Too Big to Fail?

Dr. Mark Hendrickson | Grove City College | Tuesday, July 22, 2008

Too Big to Fail?

July 21, 2008

Every year, Merriam-Webster, the dictionary company, holds a vote for “Word of the Year.” Don’t be surprised if 2008’s word is “bailout.” And if they start a “Phrase of the Year” category, how about “Too big to fail?” We heard both terms in connection with Bear Stearns in March. We are hearing them again now in connection with Fannie Mae and Freddy Mac. Get used to hearing them. There are other major financial firms in mortal danger.

The two terms are joined at the hip. “Too big to fail” is a designation for the companies and institutions that the political powers-that-be—Congress, the president, the Federal Reserve, et al.—decide should not be allowed to be liquidated because of the damaging economic effects that would ripple to other companies and individuals. To prevent such a chain reaction from happening, government devises a “bailout”—a plan to rescue the “too big to fail” entity. You and I play a major, though involuntary, role in government bailouts. We pay for them.

Bear Stearns was bailed out by being merged into JPMorgan Chase. The primary reason the feds intervened to prevent Bear’s liquidation was Bear’s key role as a market-maker for Uncle Sam’s enormous debt. The government wasn’t about to let the market for its own debt freeze up. So, the rich got richer—JP Morgan picked up some valuable assets at a bargain price (and received $29 billion from the Fed for doing so) and Bear’s CEO walked away with $63 million. Meanwhile, the value of Joe Lunchbucket’s savings, assets, and income declined due to the market’s diminished confidence in the American dollar.

The rationale for bailing out Bear was that the American people would have suffered more economic pain from lack of a bailout. While probably true in the short term (although almost certainly untrue in the longer term), the important question is: How did we get into this mess? Why did the Federal Reserve turn such a blind eye to the recklessness of the marketers of the U.S. Treasury’s debt? Instead of protecting the interests of the American people, the Fed allowed Wall Street elites to make millions in clever but unsound schemes, and then left the taxpayer holding the bag.

Fast forward a few months. Congress is now crafting bailouts for Fannie Mae and Freddy Mac. The failure of those two mortgage giants would trigger a massive firestorm throughout the world’s financial markets, causing both our stock market and the dollar to plunge. Again, nobody wants that to happen. But the crux of the issue again is: How did we get into this predicament? The short answer: because of socialistic practices in Washington.

Ever since FDR created the Federal Housing Administration (FHA) in 1934, Uncle Sam has increasingly insinuated himself into the private housing market. That trend has led to Fannie Mae and Freddy Mac now holding approximately half of all U.S. mortgage debt—over $5 trillion. If a totally private bank had cornered half of the mortgage market in this country, the government’s antitrust division would have prosecuted them, but Congress deliberately helped Fannie and Freddy dominate this market.

These government-sponsored enterprises (GSEs) were created by Uncle Sam. They were designed to take market share away from private firms. Although government guarantee of their solvency has never been explicit, it has always been assumed that Fannie and Freddy would never be allowed to fail. This created a moral hazard. The mortgage twins engaged in ridiculously reckless practices, leveraging themselves more than twice as highly as Bear Stearns was—a degree of risk exposure that is illegal (and with good reason) for private banks. While the going was good, Fannie’s erstwhile CEO received annual compensation exceeding $17 million and another dozen executives over $2 million. Now that the housing bubble has burst, the perpetrators keep their millions while we taxpayers are on the hook for trillions of debt.

The present crisis shouldn’t have come as a surprise. Freddy, for example, refused to file financial reports with the stock exchange for two years. Normally, such a firm has its stock delisted and its shares cease to trade. Freddy, however, received preferential treatment. It has powerful allies in Congress—friends like the House Financial Services Committee Chairman, for whom Freddy illegally held 40 fundraisers.

Fannie and Freddy are today’s Enrons, yet Congress’ wrath is reserved for big oil companies. Perhaps that is because the big oil companies haven’t matched the sweetheart deals that congressmen have received from the two GSEs (discounted mortgage rates, $200 million in political contributions, etc.).

During this election year, when you hear that more government is what our economy needs, think of Bear Stearns, Fannie Mae, and Freddy Mac. The evidence is clear: government helps the big boys and we small fries are the ones who get stuck with the bill.

Dr. Mark W. Hendrickson is a faculty member, economist, and contributing scholar with the Center for Vision & Values at Grove City College.