Who Invented TBTF (Too Big to Fail)?

Aaron Brown

Most controversial issues have people on both sides, and we know more or less why they disagree. People who want more gun control think it will reduce violence and fear. People who don't want more gun control think it will lead to more crime and government disrespect for citizens. We can trace the history of the dispute and find people on both sides of the issue.

TBTF (too big to fail) is different. Everyone is against it. Everyone agrees that institutions insulated from failure behave recklessly, and that government supporting the big firms in an industry creates a tilted playing field that discourages innovation, independence, and human-scale institutions. It's expensive, threatening to bankrupt many governments. It's revolting to witness governments bailing out big banks - the ones with those extortionate overdraft fees and deceptive credit card charges - and rich people while raising taxes and cutting programs to pay for it. Private profits and socialized losses offends our sense of fairness as it robs our wallets.

So why are we stuck with this unloved idea? Most people have a vague sense that the banks grew big while regulators weren't paying attention, until one day we woke up and discovered some were so big that their failures threatened the economy. If anyone had any doubts about this, the disaster following the Lehman bankruptcy proved it, and Lehman was only the twelfth largest bank in the US. But if that's true, why haven't we broken up the large banks? The answer to that question is that TBTF has an entirely different history that you have to understand in order to see what the future is likely to bring.

The story begins in 1984 with the failure of Continental Illinois Bank. The seventh largest bank in the US at its peak, it had made many imprudent business loans, especially to oil and gas companies hurt when energy prices declined, and overpaid for some acquisitions (notably Penn Square Bank) that had made even worse loans. It had some other bad exposures to developing countries and it guessed wrong about interest rates. As a result, the government had to take it over. The good news is that CI didn't have a lot of insured deposits; it funded itself mostly by taking brokered deposits too large to be covered by FDIC insurance, and by issuing notes and bonds. Another bit of good news is that it had a pretty simple corporate structure and balance sheet.

There are two basic ways to resolve a failed bank. The simplest way is to shut it down, auction off the assets, and pay off the creditors in order of seniority. If there isn't enough to cover the insured deposits, the FDIC writes a check for the difference, and if necessary, raises the insurance premium on other banks to recoup the loss.

The downside of that approach is that you sacrifice the going concern value of the bank. In addition to the assets on the balance sheet, a bank has value due to its branch network and business relationships. Perhaps the assets would fetch $50 million less than the liabilities at auction, but another bank is willing to absorb that $50 million loss in order to acquire the intangible assets of the bank. Moreover, the failed bank's assets will always be worth more to a financial institution experienced at managing distressed loans than the assets will fetch at auction.

So the second way to resolve a failed bank is to find another bank willing to take it over, possibly with some cash thrown in by the government - but less cash than a liquidation would cost. Not only does that save the FDIC money, but it also means less turmoil among bank customers, counterparties, and employees. However, there is a downside to this as well: It takes longer and is more complicated than a liquidation, and the government has to support the failed bank while searching for an acquirer.

Traditionally the government would opt for a liquidation unless a willing acquirer could be found before the troubled bank failed. But twice before CI, the FDIC had supported a failed bank by guaranteeing all creditors - not just the insured depositors. That was a risk; if the bank had to be liquidated anyway, the government was on the hook for a larger loss. The potential reward was that the extra time bought by the guarantee would be enough for a win-win deal to be structured. In both of the first two instances, the gamble paid off.

For CI, the government decided to roll the dice for a third time. That decision has been criticized, and it may have been imprudent. It certainly didn't work out, and there were some other arguable missteps in the FDIC's handling of CI. In the end, it cost the federal government seven years and $1.1 billion to resolve CI. Very little of the going concern value was preserved. An immediate liquidation would have been costless to the FDIC, CI's assets would have easily covered the insured deposits, and after-the-fact estimates suggest there would have been six follow-on failures of small banks, at no cost to the FDIC.

Even as events were unfolding, people were criticizing the FDIC. Congressman Stewart McKinney charged that the FDIC had guaranteed uninsured deposits and bonds because it thought CI was "too big to fail." The term had been used before, but this is what made it a household term. The important point is that McKinney did not like TBTF; he was accusing the FDIC of something everyone agreed was wrong. The FDIC denied the charge and said that it was acting to minimize taxpayer losses.

In the heat of the moment, lots of people said lots of different things. One major confusion is that the Fed had also gotten involved in the situation, extending discount window loans and arranging loans from other banks to help nurse CI along. But as Paul Volker (the Fed chair at the time) emphasized, these things were done with the belief that CI was not insolvent, and both direct Fed loans and Fed brokered loans were well collateralized with high-quality, liquid assets. The Fed supported CI to protect the banking system, but it took no significant risk to do so. The FDIC took risk, but with the intention of protecting taxpayer funds, not to protect the banking system. And neither one thought CI's size was particularly important. (The previous FDIC guarantees of uninsured deposits were much smaller banks, and the Fed supports banks large and small alike, as long as it considers them solvent.)

[More from Minyanville.com: Cyprus: An Inconvenient Truth (or, How Not to Manage a Debt Crisis) ]

So no one thought CI was TBTF. No one advanced risky bailout funds in order to protect the banking system. No one wanted to allow TBTF. Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991 in order to prevent TBTF.

