The problem with Too Big to Fail, as generally described, is that we have let certain financial firms become so powerful that we were forced to save them in the crisis. But, the crisis was a liquidity crisis. The collapse of the housing market and the related collapse of the subprime mortgage market were products of contractionary monetary and credit policies. This shouldn't be a controversial statement. Policy makers at the Fed and the Treasury, plus just about everyone who either supports or questions Fed policies during the boom and bust, have explicitly stated that home prices had to collapse, that the Fed could not provide support for nominal economic activity in 2006 and 2007 because that would be bailing out irresponsible investors and lenders. It is a matter of public consensus that policies in 2006 and 2007 could have lent support to housing markets and we chose not to, in order to impose discipline on the market.
I suspect that few readers will regard that last sentence as false. Most will regard it as an obvious statement of wisdom. At this point, just typing it sort of makes my blood boil. Maybe a few of you join me on that.
Below the fold is an extended excerpt from Ben Bernanke's "The Courage to Act", about events in early 2008 (pg. 202-205):
Auctions (KE: for auction-rate securities) almost never failed. If there weren't enough buyers, as happened on occasion, the big investment and commercial banks who sponsored the auctions usually stepped in as back-up bidders. Except in mid-February 2008, when they refused to buy. Many of the sponsoring institutions were wary of adding auction-rate securities to balance sheets already stuffed with hard-to-sell complex debt instruments. On February 14, an astonishing 80 percent of the auctions failed for lack of investor interest. Issuers with good credit records suddenly faced steep interest penalties through no fault of their own. The Port Authority of New York and New Jersey, for instance, saw its interest rate nearly quintuple from 4.2 percent to 20 percent.Within the month, 13(3) would be invoked in order to extend credit on a broader range of securities to primary dealers that traded with the Federal Reserve, and would also be invoked in the arrangement to facilitate the purchase of Bear Stearns.
Elsewhere in the market, financial dominoes had continued to fall. On February 11, the venerable insurance giant AIG disclosed in an SEC filing that its auditors had forced it to take a $5 billion write-down on its holdings of derivatives tied to subprime mortgages. (Derivatives are financial instruments whose value depends on the value of some underlying asset, such as a stock or a bond.) Three days later, the massive Swiss banking firm UBS reported an $11.3 billion loss for the fourth quarter of 2007. It attributed $2 billion of the loss to a write-down of its exposure to Alt-A mortgages. UBS's write-down of its Alt-A mortgage securities forced lenders with similar securities to do the same. Given the level of investor distrust and the vagaries of generally accepted accounting principles, the valuations of the most pessimistic firms and investors seemed to be determining asset prices industrywide.
Two hedge funds with assets totaling more than $3 billion, managed by the London-based Peloton Partners and run by former Goldman Sachs traders, failed on February 28. On March 3, Santa Fe, New Mexico-based Thornburg Mortgage, with $36 billion in assets, was missing margin calls - demands from nervous creditors for additional collateral in the form of cash or securities. Thornburg specialized in making adjustable-rate jumbo mortgages (mortgages above the $417,000 limit on loans purchased by Fannie and Freddie) to borrowers with strong credit. But, it also had purchased securities backed by now-plummeting Alt-A mortgages. On March 6, an investment fund sponsored by the Carlyle Group, a private equity firm whose partners moved in Washington's inner circles, also failed to meet margin calls. The fund's $22 billion portfolio consisted almost entirely of mortgage-backed securities issued and guaranteed by Fannie and Freddie. The holdings were considered very safe because investors assumed Fannie and Freddie had the implicit backing of the federal government. But the Carlyle fund had paid for its securities by borrowing more than $30 for every $1 in capital invested in the fund. It could absorb only very small losses. By Monday, March 10, it had unloaded nearly $6 billion in assets - yet another fire sale.
Peloton, the Carlyle fund, and Thornburg had something in common: Lenders in the repo market were reluctant to accept their assets as collateral - assets they had routinely accepted in the past. Until the previous summer, repos had always been considered a safe and reliable form of funding - so reliable that a company like Thornburg felt comfortable using them to finance holdings of long-term assets, like mortgages. Because longer-term interest rates are usually higher than short-term rates, this strategy was usually profitable. It's effectively what a traditional bank does when it accepts deposits than can be withdrawn at any time and makes loans that won't be paid off for months or years.
