Too Big to Fail


(B) Are Fannie Mae, Freddie Mac, AIG, General Motors, California, the US Federal Government or the G-7 nations Too Big to Fail (TBTF)? Oops, it looks like the list of the TBTFs is getting longer and longer, every month now. Let’s start analyzing it by distinguishing three types of TBTFs: the financial institutions, the manufacturing and services industries, and the states and governments.

The Too Big to Fail in Finance

We have learned again during the credit crisis of 2008 that money must be safe in a bank account and that banks must lend to consumers and businesses. If not, the economy is quickly stopping.

The government authorities must intervene in the case of severe disruptions of the financial markets. That was what the Federal Reserve did with the collapse of Bear Stearn in March 2008 by providing a $29 Billion credit line to JP Morgan to acquire Bearn Sterns. And, that was what the Treasury Department should have done with the collapse of Lehman Brothers in September 2008. Lehman Brothers was a major issuer of commercial papers and its failure started a panic in the money market funds that spread to the worldwide stock markets selling of September and October 2008. It is now clear that Lehman Brothers should have been rescued by the US Treasury.

The breakdown of Lehman Brothers pushed as well the Credit Default Swaps (CDSs) to the roof and American International Group (AIG) did not have enough liquidity to cover its large short position in CDSs. The entire breakdown of AIG would have caused it to default on all of its insurance claims and would have disturbed the operations of many worldwide businesses. AIG was rightly a TBTF and the Federal Reserve provided to AIG an $85 Billion bridge loan in order to attempt to continue its business as usual.

It was certainly the right thing also for the Federal Reserve to push Bank of America to acquire Merrill Lynch (and so Federal Reserve Chairman Ben Bernanke probably did not deserve such harassments from Lawmakers this week – see Bernanke Statement to House Panel in the New York Times video).

At the heart of the credit crisis was Fannie Mae and Freddy Mac. According to former Federal Reserve Chairman Alain Greenspan, many times interviewed by Maria Bartiromo on CNBC, “Fannie Mae and Freddy Mac was an economic fraud which socializes the losses and privatizes the gains and an accident waiting to happen”. Well, the accident occurred on September 2008 when the Treasury Secretary Paulson nationalized both institutions responsible together for half of the country’s $12 Trillion in mortgages at a cost between $200 and $300 Billion.

The credit crisis of 2009 proved that the collapse of even not Too Big to Fail financial firms such as Bearn Stearns and Lehman Brothers can spread like a virus and disrupt rapidly the system because of the intertwined financial markets that are linked like dominos.

So the present proposal of Treasury Secretary Geithner to create an agency, which probably is the Federal Reserve, to monitor and prevent any systemic risk to the financial system such as the one during the 2008 credit crisis is a prime necessity for the financial system to function normally.

The Too Big to Fail in the Manufacturing and Service Industries

Although Government authorities need if needed to intervene in the financial markets, history seems to suggest that this might not be the best way to maintain and create wealth in the manufacturing and service industries. Businesses are complex entities made of capital, people, markets, products, and technologies. Business regulations for the TBTF is a challenging art that worldwide governments do not seem to master.

Lawyers always find a workaround around regulations from Lawmakers. AT&T, for instance, was broken up in 1974 by the US Department of Justice into seven RBOCs (Regional Bell Operating Companies). But what do we have now in 2009 as telecom service providers? Mainly two players: AT&T and Verizon.

Markets and technologies are moving faster than regulations: The European Community wants that Microsoft does not launch Internet Explorer (IE) with Windows 7. But how many Windows PC owners have downloaded and are using open source Firefox? And, what about Apple and Safari?

And, too many regulations push for many more regulations. The European Community in Bruxelles is bringing layers and layers of regulations and making it difficult as a result for both North America and Asia to do business in Europe. The United-States wants to do business with China. And, China wants to do business with Africa. But outside Europe, businesses are reluctant to invest in continental Europe because of its huge level of regulations.

I think that the debate of “who is too big to fail” and “should taxpayer money should be used or not in bails-out” are leaving us going in the wrong directions. First, taxpayers money should certainly not be used in bailing-out the private sector. There are much better and more needed use of taxpayer money for social programs, health care, education, the nation’s infrastructure and fighting global warming…to name just a few. I think that the right debates about TBTF in the manufacturing and service industries should be focused around:

 Why such entity can grow so big while still being so unhealthy?
 How established monopolies of players in matured markets can be challenged by smaller players?
 And more importantly, how resources and labors from dinosaurs in declining industries can quickly and efficiently be allocated to new industries and new players?

Let’s try to answer those questions:

Why such entity can grow so big while still being so unhealthy?
General Motors (and Chrysler) should have gone to bankruptcy without the $50.7 Billion cash infusion received from the Troubled Asset Relief Program (TARP). The lack of competitiveness of both GM and Chrysler was already very much into the deep fabric of both companies. And, the credit crisis of 2008 has just accelerated quickly their collapses. According to Maryann Keller, probably one of the best automobile industry analysts, interviewed on CNBC on June 1st, GM and Chrysler should exit bankruptcy with everything that they need to be competitive again except the legacy of their culture, something that the TARP money cannot change.

