The phrase “too big to fail” (TBTF) has been used a lot throughout the credit crunch of the last twelve months or so. Now it seems that American International Group (AIG) was too big to fail as it was bailed out by the US Federal Reserve (the “Fed”), while Lehman Brothers was not and was allowed to collapse in ignominy. For those outside the financial markets, it probably doesn’t make a lot of sense (not that it makes much more sense for those on the inside), so what is going on here?
There is an old saying that if you owe the bank $1,000 that’s your problem, but if you owe the bank $1 million that’s their problem. Something similar is at work at the moment in the financial markets.
In theory, companies in a capitalist economy are free to stand or fall on the results of their own business decisions. If they do fall, investors who chose to buy shares or bonds will lose out, but that risk is supposed to keep everyone focused on making better decisions. Banks have always been a little bit different, for two reasons. First because they take deposits from “mums and dads” (or, as the banks call them, retail depositors) and it is in the interests of the smooth-running of the whole system that this money is put into banks rather than under the mattress. Hard experience over the years of bank runs has led to various forms of depositor protection around the world, such as Government guarantees in the US through the Federal Deposit Insurance Corporation (FDIC). Of course, banks make a decent, albeit shrinking, profit from all these protected deposits.
The other thing that makes the banks special is that they make up the payments system, the grease that oils the whole economy. Almost all financial transactions are facilitated through commercial banks, including credit card payments, cheques, direct salary deposits and online payments. This is an excellent position to be in to make money simply by clipping the ticket a little on every transaction.
Getting access to retail deposits and the payments system comes with a price tag: banks are heavily regulated and were limited in the risk they could run (this is what Basel II is all about). Investment banks like Bear Stearns, Merrill Lynch and Lehman Brothers, on the other hand, are quite different beasts. They operated wholly in the financial markets. They took no retail deposits and were not a direct part of the payments system. They were therefore seen as free agents who were far less regulated. The theory was they were playing with the big boys and if the risks they ran got them into trouble, that was their problem. Practice has turned out to be a little different.
I wrote a little while ago about the bursting of the credit bubble that led to the “credit crunch” that has had the financial markets in its grips since July 2007. This credit crunch has exhibited a contagion effect, with each new problem creating more problems and regulators like the Fed have realised that, due to the sheer size and interdependency of the players involved, it’s actually their problem. This was what was behind the bailout of Bear Stearns back in March this year. Technically, they were bought by JPMorgan Chase, but the helping hand of the Fed was there backing up the happy new owner. (Incidentally, JPMorgan spent more on the Bear Stearns building than on the company, another precedent that would be repeated). The Bear Stearns crisis illustrated the classic features of a liquidity failure: if people think that you are having trouble refinancing your debts, then you will have trouble because no-one will want to lend you money anymore. The Fed’s concern, and the reason they worked so hard to engineer a solution was that the financial markets have become as important to the smooth running of developed economies as the payments system. And firms like Bear Stearns have become so deeply enmeshed in the financial markets as a party to arcane financial markets transactions like derivatives, repos and other transactions, that the Fed feared Bear Stearns could bring down the whole deck of cards.
The Bear bail-out was almost exactly six months ago, and even then market speculation focused on Lehman Brothers as the next most likely investment bank to be in trouble. That probably worked against them because banks, fund managers and other market participants will have been limiting their exposure to Lehman and positioning themselves for trouble. Nevertheless, no-one really wanted to deal with a default and this weekend began with most people expecting a repeat of the Bear Stearns bail-out, with the most likely saviour being Bank of America (there were not many banks in the world with the money left to be able to buy them). Unfortunately for Lehman Brothers, Merrill Lynch beat them to the punch, negotiating a deal with Bank of America, who went home with an investment bank, just not the one they expected. Then, perhaps to show that they were not going to guarantee every failing institution, or because they thought the markets were better prepared for a Lehman failure or even because they knew that the bigger fish of AIG was around the corner, the Fed was not prepared to stand behind a buyer of Lehman Brothers. So, on Sunday night (Monday morning here in Australia), Lehman Brothers filed for bankruptcy. With around US$150bn of debt, this is the biggest default in corporate history. The next biggest was WorldCom, who defaulted on around US$30bn in debt. Even when Argentina defaulted on its sovereign debt in 2001/02, the total was under US$100bn. So perhaps Lehman Brothers were not TBTF, but they were certainly left a large carcass and there are still many people working very hard to try and untangle the mess that their failure has left.
As soon as Lehman filed, world markets turned their attention to AIG. The world’s biggest insurer had been struggling for some time with enormous write-downs arising from its exposure to the credit crunch, and rumours were intensifying that they were having increasing difficulty refinancing their short term debt. There were reports that AIG need to refinance anywhere from $20 to $80 billion or more before the end of the week and were struggling to find the money. AIG had been a very large participant in the credit default swap markets, with an estimated $440 billion in outstanding contracts. AIG was a financial giant, employing over 100,000 people in more than 100 counties. As just one example, the Telegraph in the UK reported that AIG owns the City of London airport and staff were starting the week wondering whether they would still have a job by Friday.
Like banking, the insurance industry is heavily regulated, and all of AIG’s insurance operations in different countries would be separately capitalised. Nevertheless, this was not something that anyone really wanted to put to the test and markets were fretting about the consequences of such a failure that would dwarf Lehman Brothers. As it turned out, the Fed was just as concerned and at 9pm New York time, it was announced that they would be providing an enormous bailout in the form of an $85 billion two-year loan. However, this rescue came at a significant cost: a very high interest rate of 8.5% over 3 month LIBOR (a US benchmark variable rate) and an 80% stake in the company.
AIG’s motto was “the strength to be there”. Apparently it wasn’t quite strong enough, but it was TBTF. The obvious question now is, who is next? All eyes are on Morgan Stanley, HBOS and a number of other firms who are doubtless wishing they didn’t have that sort of attention.
In an epilogue to the AIG bail-out, Barclays announced that they would be buying some of what is left of Lehman Brothers. Once again, and the item with the biggest price tag is the Lehmans building.