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Financial Markets Are Crazy to Expect Future Bailouts

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After a generation of genuflecting when the word "market" is spoken, after ascribing to the market the wisdom and knowledge of the divinity, it is time to face the truth: The market is dumber than a box of rocks, at least when it comes to politics.

Andrew Haldane, executive director for Financial Stability of the Bank of England, just published a column with the title "Have We Solved ‘Too Big To Fail’?" He does not attempt to maintain suspense: the first paragraph of the column is the word "No."

Haldane elaborates: "That is not my pessimistic verdict; it is the market's." The biggest banks can borrow more cheaply than their small-enough-to-fail competitors because the market assumes that no responsible government would allow the catastrophic collapse of a large, complex financial institution and creditors will get paid one way or another. That assumption was worth tens of billions of dollars each year to the world's 29 biggest banks before the crisis; now it amounts to hundreds of billions of dollars a year in reduced funding costs.

The market is probably right to assume that regulatory changes since the crisis have not eliminated the possibility that a large, complex financial institution could fail with significant "negative externalities," like a collapse of the financial system and global depression. William Dudley, president of Federal Reserve Bank of New York, said in a recent speech that the first resolution plans, or "living wills," submitted by the biggest institutions "confirm that we are a long way from the desired situation in which large, complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society."

The market's assumption, however, that governments would not allow a large, complex financial institution to fail if the institution's failure would have catastrophic consequences is wildly unrealistic. The market assumes that would be crazy and the governments of industrialized nations that host the biggest banks would not be that crazy.

Really? Does the market watch the news?

We may never know everything the Fed and the Federal Deposit Insurance Corp. did to prevent the collapse of the financial system during the crisis. The Fed helped JPMorgan Chase acquire Bear Stearns and made extraordinary loans so AIG could pay counterparties in full on credit default swaps. The FDIC guaranteed deposits and other bank liabilities not subject to the FDIC's insurance. The Dodd-Frank Act amended the legal authority that the Fed and the FDIC used for those extraordinary interventions to assure that taxpayers will never again bail out financial institutions.

Haldane said in his column that "on paper" the Dodd-Frank Act "rules out future bailout," but "market expectations of state support for U.S. banks are higher today than before the crisis struck and unchanged since Dodd-Frank became law." In fact, Dodd-Frank may give the Fed and the FDIC some wiggle room, but they may not have time to wiggle in a crisis.

That means the market expects that Congress would act, and quickly. At the height of the financial crisis, Congress passed the Emergency Economic Stabilization Act of 2008, authorizing $700 billion to fund the Troubled Asset Relief Program. It took less than two weeks, but it was ugly. The House first soundly defeated the legislation in a bipartisan vote. The market crashed in disbelief. The Senate passed the legislation a few days later. Then-senator Barack Obama, the Democratic nominee for President, called Democratic House members who had opposed the bill to urge that they reconsider. Senator John McCain, the Republican nominee, also supported the legislation to less noticeable effect. The House reluctantly went along.

The bailout was unpopular across the political spectrum. Every member's office was swamped with furious emails and telephone calls. Much of the rage of the Tea Party began with Tarp. Then-Senator Bob Bennett, a Utah conservative who supported the legislation, lost the Republican nomination for re-election in 2010 at the Republican state convention. Tea Party delegates chanted "Tarp, Tarp, Tarp."

On the left and the right, the bailout is seen as helping the blameworthy rich on Wall Street, and doing nothing for the relatively innocent middle class.

Recently departed Treasury Secretary Timothy Geithner told The New Yorker that the bailout "saved the economy, but we kind of lost the public." It will kind of matter the next time that we kind of lost the public the last time, since we are kind of a democracy.

Our politics is far more belligerently partisan and dogmatic now than in 2008, and the memory of the public rage over the last bailout is very fresh. Bank bailouts really do not fit anyone's ideology.

As you watch the melodrama in Congress over the "fiscal cliff," sequestration, government shutdown and the debt ceiling, all problems of Congress' own making, imagine how this Congress would handle legislation to spend hundreds of billions of dollars to bail out the financial system.

If you think Congress might not close ranks and bail out the banks again, you are probably smarter than the market.

Brad Miller is a former U.S. congressman.

 

 

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Comments (6)
Former Fed Chairman Paul Volker has stated publically that regulators anywhere will do whatever it takes regardless of their legal authority to prevent a financial crisis. Legal authority has long since ceased being a constraint, and most of the time politicians assist in the cover-up as the costs of a bailout are opaque.
Posted by kvillani | Monday, January 28 2013 at 11:31AM ET
What does crazy mean here? Einstein's definition of crazy turns on the idea of expecting things to be different the next time. Months of repeating the misleading claim that taxpayers "made money" on the bailout will prepare the public to support bailouts in the next crisis and help Fed officials to overcome statutory and procedural restrictions on their authority.
Posted by kaneeb | Monday, January 28 2013 at 12:45PM ET
It's one thing to talk tough about not bailing out banks now. It's another thing to say you're not going to do it during a full fledge crisis. Addressing entitlements (Social Security, Medicare, Medicaid) come to mind here. Any politician who utters "reform" knows they will have to hang up their hat come voting season. Do you really think in the throws of a crisis, when your constituents think they are going to lose their life savings, that the government won't step in to prevent it? Is today April Fools?
Posted by BankerBud | Monday, January 28 2013 at 1:00PM ET
The need for a new bailout would give some members of congress pause, perhaps, but since so few are truly there for the good of the nation, they'd cave. Then they'd go take that nice, cushy job at one of their former lobbyist's place of influence, er, business, and the game would go on. I wish it were otherwise.
Posted by conch65 | Monday, January 28 2013 at 2:16PM ET
Let's be serious here. The only way to really prevent the risk of future bailouts is to break up the financial institutions that are so big, so opaque, so interconnected, and so complex that their failure would bring down the rest of the domestic and international banking world.
Posted by terryj | Monday, January 28 2013 at 2:51PM ET
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