The GM and Chrysler case studies make the point that government intervention to fund them is not helping in solving the root cause of their challenges. Warren Buffet did not invest in GM but he invested into an unknown Chinese electric car company named BYD (but Mr. Buffet invested during the credit crisis into GE and Goldman Sachs).

How established monopolies of players in existing markets can be challenged by smaller players?
It seems to me that venture capital funds are always allocated to new start-ups creating new markets and not very often to new start-ups creating disruptive products for existing markets. It is unfortunate that over the years in any mature markets, they are only three or four players that are regulated by anti-trust laws. Why don’t we have any new major car manufacturer or any new PC manufacturer leader?

How resources and labors from dinosaurs in declining industries can quickly and efficiently be allocated to new industries and new players?
Ideally, what we need is for assembly workers, technicians and engineers from Detroit to become the valuable resources for the new generation of GMs such as Tesla Motors, Aptera and many others Green Tech car start-ups here in California. Start-ups that we desperately need to build the new generation of clean transportation vehicles.

To protect employment, European governments make that mistake over and over to keep declining TBTF players and declining industries instead of focusing their energies on the new players and the new industries. It should not a big deal for someone to lose a job. But it is a big deal not to be able to find one.

The Too Big to Fail in States and Governments

More alarming is the TBTF of states and governments.

California who has the 7th largest GDP in the world has a $24.3 Billion budget deficit. And according to California State Controller John Chiang, California will not have enough cash to pay its bills if there is no new budget agreement by late July.

California has been at the forefront of the housing bubble and is now deeply affected by the credit crisis. But California is not the only US state trapped in a budget crisis. For political or economic reasons, Ohio, Indiana, Illinois, and Pennsylvania are also struggling to find solutions to their budget gaps.

As of June 28, 2009, the current US Federal Government debt is:

(or $11.3 Trillion). According to the IMF, the fiscal balance and public debt projections for the US in 2009 are 81.2% of its GDP.

That puts the US in the third spot after Japan, in the first place, which debt is 217% of its GDP and Italy, second, with its debt of 109.4% of its GDP; while Germany is fourth with its debt of 76.1% of its GDP and France, fifth, with its debt of 72.3% of its GDP.

What makes the problem worse for the US is first that the present recovery might not be strong enough to pay back enough of that debt quickly and second that spending is likely to increase to support an aging population. As we all know, there are more people leaving the workforce than people entering it and people are living longer. This is not, however, a problem specific to the US but also largely spread in Japan and in Europe.

So much US debt will have two consequences for the US economy.

This debt is generating pressure on the value of the dollar which will likely be lower again moving forward.

And, it is unlikely that China and the oil exporting countries will finance as much of that debt as they did earlier in this decade. Therefore to have candidates writing checks to the US government to finance its debt, interest rates on that debt will have to be attractive. That will contribute to the risk of inflation that is already pretty high considering the amount of money supply that has been produced during the credit crisis by the US Treasury to provide enough liquidity to the financial markets to function.

But much more disturbing than a weak dollar and the risk of inflation, as rightly noted by Mr. Bill Gross from PIMCO in his June Investment Outlook:

“While policymakers, including President Obama and Treasury Secretary Geithner, assure voters and financial markets alike that such a path is unsustainable and that a return to fiscal conservatism is just around the recovery’s corner, it is hard to comprehend exactly how that more balanced rabbit can be pulled out of Washington’s hat.”

In a few years, the US debt could reach 100% or more of its GDP as it is today the case for the Japanese and the Italian governments, and at that stage, the US will reach a “Point of Non-Return” according to Mr. Gross to be sustainable for the capital markets.

In over nine years, the US has moved from a budget surplus of $559 Billion under President Clinton to a budget deficit of $11.3 Trillion under President Obama.

Between President Clinton and President Obama, the US has known two economic recessions, the first one due to the technology bubble and the second one due to the credit bubble. And the US had to finance increased health costs and a meaningless and frenetic war, like any other war!

Over the next few years, the US and the other developed countries need urgently to find the courage and the discipline to reduce and balance their debts. No country wants to be in the same case as Brazil, Argentina and Mexico were during the Latin America debt crisis of the 1980s.

And, no country is Too Small To Fail (TSTF).

But in the meantime, the story about banks, businesses, states, and governments – Too Big To Fail (TBTF) – is certainly not yet finished!

Note 1: The economist in its June 11th edition has as well an interesting article about government debts: “the big debts”.

Note 2: The G-7 nations are: Britain, Canada, France, Germany, Italy, Japan, and the US.

Note 3: The picture above is the Trans America Tower in San Francisco.

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Categories: Economy, Financial Markets