Three Considerations on the 'Too Big To Fail' Issue

Questions for William Poole:

 

Seven Questions: How Bad Will It Get? [Foreign Policy]: When William Poole warned in 2003 that Fannie Mae and Freddie Mac lacked the capital to weather a financial storm, his advice went unheeded. Five years later, the outspoken former president of the Federal Reserve Bank of St. Louis is far too polite to say “I told you so,” but he does have a message for the Fed: Wait too long to tackle inflation, and you’ll face an even worse recession in the years to come.

Foreign Policy: What’s your diagnosis of what happened to Fannie Mae and Freddie Mac?

William Poole: First of all, they had too little capital to withstand adverse circumstances. And the adverse circumstances were the severe downturn in housing, the decline in house prices, and the rising default rate on mortgages. I don’t know of anyone who early enough was saying that there would be a major national decline in house prices, so I can’t hold them to that standard, but I can hold them to a standard of holding adequate capital to be able to withstand unforeseen circumstances. That’s what capital is for. ...

FP: Now, there has obviously been some turmoil in the banking sector. ... Analysts are wondering where the line is in terms of what banks are considered “too big to fail.” Where would you draw that line?

WP: I like the way that Greenspan used to put it and probably still does put it, that no firm should be too big to fail. Some might be too big to liquidate quickly and may require some support until they can be wound down, but there should be no firm too big to fail. We don’t know yet what the nature of the bailout of Fannie and Freddie is going to be, but I believe the plan would be to pay off at par all of the regular obligations. They are being turned into full faith and credit obligations of the United States government. ...

FP: NYU economist Nouriel Roubini, who has been sounding the alarm for quite a while, told Bloomberg News that we’re seeing the worst U.S. financial crisis since the Great Depression.

WP: I think that’s right, but let’s go back and revisit the Great Depression for a moment. ... There was a total and complete collapse of the banking system, and the economy that had functioned on credit and deposits was suddenly left to function on hand-to-hand currency. We aren’t anywhere close to that and we won’t get close to that because of ample Federal Reserve resources and also intellectual understanding that would not permit that to happen.

FP: How bad will it get, then?

WP: We are going to have failures of large numbers of firms, financial firms in particular..., failures of smaller commercial banks ... that were the most heavily involved in real estate are the ones at the greatest risk. ...

FP: Meanwhile, consumer prices are rising at their fastest rate in 17 years. Does that mean the Fed is running out of tools to keep growth going?

WP: All the financial turmoil that we’ve just been talking about—the tightening of credit...—that’s putting downward pressure on the economy, and the big increase in fuel prices is also putting downward pressure on real activity. ... There is a growing amount of unemployment in those sectors, and the Federal Reserve is trying to support economic activity by holding the federal funds rate ... at its current level. If the downturn in employment becomes much more severe, the Fed might even cut rates.

Now, to me, the inflation problem is actually part of what is depressing economic activity, because the generalized inflation that I think we have underway—although it’s not showing up in core inflation and wages just yet—is showing up in the depreciating dollar, and the depreciating dollar directly feeds through to increased energy prices and food prices. So, the depreciation itself is leading to depressed economic activity.

Moreover, if the inflation really starts to go into wages and into the core ... price indices—it will probably develop a fair amount of momentum and the Federal Reserve is not going to be able to reverse it even with a tighter monetary policy for probably a year or two, maybe even three. If the policy is too expansionary too long and we end up with a real inflation problem, all we’re doing is trading a bigger recession later for a smaller recession now.

 

On the too big to fail issue, I don't think it is the size of firms alone that is the problem. For example, suppose that we take a firm too big to fail and break into two smaller firms of one half the original size. If the factors that would have caused the one large firm to fail would have also caused the two smaller firms to fail, then we really haven't accomplished much, the size of the banking disaster will be the same. The problems that affected the GSEs came from factors they did not anticipate, factors that were out of their control. In such a situation, it's not clear to me that having more firms specializing in the same business is any safer than one combined firm. Maybe if there are 100 firms a few will pursue safer strategies and survive, but if we then have 97 smaller banks in trouble rather than just one large bank having problems, the scale of the problem is essentially the same and it would be harder, not easier, to take action to shore up the system since it would take 97 separate arrangements rather than just one.

For that reason, I think regulators should consider the overall size of certain classes of risky activity in addition to the size of individual firms. If a risky activity is too large a component of the financial system, and there isn't adequate backup in the event of widespread default, it doesn't matter whether problems bring down a large number of small firms or one large one, the result will be the same.

