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Too Big to Fail

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Too big to fail

New York Financial District (Credit: Mario Tama/Getty Images)

What Is Too Big to Fail?:

The phrase, "too big to fail," arose during the 2008 financial crisis to describe why the government needed to bail out some companies. These banks, insurers and auto companies had improved their profitability by creating, then selling, complicated derivatives. They also traded risky loans, commodities, currencies and stocks.

When the economy was booming, they derived an unfair competitive advantage, took over smaller firms, and became even bigger. When their investments started going south, they knew the taxpayers would be forced to bail them out -- or risk global economic collapse.

Why AIG Was Too Big to Fail:

A great example is AIG, one of the world's largest insurers. Most of its business was traditional insurance products. When it got into "credit default swaps," it got into trouble.These swaps insured the assets that supported corporate debt and mortgages. AIG was too big to fail because, if AIG went bankrupt, it would trigger the bankruptcy of many of the financial institutions that bought these swaps.

What Other Companies Were Too Big to Fail?:

An investment bank, Lehman Brothers, was also too big to fail. Lehman wasn't a big company, but the impact of its bankruptcy was alarming. This became apparent in 2008, when Treasury Secretary Hank Paulson said no to its bailout, and it filed for bankruptcy. On the following Monday, the Dow dropped nearly 350 points. By Wednesday of that week, widespread panic in the financial markets threatened overnight lending, needed to keep businesses running. The problem was beyond what monetary policy could do. This meant a $700 billion bailout was needed to re-capitalize the major banks

Banks That Were Too Big to Fail:

Citigroup received a $20 billion cash infusion from Treasury. In return, the government received $27 billion of preferred shares yielding 8% annual return, and warrants to buy no more than 5% of Citi's common shares at $10 per share.

The investment banks, Goldman Sachs and Morgan Stanley, were also too big to fail. Although they weren't taken over by the Federal government, as AIG was, they became commercial banks. This ended the era of investment banking made famous by the movie "Wall Street." The 1980s mantra, "Greed is Good," was now seen in its true colors -- Wall Street greed led to taxpayer and homeowner pain.

Fannie and Freddie:

The mortgage giants, Fannie Mae and Freddie Mac, were also too big to fail because they guaranteed 90% of all home mortgages by the end of 2008. Treasury guaranteed $100 million in their mortgages, in effect returning them to government ownership. If Fannie and Freddie had gone bankrupt, the housing market decline would have been much, much worse since banks were not lending without their guarantees.

How Did AIG Almost Fail?:

AIG's swaps against subprime mortgages pushed the otherwise profitable company to the brink of bankruptcy. As the mortgages tied to the swaps defaulted, AIG was forced to raise millions in capital. As stockholders got wind of the situation, they sold their shares, making it even more difficult for AIG to cover the swaps. Even though AIG had more than enough assets to cover the swaps, it couldn't sell them before the swaps came due. This left it without the cash pay the swap insurance. (Source: WSJ, U.S. to take over AIG, September 17, 2008)

What Saved AIG?:

The Federal Reserve provided an $85 billion, two-year loan to AIG to prevent bankruptcy and further stress on the global economy.In return, the government received 79.9% of AIG's equity, the right to replace management, and veto power over all important decisions, including asset sales and payment of dividends. In October 2008, the Fed hired Edward Liddy as CEO and Chairman to manage the company.

The plan was for the Fed to break up AIG and sell off the pieces to repay the loan. However, the stock market plunge in October made that impossible, as potential buyers needed any excess cash for their own balance sheets. The Treasury Department purchased $40 billion in AIG preferred shares from its Capital Repurchase Plan. The Fed will purchase $52.5 billion in mortgage-backed securities. The funds are allowing AIG to retire its credit default swaps rationally, saving it and much of the financial industry from collapse.

Ending Too Big to Fail:

The Dodd-Frank Wall Street Reform Act was the most comprehensive financial reform since the Glass-Steagall Act. It sought regulate the financial markets and make another economic crisis less likely. It set up the the Financial Stability Oversight Council to prevent any more banks from becoming too big to fail. How? It looks out for risks that affect the entire financial industry. It also oversees non-bank financial firms like hedge funds. If any of these companies get too big, it can recommend they be regulated by the Federal Reserve, which can ask it to increase its reserve requirement.
The Volcker Rule, another part of Dodd-Frank, also helps end too big to fail. It limits the amount of risk large banks can take. It prohibits them from trading in stocks, commodities or derivatives for their own profit. They can do so only on behalf of their customers, or to offset business risk.
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