Too Big To Fail: From Lehman To GM To Maybe Detroit, Can The Bailouts Finally Stop?

Dozens of bankers and investors piled into a small room in the Grand Hyatt New York Hotel last month to discuss the future of global banking.

Considering the combined experience and knowledge of the group, most of what they had to say ended with a question mark. How can Europe’s banks be fixed? What is most worrying about China’s shadow banking industry? What are the new realities for North America’s banks?

Possible answers were as diverse as the panelists’ financial portfolios, yet there was consensus about one tried-and-true, nearly 30-year-old concept: Some banks are simply too big to fail. When polled, 68 percent of the audience said they believed taxpayer-backed bailouts of large, failing banks would remain the go-to option in financial crises for years to come. That, despite widespread public distaste for the bailouts, and the feeling among industry insiders that they are in fact a bad idea.

“The American public feels there was no, like, Old Testament justice,” Jamie Dimon, the CEO and chairman of JPMorgan Chase (NYSE:JPM), said on Bloomberg TV last year. “What they saw, banks bailed out and all these people make all that money, and including the banks that failed, people made a lot of money, and there's some truth to that. There is some truth to that. I can't make up for what other boards did and didn't do, but there's truth to that.”

The last major bank bailout was in 2008 , when the federal government notoriously spent up to $700 billion to buy distressed mortgages from Wall Street firms undercut by their own shifty deals. Among the other taxpayer funded bailouts: The $85 billion for insurance giant American International Group; $29 billion to encourage the marriage of Bear Stearns and JPMorgan; and $25 billion for financial giants Fannie Mae and Freddie Mac. What all the bailouts have in common is the theme “too big to fail.”

“We were asked to buy Bear Stearns -- so it’s said, the Fed did us a favor to finance that … No, we did them a favor,” Dimon said, grinning. “Let’s get this one exactly right – we were asked to do it, we did it at great risk to ourselves, and we had the capability and capital and people to do extensive due diligence.”

Dimon said the bailout “pisses me off” and described the “favor” his company -- the country’s largest bank by assets -- did for the Fed as a “punishment.”

“I’m going to say we lost $5-10 billion related to Bear Stearns right now and yes I put it in the unfair category,” he said.

As the nation grapples with the bankruptcy of Detroit, many are again asking whether a bank, a company, or – for that matter – a city ought to be provided a safety cushion stuffed with tax dollars. And the resounding answer, according to fiscal hawks and banking industry leaders, is no.

Bailouts tend to out-price services at small community banks and bestow unfair privilege to corporate financial mega-firms that already enjoy the advantages of deep pockets and far reach, observed Terry Jorde, a former chairwoman of the trade group Independent Community Bankers of America, in a recent interview with International Business Times.

“We believe that businesses that are allowed to fail are important to the economy because if you take away the right to fail, you take away the right to succeed,” Jorde said. “In a free market, whether you’re a community bank or a large bank, you should be competing on the same merits of the services you provide and the free-market pricing.”

Already this year, 16 small banks around the country – mostly in Southern states such as Georgia, Florida and North Carolina – have failed, according to the Federal Deposit Insurance Corporation. Notably, the state in which the largest corporate banks are based, New York, did not appear on the list. “These [big] banks have a built-in subsidy,” Jorde said. “Because they’re too big to fail, because the government has already indicated that they cannot go under, they are able to attract funding through creditors and depositors because creditors know a bank of that size will not be allowed to go down.”

So when does a bank go from being merely big to being too big to fail? What is the criteria? There is no simple answer, which raises further questions.

In a speech in April, International Monetary Fund Chief Christine Lagarde said the “oversize banking model of too-big-to-fail is more dangerous than ever,” though her call to action was ambiguous, at best. "We must get to the root of the problem with comprehensive and clear regulation and more intensive and intrusive supervision," she told an audience at the Economic Club of New York.

