There is a theory in finance and economics called the “Big Bank Theory” which asserts that governments — through the Central Bank or the Federal Reserve (in the case of the US) — will not allow a “big bank” to collapse because the economic impact of such occurrence will surely be great.
That was exactly the rationale behind last week’s bailout of the American International Group (AIG) by the US Federal Reserve (Fed).
Says the Fed: A disorderly failure of American International Group could hurt the already delicate financial markets and the economy. It could also lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.
US President George Bush agrees: The risk of not acting would be far higher.
AIG’s bailout was obviously consistent with this “Big Bank Theory” because the US government is afraid the collapse of AIG would cause an economic catastrophe that can affect not just the local economy but perhaps the global markets as well.
Why not Lehman Brothers?
But why was AIG bailed out and Lehman Brothers was not?
To put it simply, it’s all about the impact on financial markets. As the largest insurance company in the world, AIG insures millions not just of individuals but of institutions as well.
It is also the insurer of million dollars worth of securities issued by institutional lenders and borrowers. The collapse of AIG would surely bring down these companies too.
Humorously put by Stephen Colbert of The Colbert Report, the AIG bailout was proof that you can be saved by the government as long as “you suck big time to the point of endangering the whole world.”
Not “big” enough?
That’s not to say that Lehman Brothers is not “that big.” It is big, as seen in its billions of dollars of assets and hundreds of thousands of clients and investors.
But the people behind Federal Reserve had most probably conducted assessments already which show that the collapse of Lehman won’t bring much chaos to the markets as opposed to the collapse of AIG or Bear Stearns or Fannie Mae or Freddie Mac.
Besides, Lehman’s financial troubles have been plaguing the company for more than a year prior to bankruptcy filing.
In August 2007, it closed one of its subprime lenders and recorded a one-time after-tax charge of $25 million. Further subprime-related problems, particularly the writedowns of its subprime mortgage securities, continued in 2008 with the company reporting a $2.8 billion loss during the second quarter. From January to June 2008 alone, the company’s stock lost more than 75% in value. In short, investors had an idea what was going on in the company.
The Fed decided not to help these investors, probably because it thought Lehman’s investors could have saved themselves by managing investment risks in a company already suffering from poor financial health.
An “extraordinary event”
In the case of AIG, however, the emergence of its financial woes was sudden, triggered by the downfall of Lehman Brothers. As an aftermath of that collapse, writedowns in mortgage-related securities continued in other financial service firms, AIG included.
This paved the way for credit rating agencies such as Moody’s and Standard & Poor’s to warn that AIG’s credit rating may be soon downgraded. This announcement further caused AIG’s stock price to plummet. The Fed then stepped in to try to calm a market spooked by the Lehman Brothers bankruptcy. The Fed decided to provide AIG with a $85 billion credit-liquidity facility, and the move temporarily calmed financial markets.
The Freakonomics blog also argued that the Fed’s decision not to bail out Lehman was hinged on the fact that the Fed did not want to appear like it does not “walk the talk.”
According to the blog, when the Fed bailed out similarly-bankrupt investment firm Bear Stearns in March 2008, it defended its action by claiming the bailout was an “extraordinary event.” Saving another troubled financial firm after the Bear Stearns incident would mean that the Federal Reserve would not keep its word and lie:
Against this backdrop, if the government had rescued Lehman, it would have repudiated the claim that the Bear rescue was extraordinary… Essentially, the Fed and the Treasury would have been admitting that they had lied.
When will bailouts end?
But this is now beside the point, because the Bush administration recently proposed that the US Congress approve a bill authorizing the government to buy up to $700 billion in distressed mortgage-related assets from problem-ridden financial firms.
That much from taxpayers’ money to be used to protect corporate interest? Not theirs alone, Mr. Bush argues, but the interest of the average American who will be greatly affected should these troubled private firms collapse.
In the words of Bush himself: “The government needed to send a clear signal that we understood the instability could ripple throughout and affect the working people and the average family, and we weren’t going to let that happen.”
If that is not an application of the “Big Bank Theory,” then I don’t know what it is. I wonder how many banks and financial institutions would continue to use this as reason to get help and bailouts from their governments.
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