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By Michael A. Martorelli, CFA

"Financing Failure: A Century of Bailouts." 2012. Vern McKinley.

Investment professionals trying to increase their understanding of such seminal events as the many government bailouts of financial institutions in 2008 and 2009 do not ordinarily seek out the publications of independent think tanks that have potentially biased points of view. Perhaps surprisingly, they will find the provocatively titled "Financing Failure: A Century of Bailouts," by Vern McKinley — a research fellow at the Independent Institute — a compelling historical analysis. He suggests that the 2008–09 interventions, as well as those made during the 1970s and 1980s, were ill conceived and inadequately justified. To appreciate this book, it is not necessary to agree with his corollary argument that misguided government policies were largely responsible for the financial crises that necessitated such bailouts.

The author extensively cites other crisis-related books written during the past few years, as well as the investigative reports of public and private organizations. Fortunately for readers who desire more details, he does so through more than 860 footnotes spread throughout the book. Those sources have helped McKinley produce a critical examination of the analyses that policymakers considered (or did not consider) as they struggled to ameliorate the systemic financial crises of the past several decades. Financing Failure describes only the essence of the major financial crises that enveloped the U.S. economy from the 1930s to the 2000s. McKinley’s main thrust lies not in retelling the difficulties but in describing in detail the U.S. government’s analysis of the problems.

In the 1930s, U.S. regulators and legislators seemed quite aware of their predecessors’ actions. They crafted the Reconstruction Finance Corporation (RFC), which was modeled closely after the earlier War Finance Corporation (WFC). However, the long-lasting Great Depression put a much greater strain on the banking system than the brief difficulties involved in financing and prosecuting World War I did. In 1933, the RFC — unlike the WFC in 1918 — actually injected capital into many of the nation’s commercial banks, thereby ensuring their survival and (allegedly) preventing the cascade of business failures that would have resulted from their demise.

McKinley notes that in a series of actions that would set the tone for the future, the U.S. Congress went to great lengths to justify its assistance to troubled financial firms and later enacted legislation aimed at dealing with a similar crisis in the future. Both the creation of the Federal Deposit Insurance Corporation (FDIC) and the expansion of the Federal Reserve’s lending authority through the addition of the “unusual and exigent circumstances” clause in the Federal Reserve Act promised to institutionalize the responses government officials had crafted in the recent emergency. For the first time in the country’s history, officials from the Treasury, the Federal Reserve, the FDIC, and Congress would be adequately empowered to deal with periods of financial distress.

Inevitably, another period of financial stress would threaten the survival of certain financial institutions and the financial well-being of a range of customers, depositors, creditors, and correspondents more representative of the broader economy than any one firm’s roster of clients. McKinley notes only briefly how the boom–bust macroeconomic cycles and the specific investment decisions made by the managements of Franklin National Bank (1974), First Pennsylvania Bank (1980), and Continental Illinois National Bank and Trust Company (1984) threatened the existence of those leading banks. He spends a great deal of time, however, exploring how the banking regulators’ amnesia led to the government’s interfering in the free market by supplying the funds or financial backing to bail out those firms.

Some readers may be surprised to learn that lawmakers and regulators first invoked the “too big to fail” (TBTF) concept not in 2008 but some 24 years earlier. Regulators at the time raised dire but unsubstantiated warnings that extensive interbank exposure would make the failure of one institution trigger a cascade of failures among numerous counterparties. Congressional hearings conducted after the Continental Illinois bailout, however, uncovered no analytical studies of that issue by any relevant government agency.

McKinley devotes an extraordinary amount of space (and footnotes) to details of the crisis of 2008–2009. He brings few new facts to light, but his extensive footnotes are particularly useful for anybody unfamiliar with the tragic events of those years. Moreover, by recounting the attempts to cope with the problems of Bear Stearns, Lehman Brothers, AIG, and others immediately after detailing the concerns about the TBTF problem raised in an earlier era, the author adds considerable strength to his message about the inadequacy of the government’s responses to financial crises. He shows that politically motivated officials repeatedly engage in seat-of-the-pants, ad hoc analysis, ignoring both the lessons of history and the potential long-term ramifications of their proposed actions.

Here’s hoping that policymakers will avail themselves of this comprehensive analysis of several decades’ worth of decisions to bail out troubled banking firms and that they will do so before they become embroiled in coping with the next financial crisis.

Source: Book Review: 'Financing Failure: A Century Of Bailouts'