I don't mean to say that large firms shouldn't be broken up. Even with a (seemingly) well diversified portfolio, i.e. one that avoids over exposure to any particular type of risky asset, size alone could be a risk should a very large firm fail, though hopefully diversification would make failure less likely. I'm saying that breaking firms up into smaller pieces isn't enough in and of itself to reduce the risk of massive financial meltdown. We also need to worry about the overall magnitude of particular classes of risk and how concentrated those risks are within particular sectors of financial markets. If x is a big part of overall financial activity, i.e. if a bad outcome involving x could cause a financial meltdown, one firm doing nothing but risky activity x isn't much (or any) safer than ten firms doing nothing but risky activity x (scale effects could even increase the likelihood of failure).

So I think three things should come under consideration. First, the size of individual banks. Unless scale effects justify it (a natural monopoly argument, in which case it would be heavily regulated), no firm should to large enough to bring down the economy by itself in the event it fails.

Second, no particular class of risky assets should be large enough to pose a threat to the financial system. Either the overall size of the asset class should be constrained, or the degree of risk should be limited.

Third, the risk from particular classes of asset should not be concentrated in a small number of firms or concentrated within a particular sector if that group of firms or that sector is, collectively, too big to fail.

Comments

[batjak1:]

I bought preferred bank stocks because of the yield of 8% and better.
should I sell even though the stock is down 40%, and recieve my dividends and wait the years for the bank to recoup???

2008 Jul 17 08:17 AM

[goldilocks:]

That there exists "intellectual understanding that would not permit that to happen"...could someone please explain that to me ?

2008 Jul 17 08:39 AM

[kotika98:]

has anyone mentioned that maybe all those banks and non-bank lenders would have better things to do than lend to people who coulnd not and would not pay, if only Fannie and Freddie did not crowd out the private sector out of the prime mortgage business? Perhaps we would not be here where we are today without them?

2008 Jul 17 08:52 AM

[carey_jim:]

Goldilocks, "intellectual understanding" is what the majority of Harvard economics professors understand to be true.

Eat your porridge before you think about that too much.

2008 Jul 17 10:42 AM

[goldilocks:]

Thank you, Jim ! My porridge was just right ! Please, let me ask the question another way...Is it 'Intellectually understood' that we are unable to come close to another collapse of our banking system - do you believe that this is impossible ?

2008 Jul 17 11:07 AM

[biomedlives:]

Right on, Mr. Poole! We should take steps to prevent the formation of "too big to fail" institutions or groups of institutions when times are good, rather than wait to clean up the mess when they fail in tough times.

One may intellectually understand that he/she will be washed away by a tsunami in 30 seconds without being able to prevent it. As for the Harvard economics faculty, I'd rather have economic policy dictated by the first 200 people in the Boston phone book (credit to William F. Buckley).

2008 Jul 17 11:49 AM

[carey_jim:]

Unfortunately, Goldilocks, there is no short answer to your question, only a Harvard Ph.D. thesis answer.

2008 Jul 17 12:16 PM

[Thomas J. G...:]

Mark Thoma,

Thanks for the interview and article, it was great. Poole seems like a character who speaks his mind. Difficult in a position like his.

batjak1

first things first. don't put more than 5% of your portfolio in any one company for any reason, even if you think that gives you the income you want/need. that said, wfc and jpm are the class of the banking act right now. preferred in c, bac, wb, others are more more risky. more subtley, check your preferred. Some of them are not allowed to not cut the preferred dividend unless the common dividend is 0. jpm-pz is an example of this.

goldilocks: I interpret Poole's comment to mean that the Fed and Treasury are very cognizant of the public confidence affects of financial institutions failing now, and that in the 30's part of the problem might have been that the Fed and Treasury weren't as sensitive to that. That's why they made Bear Stearns counter parties whole, gave all indy mac depositors there money less than 100k, and pre-emptively shored fnm and fre up before they even said they had a problem. One question I have in terms of the financial system. Is the sum of all consumer and small business checking/saving accounts where the wealth of the country is anymore, like it was in the early 1930's ? Or is the financial wealth of the country with Fidelity and Schwab, invested in hedge funds or somewhere else?

2008 Jul 17 01:22 PM

[xsuddensam:]

All this "intellectual understanding" BS sickens me. All the politicians and pundits are asking what happened, how do we fix it and how do we prevent it from happening again.

What I want to know is when are all these crooks who got rich on these mortgage scams going to jail.

2008 Jul 18 12:07 AM

[goldilocks:]

Also enjoyed this article & am an admirer of Mark Thoma. Thanks, Flash, for the explanation, I appreciate it ! I sure don't know where the wealth is, but my head is spinning just thinking about all those trillions out there in derivativeland...Reall... like your idea, biomedlives ! On the subject of 'scams', thought the article "Did Bear Stearns Fall or Was it Pushed?"by Ellen Brown very interesting...In regards to the housing bubble, I share the same curiosity as you, xsuddensam...

2008 Jul 18 11:08 PM