But Thornburg wasn't a bank, and, of course, its borrowings were not government-insured. When concerns about Thornburg's assets surfaced, nervous repo lenders began to pull back. In what was becoming an increasingly common scenario, some repo lenders shortened the term of their loans and demanded more collateral per dollar lent. Others wouldn't lend at all. With no means to finance its holdings of mortgages, even its high-quality jumbo mortgages, Thornburg found itself in serious trouble - much like a bank suffering a run in the era before deposit insurance...
...I called Thornburg. I was sympathetic. He and his company were caught up in a panic not of their own making. But in my heart I knew that use of our emergency authority could only be justified when it served the broad public interest. Whether the firm was in some sense deserving or not was irrelevant. Lending to Thornburg would overturn a six-decade practice of avoiding 13(3) loans - a practice rooted in the recognition of the moral hazard of protecting nonbank firms from the consequences of the risks they took, as well as the understanding that Congress had intended the authority to be used only in the most dire circumstances. The failure of this firm was unlikely to have a broad economic impact, and so we believed a 13(3) loan was not justified. We would not lend to Thornburg, and it would fail.
Congress had added Section 13(3) to the Federal Reserve Act in 1932, motivated by the evaporation of credit that followed the collapse of thousands of banks in the early 1930s. Section 13(3) gave the Federal Reserve the ability to lend to essentially any private borrower. At least five members of the Board needed to certify that unusual and exigent circumstances prevailed in credit markets. The lending Reserve Bank also had to obtain evidence that other sources of credit were not available to the borrower. And importantly, 13(3) loans, as with standard discount window loans, must be "secured to the satisfaction" of the lending Reserve Bank. In other words, the borrower's collateral had to be sound enough that the Federal Reserve could reasonably expect full repayment. This last requirement protected taxpayers, as any losses on 13(3) loans would reduce the profits the Fed paid each year to the Treasury and thus add to the budget deficit. But, the requirement also limited the interventions available to the Fed. Invoking 13(3) would not allow us to put capital into a financial institution (by purchasing its stock, for example) or to guarantee its assets against loss.
The Fed used its 13(3) authority during the Depression, but only sparingly. From 1932 to 1936, it made 123 such loans, mostly very small. The largest, $300,000, was made to a typewriter manufacturer; another, for $250,000, was extended to a vegetable grower. As the economy and credit markets improved in the latter part of the 1930s, the Fed stopped making 13(3) loans.
The mental disconnects here are large. What is described here is clearly a liquidity crisis. The problem these firms were facing was that they existed in an economy that was short of cash. Whether that shortage can be attributed to a sharp rise in demand or a relative decline in supply is not particularly meaningful. The economy needed cash.
Considering this, what was holding the Fed back? Maybe the sharp drop in the Fed Funds Rate from 5.25% to 2.25% in just 7 months seemed like accommodation. But, the Fed was just chasing the collapsing neutral rate down. They weren't buying treasuries. In fact, they had already been making emergency loans and were selling treasuries in order to prevent cash from remaining in the economy.
It's strange that the "Too Big To Fail" problem is a core part of criticisms of the Fed, yet here Bernanke essentially states "Too Big To Fail" as a sort of principle. It's not so much a matter of saving the large firms because they have some power over the Fed or the economy. It's that, on principle, the Fed refuses to help firms that aren't "TBTF". But why not? In the passage above, written by Bernanke himself, he explicitly points out that the original 13(3) authority was used exclusively to support systemically insignificant firms.
In the end, 13(3) authority is somewhat useless. The reason that the Fed wouldn't invoke 13(3) earlier in the crisis is because the only reason there was a crisis was because they were creating a crisis, and they didn't know it. There is not a conceivable context where the Fed would utilize 13(3) in a productive way, because in order to do that, they would have to understand that the firms they would be supporting are suffering from a systemic liquidity crisis. If they understood that, they would invoke more conventional forms of support, and 13(3) would be unnecessary.
You might argue that firms like Carlyle were overleveraged, so it was their recklessness that got them in trouble. But, in every conceivable liquidity crisis, it will be the most leveraged and most financially vulnerable firms that will need support. If this is your measure for when nominal stability can be an acceptable policy, then you will inevitably support purposeful instability. That is actually what we have been doing since 2006.