Introduction
The phrase “too big to fail” is used to describe a company that is so interconnected with the global economy that its failure would be catastrophic. “Big” does not refer to the size of the company, but rather its involvement in multiple economies.
Banks That Became Too Big to Fail
The first bank to become too big to fail was Bear Stearns. Bear Stearns was a small but well-known investment bank heavily invested in mortgage-backed securities. When the mortgage-backed securities market collapsed, the Federal Reserve lent $30 billion to JPMorgan Chase & Co. (JPM.N) to purchase Bear Stearns to alleviate fears of destroying confidence in other banks.
CitiGroup, a giant in the financial services industry, was also affected by its involvement in the web of mortgage-backed securities issuances. Lehman Brothers was affected by the crisis as well, but unlike other investment banks and money centers, Treasury Secretary Hank Paulson decided not to bail it out. As a result, it filed for bankruptcy. On the same day, the Dow Jones Industrial Average fell by 504 points, highlighting the severity of the situation in the capital markets.
On Wednesday, a panic erupted in the markets, threatening the overnight loans necessary for the continuation of business. The problem escalated beyond the bounds of monetary policy. The only option that leaders in the financial services industry saw was a $700 billion bailout to recapitalize the major banks.
Bank of America, Morgan Stanley, Goldman Sachs, and JPMorgan Chase were also at the forefront of events as they suffered losses from deteriorating security values.
Companies That Were Bailed Out
After receiving a $25 billion injection, CitiGroup received $20 billion in cash from the Treasury. In return, the government received $27 billion in preferred stock yielding an annual return of 8%. It also received the right to purchase no more than 5% of Citi’s common shares at $10 per share.
Investment banks Goldman Sachs and Morgan Stanley were saved by the Federal Reserve, allowing them to become bank holding companies, meaning they would be regulated by the government.
Subsequently, the banks could take advantage of the Federal Reserve’s discount window and benefit from other guarantee programs aimed at retail banks. With the collapse of these investment banks, an era of highly successful investment banking came to an end.
Mortgage Companies Fannie Mae and Freddie Mac
Among government agencies, including mortgage giants Fannie Mae and Freddie Mac, 90% of all new mortgages issued in 2009 were guaranteed. These agencies purchased mortgages from banks and created securities from them. In this process, investors flocked to these securities due to the high returns.
Home loans were granted to people who could not afford them (subprime loans), which were sold as securities. Investors spent thousands of dollars on these securities when the mortgage bubble burst due to a significant number of defaults.
The U.S. Treasury covered $100 billion in mortgages, effectively making them government-owned. If Fannie and Freddie had gone bankrupt, the housing market would have collapsed.
American International Group (AIG)
American International Group (AIG) was one of the largest insurance companies in the world. Most of its business consisted of traditional insurance products. When the company became involved in credit default swaps, it began to take on massive risks.
These swaps insured mortgage-backed securities purchased by investors, in an attempt to reduce the risks associated with those securities in case borrowers defaulted. If AIG had gone bankrupt, it would have led to the failure of the financial institutions that bought those swaps.
It paid
AIG’s swaps against subprime mortgages brought the company to the brink of bankruptcy. With the mortgage defaults linked to the swaps, AIG was forced to raise millions of dollars in capital. With shareholders aware of the situation, they sold their shares, making it difficult for AIG to cover the swaps.
Although AIG had enough assets to cover the swaps, it could not sell them before the swaps’ due date. This left it without cash liquidity to pay the insurance on the swaps.
The Federal Reserve provided an $85 billion two-year loan to AIG to alleviate pressures on the global economy. In return, the government received a 79.9% stake in AIG and the right to replace management.
The government also gained the right to veto all major decisions, including asset sales and dividend payments. In October 2008, the Federal Reserve enlisted Edward Liddy as CEO and Chairman to manage the company.
The plan was for the Federal Reserve to break up AIG and sell parts to repay the loan, but the stock market collapse in October made that impossible. Potential buyers needed any additional cash liquidity for their balance sheets. The Treasury Department purchased $40 billion in AIG preferred stock as part of the troubled asset relief program.
The Federal Reserve bought $52.5 billion in mortgage-backed securities. AIG’s funds were able to regularly make payments on the swaps, saving it and many in the financial services industry from collapse. The AIG bailout became one of the largest financial rescues in US history.
Preventing banks from becoming too big to fail
The Dodd-Frank Wall Street Reform Act (Dodd-Frank) was the most comprehensive financial reform since the Glass-Steagall Act of 1933 (repealed in 1999), which set the framework for investment banking crises. It aimed to regulate financial markets and make another economic crisis less likely, and it established the Financial Stability Oversight Council to prevent any banks from becoming too big to fail.
The council monitors risks that affect the entire financial services industry. It also oversees non-bank financial companies such as alternative investment funds. If any of these companies become too large, the council can recommend that they be regulated by the Federal Reserve. The Fed can require them to increase their reserve requirements (the amount of cash or deposits that financial institutions must hold at Federal Reserve banks).
The Volcker Rule, another part of the Dodd-Frank Act, also helps to prevent banks from becoming too big to fail. It limits the amount of risk that large banks can take on. It prohibits them from trading in stocks, commodities, and derivatives for their own profit. They can only do so on behalf of their clients or to offset business risks.
Source: https://www.thebalancemoney.com/too-big-to-fail-3305617
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