Too Big to Fail – Explained

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The phrase too big to fail did not exist in the world of finance before the 2008 financial crisis. The fact of the matter was that companies and institutions were thought of as being independent and their finances were seen as limited and restricted enough not to overflow its own accounting boundaries. The word first got some traction when the Long Term Capital Management (LTCM) crisis took place in 1999. The company was set up by John Meriwether and included Nobel Laureates Myron Sholes and Robert Merton and their models to determine prices of derivatives. The hubris that existed in the company allowed it to have large positions on minuscule spreads and earn profits from it. However, when the market finally turned for the worst and Russia defaulted on its sovereign debt, the company saw huge losses in its value and had to be rescued.

In a capitalist structure, bailouts and rescue funds sound like the anti-thesis of the whole idea. You come into the market, provide goods or services. Either you succeed or fail. If you succeed, you earn huge profits. If you fail, you go bust and leave the market. LTCM should have been allowed to fail in the normal sense of capitalism. However, this did not happen. The reason is because it had built a domino like structure in the whole system. LTCM was connected to different institutions and was dealing with the whole financial system in one way or the other. Imagine a system where one person has borrowed money from 20 different people. It would be in the interest of those 20 people to get their money back in one form or another.

The process is further complicated by the fact that each of the 20 people have further borrowed from more people who they are answerable to. So in some sense, everyone is exposed to the risk of that one person defaulting. How is this structure different from any other loan system? For example if a company had loaned from 20 banks, its default should have the same effect. In this case, not quite. When a bank loans out money, it sees the quality of the collateral given to it and then loans out the money. Financial instruments are not used in these situations whose values are not volatile.

The collateral used by these institutions, however, can include anything like options or derivatives whose values are nothing by themselves but are based on another asset. In the LTCM, the value was based on the Russian debt for example. When the government defaulted, the assets became worthless and the people holding it as collateral were left with nothing on hand and in their books. Not only had LTCM made a loss but so had many of the other companies who were involved with it one way or the other. Seeing the contagion or domino effect created, the US government had to step in to save the company. LTCM was too big to fail and it had to be saved. The necessary fund was collected from the other institutions and the company was saved.

In 2008, same thing was witnessed but this time it was LTCM on steroids. The new financial system and alchemy had caused a much more vast impact on the institutions and the concept of too big to fail increased from one institution to many. This time the products created were made of Collateralised Mortgage Obligations and Credit Default Swaps written on them. Sounds confusing? It is. Consider that a bank loans money to General Electric. Now it has that debt on its books which means that funds have been locked.

Alongside this, it also makes 1000 mortgages to different home owners. Now in order to get these finances back, the bank goes to a group of investors and combines all the mortgagees into one paying them a fixed income that the mortgage payers pay the bank and sells off the mortgages as a CMO to them. Similarly, it also finds investors who want to buy parts of the debt obligations it has on its books. Investors keep getting a fixed return and the bank uses the finances given by the people in its daily operations. This is one transaction and it involves a leverage of nearly one to one. Now the bank is not happy with the small margins it makes so it speeds up the process by first making a lot of mortgage loans. This was encouraged by the government so the bank was just doing what its duty was.

These mortgages were then packaged as CMOs and sold to investors looking to invest in the mortgage market. This was how different institutions were exposed to this risk. The structure that was constructed involved different investment banks who were exposed to the risk that the mortgages could default and they would have to pay the money in the end. The volume of loans being made and being packaged allowed the rating agencies to distort the system and give them higher rating than they should have been awarded for fees and more business. So investment banks were creating a house of cards based on mortgages. Now let’s consider the debt side.

GE had loaned money and the bank was able to sell it off to investors XYZ by giving them part of the debt and giving them a fixed return. Seeing this, Morgan Stanley buys different debt from GE, IBM and other corporations and then creates another product from it called the CDO squared which is a part of a debt further divided into another part of a debt. Now the analogy of house of cards starts looking more appropriate.

Lastly, the CDS which means that an institution buys the debt from another institution but they want to hedge their risk. They feel that GE is not as stable as it seems to be so it buys an insurance policy. They pay a premium into the loan and then if GE fails to make a payment or defaults, the company that insures it has to pay out a large amount to the institution that took out the CDS. This is where AIG gets involved. AIG looked at the debts and the assets and as they had been given high rating by the rating agencies, wrote insurance policies on these debts. Everyone was making money so why change the system or be the whistleblower?

And then the collateral lost its value. The houses that were being bought to be turned over on a profit started losing their value. The homeowners who had bought the houses starting defaulting and the CMOs starting losing their value. The institutions started defaulting and so people were left holding nothing on their books. And oh yes, AIG had to make the huge payouts it has promised. And this is how AIG, Goldman Sachs and others became too big to fail as they had become quintessential to the whole system. This is how these institutions became too big to fail and they could not be allowed to just dissolve as everyone depended on each other. Roll out the $700billion TARP (Toxic Asset Repurchase Program) to buy off the assets that had lost most of their value and save the institutions.

Too big to fail seems to be a new concept but an inevitable and blatant one. It is not the fact that these organisations make them happen in a certain way. It is a truth that has to exist in order for these organisations to be allowed to compete in the financial markets. It is the abuse and exploitation that takes place perpetrated by every stake holder involved which seems to make them sound preposterous. It seems like the government and regulators sit on the side allowing the malpractices to happen.

When the organisations are asked to curb or haul in their ambitions, it is called anti-capitalistic and new methods are found to keep as much of the profits inside the company as possible. The term of too big to fail seems like just another way to keep out the government in another fashion. What it says is that if we make profits, that’s based on our own ingenuity and gusto. On the other hand, if we fail, we can bring the whole system down so it gives us a rationale to hold everyone hostage. Lessons should be learned by now or soon enough the phrase “too essential to cease” would be part of our vocabulary.

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