at www.businessweek.com/ bwdaily/dnflash/content/mar2008/db20080314_993131.htm?campaign_id=rss_daily (accessed May 19, 2010).
10. Senate Committee on Banking, Housing, and Urban Affairs, Statement of Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, 110th Cong., 2d sess., April 3, 2008, 3-4, available at http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=0a0ec016-ad61- 4736-b6e3-7eb61fbc0c69 (accessed May 19, 2010) (emphasis added).
11. See, for example, Mark Gongloff, "Street's Fate Is in Hands of Uncle Sam," Wall Street Journal, September 18, 2008; Stephen Labaton, "Trying to Rein in 'Too Big to Fail' Institutions," New York Times, October 26, 2009; Caroline Baum, "Ask Bear Stearns Stockholders about Moral Hazard," Bloomberg.com, March 18, 2008, available at www.sddt.com/Search/article. cfm?SourceCode=20080318fm (accessed May 19, 2010); and Irwin Stelzer, "Banking Crisis: It's Déjà Vu All Over Again," Sunday Times (London), March 23, 2008.
12. Ken Sweet, "Lehman's Harsh Lesson to the Global Economy," FoxBusiness.com, September 14, 2009, available at www.foxbusiness.com/story/markets/industries/finance/lehmans- harsh-lesson-global-economy (accessed May 19, 2010).
13. Jeffrey Rosenberg, "Toward a Clear Understanding of the Systemic Risks of Large Institutions," Journal of Credit Risk 5, no. 2 (Summer 2009).
14. Barack Obama, "Text of Obama's Speech on Financial Reform," New York Times, September 15, 2009 [emphasis added].
15. The white paper says, "All large, interconnected firms whose failure could threaten the stability of the system should be subject to consolidated supervision by the Federal Reserve regardless of whether they own an insured depository institution." See U.S. Department of the Treasury, Financial Regulatory Reform: A New Foundation; Rebuilding Financial Supervision and Regulation, 111th Cong., 1st sess. (Washington, DC, June 17, 2009), 6, available at www.financialstability. gov/docs/regs/FinalReport_web.pdf (accessed May 19, 2010).
16. FinancialStability.gov, "Treasury Secretary Tim Geithner Written Testimony House Financial Services Committee Hearing," news release, March 24, 2009, available at www.financialstability.gov/ latest/tg67.html (accessed May 19, 2010).
17. Paul Volcker, "How to Reform Our Financial System," New York Times, January 30, 2010.
18. Benton Ives, "Kanjorski Unveils Proposal to Break Up Risky Firms," Congressional Quarterly Today, November 18, 2009.