The four-word buzz phrase “too big to fail” has become applicable to everything from cities to well-connected political leaders (see Illinois gubernatorial candidate Bill Daley), yet is itself a fairly recent concept, borne of the Fed’s last major bailout before the 2008 program, which came in 1984. By the time it collapsed that year, Chicago-based Continental Illinois National Bank and Trust was the nation's eighth-largest bank, but had been crippled after buying loans from a much smaller Midwestern firm, Penn Square Bank in Oklahoma, which had begun inflating itself in 1976 from a tiny state bank to one of the oil and gas industries' largest lenders on the backs of bad loans that constituted a Ponzi scheme. In the end, Continental got saddled with more than $1 billion of those shaky energy-company loans.

Prior to Penn Square's default, many analysts considered Continental's loan-buying programs an industry darling, leading to rapid growth that made the bank the nation's sixth-largest by 1981, just before the proverbial financial fecal matter hit the fan. "I give Continental credit for doing what they do best, and that is lending money," one analyst wrote in 1981. "They've been able to pick out certain niches. I'm continually amazed by their reception as energy lenders."

Penn Square failed a year later. And by then, Continental was in trouble.

But the Fed and the FDIC dubbed Continental "too big to fail," a phrase coined by Congressman Stewart McKinney in a 1984 Congressional hearing. So the FDIC injected the bank with $4.5 billion, prolonging its death. Since then, the horizons of what constitutes “too big to fail” have broadened – vastly.

“Continental was one big bank, but it was not really a threat to the system,” William J. Quirk, a law professor at the University of South Carolina, told International Business Times. “You didn’t have to put up that amount of money,” he said of the 2008 bailout.

And now, with much of Wall Street enjoying a taxpayer safety net, many want to advance the idea even further. Democratic Pennsylvania Congressman Chaka Fattah, a leader of the Congressional Urban Caucus, said Friday that the legislature should “analyze Detroit’s fiscal situation and intervene on the city’s behalf.”

“If the 2008 bailout of the biggest players in the financial sector – and policy-making over the ensuring years – tells us anything, it is that Congress and the Federal Reserve take care of Wall Street,” John Nichols, the co-author of “Dollarocracy: How the Money and Media Election Complex is Destroying America,” wrote in a recent op-ed. “America’s great cities? Not so much.”

So, should “too big to fail” be scrapped? Or expanded?

For the fiscal hawks in the Republican-controlled House of Representatives, the answer is clear: End it.

“Taxpayer-funded bailouts reward bad behavior,” Texas Rep. Jeb Hensarling, who chairs the Financial Services Committee, said in a recent statement post on his website. “Taxpayers should not be held responsible for the failure of big businesses any longer.”

Yet even as financial and political leaders call for eliminating “too big to fail,” a mechanism for doing so remains elusive. As evidence, look to the Financial Stability Board, a body which includes all of the Group of 20 major economies. In an April 2013 report, the organization found that it couldn’t impose losses on creditors and resolve banks without bailouts. “Few jurisdictions have equipped administrative authorities with the full set of powers to resolve banks,” the report noted.

“Ending too big to fail will require steadfast implementation by global regulators over the next few years of the work already in train,” Janet Yellen, the vice chair of the Fed and a leading contender to replace Chair Ben Bernanke. “Some have proposed ideas for more sweeping restructuring of the banking system to solve too big to fail … I am not persuaded that such blunt approaches would be the most efficient ways to address the too big to fail problem.”

So, for now, reform inches at a molasses-like pace through the international bodies, with more rhetoric than action. Should a massive bank begin to slip up, it’s unlikely any buyers would step in. But the bank’s far-reaching tendrils mean leaders must act fast, before other banks are infected. Political leaders will face the choice: Let a contagion topple a series of companies? Or bail out the source of the problem?

“To let one of the largest financial firms fail requires regulators to have confidence that they can close down the firm without damaging the economy, and as a nation we are not there yet,” Christy Romero, Troubled Asset Relief Program special inspector general, said in a quarterly report to Congress in April.

All of which means that for now, “too big to fail” is itself too big to fail.