the government now finds itself hip-deep in the direct management of the financial system, rescuing four of the country's biggest financial institutions -- Bear Stearns, Fannie Mae, Freddie Mac and now Lehman Brothers -- from the harsh discipline of markets and the consequences of their own misjudgments.
Let's step back a bit and think about what has been going on.
1. We had a liquidity bubble or a credit-spread bubble. By that, I mean that some financial institutions--hedge funds, investment banks, Fannie and Freddie--were able to pay a very low risk premium to investors. This meant that they could earn a profitable spread on risky investments.
2. However, credits spreads can move in two directions. When investors change their minds about the riskiness of, say, Fannie Mae, the cost of funds to Fannie goes up and the business becomes unprofitable all of a sudden. See my earlier illustration.
3. When one firm goes down, it threatens to take down other firms, because the financial sector is highly inter-connected.
4. When a really big firm gets in trouble, its sheer size makes it awkward to merge with other firms. In the case of Freddie and Fannie, change "awkward" to "impossible."
5. Government officials try bailouts for two defensible reasons. First, they believe that the firms' assets are more valuable than they will appear to be if they have to be sold quickly. Thus, the government may lose little or nothing if it arranges to hold those assets for a while. Second, the officials are hoping to avoid a domino effect in which the failure of shaky firms causes good firms to fall also.
6. However, government officials also have a "not on my watch" attitude. That means, it always makes sense to engage in short run behavior that props up the system, even if in the long run it makes the system more fragile. In the long run, it might be better to have Bryan as Treasury Secretary. In the short run, it is unthinkable.
7. The bailouts serve to demonstrate that there is a sort of de facto insurance for large financial firms that is analogous to the deposit insurance for banks. However, this insurance is ad hoc and unmanaged. With deposit insurance, there is an insurance fund, there are capital regulations, there is risk-based pricing, and there are routine procedures for monitoring and closing troubled banks. None of this is in place for the rest of the financial sector.
8. Above all, in the banking sector, you don't have any one institution that is too large to merge. The Freddie-Fannie duopoly is an entirely artificial creation, as I argued in my exit strategy paper for Cato. The reasons for the consolidation of investment banking are less clear. But if I were designing an insurance and regulatory structure for investment banking, one of the things I would want to encourage is a decrease in industry concentration.
9. Even with a less consolidated industry, there is still systemic risk. Remember the S&L's.
10. I don't see partisan politics coming up with a good solution. My guess is that financial reform has to start with a non-partisan commission of some sort.