Too Big to Fail: The Evidence

Ironically, Cafe Hayek takes issue with my Austrian claim that bankers were (in general) ignorant of the risks they were taking, hence could not have been taking these risks due to their knowledge that they were “too big to fail” and thus would be bailed out. Or at least I think that’s what Russ Roberts is suggesting, because he is disputing what I said, and what I said is that TBTF did not cause the crisis–not that the thought of a bailout never crossed any bankers’ minds. (If I were one of them and it crossed my mind, however, I would have said to myself: “Maybe. But I’m not going to count on it.”)

Roberts cites a speech by Andrew Haldane,an official of the Bank of England, who claims that at an undated meeting of unnamed bankers, an unnamed individual said that bankers had no incentive to run severe stress tests because in a severe event, they would lose their jobs and then “the authorities would have to step in.”

Props to Russ for this interesting evidence, which I hadn’t seen before. But it’s not exactly unambiguous.

Consider a banker who, as posited in the anonymous scenario, thinks that a disastrous financial situation would get him fired. What difference would it make to this allegedly self-interested banker that the bank would subsequently be bailed out?

Of course, as the bailouts actually unfolded, the bankers did not get fired in many cases–but according to Haldane’s anecdote, the bankers did not know that in advance.

So, as I said, when it comes to the TBTF, corporate-compensation, and ABCT theories of the crisis, we’re in a high-conviction, low-evidence zone. However, we are not in an evidence-free zone. Consider, on TBTF:

1. Many banks that were too small to be bailed out (except by the FDIC, in which case the bankers would definitely be fired) invested in the same AAA-rated MBS as the big banks that got bailed out.

2. Commercial bankers like Sandy Weill and investment bankers (e.g., Jimmy Cayne, Ralph Cioffi, and Matthew Tannin at Bear Stearns) lost many millions–in Weill and Cayne’s case, $1 billion each–because they were fully invested in their banks’ stock right up to the end.

Cafe Hayek quotes Cayne: “The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?” What is the point of this quotation: That Cayne didn’t care about his heirs, so he didn’t care about losing $1 billion, so that’s why he knowingly allowed Bear Stearns to take risks that led to its collapse?

That is certainly not the implication of the passage when it is read in context.

3. If one reads the rest of the book from which the quotation is drawn, one finds that Cayne was consumed by the construction of a new skyscraper headquarters for Bear Stearns that would symbolize the permanence of the success of this once-underdog, scrappy, Jewish firm. Is it really plausible that Cayne would risk that success, his life’s legacy, because, in the event that the risk brought down Bear Stearns, the firm might get bailed out (by being absorbed, in the event, into arch-rival JP Morgan)?

Similarly, as I document in my introduction to the Critical Review financial-crisis issue, Cioffi and Tannin, who were the only ones at Bear Stearns who actually knew what was going on, revealed in secret emails to each other (discovered by the FBI) that they were true believers in the accuracy of the triple-A ratings. They were mistaken.

Again, as the crisis unfolded, all the books on the crisis show that the principals were shocked, frantic, and bewildered. If they had deliberately taken risks because they had a bailout in the back of their minds, would they not have have reacted with knowing cynicism and serenity?

(More documentation will appear in the revised introduction to the book version of Critical Review’s financial-crisis issue, The Causes of the Financial Crisis, forthcoming from the University of Pennsylvania Press.)

4. I’m still waiting for somebody to explain why these bankers who were supposedly insensitive to risk–due to being TBTF, or due to their compensation incentives–bought government-guaranteed or AAA-rated MBS 93 percent of the time.

AA-rated MBS were riskier, paid higher returns, and got exactly the same capital relief as AAAs. They would have been the MBS of choice if both the capital-relief theory of the crisis, which I favor, and the TBTF or corporate-compensation theories of the crisis were true. Subtract the capital-relief motive, though, and BBB or lower-rated securities would have been the choice. But never, ever, AAAs.

I respectfully submit that the bankers–like the regulators–simply did not realize that this was the first-ever significant nationwide housing bubble. And they did not realize how fragile the bubble was, due to subprime lending. Meanwhile, the Basel regulators encouraged them to leverage into the bubble by buying AA- or AAA-rated MBS. That is the crisis in three easy sentences.

The crisis has ideological ramifications. So economists of libertarian bent want to blame it on TBTF. Those of leftist bent want to blame it on bankers greedy for bonuses. Is it so difficult to imagine, though, that both the regulators and the bankers, being human, were ignorant of what was to come?

That, I think, is what Hayek might have said.

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About Jeffrey Friedman 4 Articles

Affiliation: University of Texas, Austin

Jeffrey Friedman is a political scientist and the editor of Critical Review: An Interdisciplinary Journal of Politics and Society.

Friedman graduated from Brown University in 1983 with a double major in History and Philosophy, and received an MA in History at the University of California, Berkeley, in 1985 and a Ph.D. in Political Science from Yale in 2002. He taught in the Government department at Dartmouth College in 1998, the Social Studies program at Harvard from 1998 to 2000, and the Political Science department at Barnard College, Columbia University from 2001 to 2006.

In 2006 he resigned from the Barnard faculty to edit Critical Review, which he had founded in 1986. The initial purpose of the journal was to bring critical scrutiny to bear on libertarian scholarship, and to subject mainstream scholarship to similar scrutiny. As part of this effort, Friedman published an article, "What's Wrong with Libertarianism," that prompted wide discussion among libertarian writers. Since then, the journal has evolved into a scholarly forum for critically assessing the realities of democracy and capitalism, emphasizing the actual functioning of democracy in the light of political scientists' findings of "public ignorance" of political affairs, and related questions such as electoral "mandates," media bias, academic bias, and the autonomy of state officials from public scrutiny. Friedman's articles "Public Opinion and Democratic Theory" (1998), "Public Opinion: Bringing the Media Back In" (2003), and "Popper, Weber, and Hayek: The Epistemology and Politics of Ignorance" (2005) addressed these issues.

Friedman is a visiting scholar in the Government Department of the University of Texas at Austin, and the Max Weber Fellow of the Institute for the Advancement of the Social Sciences at Boston University.

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