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Why Banks are Still Too Big to Fail

The Ghost of Lehman Brothers

Written by Joseph Cafariello
Posted May 15, 2013 at 7:02PM

Describing a bank failure as a “collapse”, as in the collapse of a building, is really quite fitting. The collapse of a bank is triggered by the exact same flaws – too weak a foundation supporting too heavy a load.

lehmanLeading up to the 2008 financial meltdown, banks were taking on much greater risk than they had capital to support. In many investments, they were leveraged 40:1, meaning the banks had taken on $40 worth of risk for each $1 set aside to cover it. It was more load than their foundations could support, and they nearly collapsed under it.

The government then drew on its own taxpayer resources to patch up and buttress the largest of the banks, which were considered too big to let fall. Some fear they still are.

The Lehman Warning

It was probably a good thing for the government to let at least one large bank fall back in 2008, if only to use it as a case study to learn what really are the risks and consequences of a large bank rupture. For reasons never completely disclosed, Lehman Brothers Holding Inc. was chosen as the financial curiosity to be dissected.

The world’s fourth-largest investment bank at the time, Lehman Brothers became the largest bankruptcy in U.S. history in 2008 after losing billions in the subprime mortgage implosion. After 5 years, the settling of accounts is still nowhere near an end, with over 1.7 million trade contracts to unwind involving thousands of banks, investment funds, corporations, municipalities, and foreign governments.

To pay off its losses, the bankrupt bank is still trying to collect what it is owed by institutions who bought the bank’s bonds. Needless to say, it’s a tough thing to do when the bank is accused of misleading its bond purchasers.

Still, what’s left of Lehman is claiming that bond buyers were well aware of the risks involved, and they are going after everybody – including pension funds, universities, municipalities, even charities.

One problem lies in determining the replacement value of the defunct contracts. Typically, the process entails comparing quotes from at least three banks to arrive at a fair replacement cost for the defunct contract. But because the banking climate is so much more conservative now than it was pre-crisis, bond holders are submitting discounted quotes in an effort to pay less, while Lehman wants the quotes as they are received in order to get paid more.

The legal battles still rage on as the failed bank tries to settle with creditors and debtors alike. Lehman Brothers will forever serve as a classic example of what can happen when a bank’s assets are grossly insufficient to back its over-leveraged liabilities.

Never Again

The solution, it would seem, is to ensure that banks hold enough assets to cover their liabilities, at least within a reasonable ratio. Since 2008, a series of national and international banking acts and laws – including the international Basel III banking accord – were introduced, requiring banks to do precisely that: increase their asset holdings and decrease their investment risk to a more manageable and less destructive proportion.

But the banks still needed to be propped up during the years it would take to properly implement these structural reforms. One by one, governments around the world started redirecting taxpayer resources into their banks. The U.S. government, for one, did not have the stomach to let another bank go the way of Lehman.

Since the 2008 financial crisis, the largest six banks in the U.S. – Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM), Morgan Stanley (NYSE: MS), and Wells Fargo & Co (NYSE: WFC) – have received some $102 billion in tax breaks and government bailouts estimates Bloomberg. Though others, such as ProPublica, believe the total is closer to $160 billion.

As divided as the nation may be on almost every other issue, on bank bailouts most seem to stand united – never again should banks be bailed out at the tax-payers’ expense. Out of that universal resolve came The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, outlining how to deal with failing banks in the future. The Act calls for outright liquidation, no matter how big they are.

The U.S. President himself declared the end of bank bailouts. “Because of this reform, the American people will never again be asked to foot the bill for Wall Street’s mistakes,” President Obama said in his July 15, 2010 speech on the passing of the Act, as quoted by Bloomberg. “There will be no more taxpayer-funded bailouts - period.”

Never Believed

Yet the general sentiment is of disbelief and outright disregard. Investors, for instance, are still more than eager to deposit tens of billions of dollars in U.S. bank bonds for just a few percentage points of interest.

University professors Deniz Anginer (Virginia), Viral Acharya (New York), and Joseph Warburton (Syracuse) studied the discounts that investors were willing to accept from banks compared to fixed income returns they could get elsewhere. From 1990 to 2010, investors were receiving discounted returns from banks averaging about $20 billion each year.

But since 2009, investors have been happy with discounts of as much as $100 billion each year. Now that is a sign of big-bank investor confidence.

“The big banks have the taxpayers standing behind them, so people who lend them money know they’ll be paid back,” Cornelius Hurley, director of the Center for Finance Law & Policy at Boston University and former assistant general counsel at the Fed, explained to Bloomberg. “That too big to fail no longer exists is not credible.”

Even credit-rating agency Moody’s Investors Service has factored the expectation of government bailouts into each bank’s rating. Each of the top six U.S. banks have had their credit ratings raised by two grades in some cases and three grades in others. The bonds of at least two of those banks would be wallowing in junk status right now if not for the perception that the government is still ready, willing, and able to rescue them if needed.

Never Permit

Yet others believe the government should and must step in if one or more of the large banks begins showing signs of failing. In their assessments, the consequences of another bank failure would be catastrophic and should never be permitted.

“The biggest mistake that could be made would be to allow significant banking institutions to fail,” Gabriel Borenstein, managing director of New York-based Enclave Capital LLC, stressed to Bloomberg. “The sequential events that would follow, largely driven by psychology, cannot be quantified. Another Lehman Brothers collapse could trigger a potential implosion.”

When the 2008 summer meltdown first began, just the threat of failure was enough to cause U.S. stock markets to plunge. From the summer of ’08 to the spring of ’09, the S&P 500 fell from 1,300 to 670 – a drop of 630 points, or 48% – in just six months. It took two full years to return to that pre-crisis level. And this was with that first rescue package of $700 billion in 2009. We can only imagine what the last 5 years would have been like without stimulus.

The spill-over into other sectors of the economy cannot be forgotten either, including the near collapse of the automotive industry and the recession that spread across the country and around the globe. Even with stimulus, we are still talking about all the lost jobs that have not yet returned.

Never Mind

It might seem that banks and government are well aware of these dangers too and are thus continuing to walk hand in hand, although they may have a coat draped over their arms as they try not to show it. Never mind their talk – it’s their walk that gives them away.

After 5 years, the Federal Reserve is still providing liquidity to banks, purchasing their mortgage bonds, taking some of the debt burden off their shoulders, and giving them cash at the same time.

Bloomberg has found that Wells Fargo – provider of almost one-third of U.S. home loans – has already received $2.07 billion from the Fed’s mortgage purchases, with Bank of America receiving $1.16 billion, JPMorgan receiving $767 million, and Citigroup collecting $332 million.

Perhaps officials can still proclaim no more bailouts to failing banks after all. The way the government is tossing money at them, none of the large banks will ever be in a position to fail in the first place.

Joseph Cafariello


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