[More from Minyanville.com: The Banking System Is Both Too Big and Not Big Enough ]

But the 1991 Act had a more complex effect. During the seven years of wrangling, a prohibition on TBTF rescues got watered down into strict conditions on TBTF rescues. It worked to some extent. In the seven years between CI and the 1991 Act, most bank rescued uninsured depositors took losses in less than 20% of bank failures. From 1992 to 2000, that percentage jumped to 65%. It was not all the result of the Act; we had a major banking crisis in the second half of the 1980s and regulators were nervous about a total collapse, while the 1990s were a little calmer. It's important to note that the choices of which banks to bail out and which banks to liquidate were not based on size.

For some reason, however, the idea grew up so that TBTF was part of official US bank policy, even though nobody thought it was a good idea. Some of that might have been fanned by Fed involvement in the rescue of hedge fund Long-Term Capital Management in 1998. But the Fed only brought creditors together to forge a voluntary pact to protect each other, no government money was involved, and in the end, no losses were taken. It's true that the Fed was concerned that LTCM might be too interconnected to fail, but no one considered that an excuse for putting taxpayer money at risk.

Fast forward to March 2008. The Fed very reluctantly agreed to provide some non-recourse funding and guarantees to JPMorgan (JPM) to encourage it to purchase Bear Stearns because it was concerned about the potential effects on the financial markets of Bear's bankruptcy. While this is farther than the Fed had gone in the past, it was well short of a bailout, and it was based more on the confusion from the speed of Bear's decline and the complexity of its dealings than on a determination that large banks cannot fail. The FDIC is not involved. Then in September, Lehman is allowed to fail.

[More from Minyanville.com: Insider Trades: Carl Icahn Increases Stake in Herbalife, JPMorgan Director With 'London Whale' Connection Buys Company Stock ]

So in the entire history of the idea up to September 2008, there really is no TBTF. People accuse other people of it, and explain how bad the idea is, but no one supports it, and it is never policy. Creditors and uninsured depositors of some banks are bailed out sometimes, but not because the banks are big, or interconnected, or systemic.

After the failure of Lehman, of course, was the gigantic bailout package. But it wasn't for big banks; it was for hundreds of banks, large and small. And it wasn't aimed at protecting individual institutions, but at preventing a simultaneous systemic collapse. It was a terrible idea at the time. It was only passed on the second attempt by extraordinary political arm-twisting, and many of the proponents have since come to regret it, some bitterly. The chance of another bailout anytime soon is very slim.

So TBTF is a myth. It is the monster under the bed, the dragon on the edge of the map. We never had it, and we certainly do not have it now. The Fed will act aggressively to protect the financial system, but it will not bail out large banks, nor any banks that it believes to be insolvent. The other bank regulators will sometimes protect uninsured depositors and creditors, but because they think it will save money, not because the bank is big, or interconnected, or systemic. There's no shortage of real financial issues to worry about, and plenty of controversies with people on both sides. So don't spend time worrying about made-up issues about which everyone agrees.

Related Articles

  • 8 Things Never to Keep in Your Wallet
    Business
    Kiplinger.com

    8 Things Never to Keep in Your Wallet

    That overstuffed wallet of yours can’t be comfortable to sit on. It’s probably even too clunky to lug around in a purse, too. And with every new bank slip that bulges from the seams, your personal information is getting less and less safe. With just your name and Social Security number, identity thieves can open new credit accounts and make costly purchases in your name. If they can get their hands on (and doctor) a government-issued photo ID of yours, they can do even more damage, such as opening new bank accounts. These days, con artists are even profiting from tax-return fraud and health-care fraud, all with stolen IDs. We talked with consumer-protection advocates to identify the eight things

  • See Apple's huge new auditorium before it's buried forever
    Technology
    CNET

    See Apple's huge new auditorium before it's buried forever

    Apple's new futuristic, UFO-shaped home continues to rise out of the California dirt as we can see in the above video shot by drone pilot Matthew Roberts in 4K . Roberts has been posting periodic construction updates to YouTube for the past few years, and the latest shows some of the finishing touches going on the massive circular main building. Solar panel installation on the roof -- a key component to Apple's plan to generate as much of its own power as it can -- is nearly halfway done. Perhaps the most interesting thing in the flyover is the chance to see Apple's planned underground auditorium while it's still above ground. Future iPhones and other products will be revealed in the building.

  • Law and Order? Trump's Legal Problems Pile Up
    Politics
    The Fiscal Times

    Law and Order? Trump's Legal Problems Pile Up

    For all his claims that he would be a “law and order” president, it is becoming increasingly clear that Donald Trump and the organizations he runs -- from his multiple businesses to his family foundation -- appear to have a very difficult time obeying the law themselves. A revelation today from The Washington Post’s David Fahrenthold that the Donald J. Trump Foundation appears to have been soliciting donations in the state of New York without the required certification is only the most recent in a long and growing series of apparent violations of various laws. According to the report, the New York attorney general’s office has determined that the Trump Foundation never received the certification required of all charities that accept donations of more than $25,000 a year, which it regularly does.

  • Magician's DEAD is a crazy arcade game that's actually coming to the US
    Entertainment
    CNET

    Magician's DEAD is a crazy arcade game that's actually coming to the US

    Magician's DEAD isn't your ordinary beat 'em up arcade game. It's not about tapped combos or how fast you can rotate the joystick -- it's about how nimble you are with your own hands. And, unlike a lot of crazy new arcade games from Japan, it's actually playable in (some) US arcades. To play the game, you'll use a combination of a Wii Nunchuck-like controller and a Leap Motion motion-detecting sensor at the front of the cabinet. The controller is for movement, while the sensor is for combat. You use gestures to attack and pick up objects such as cars, shipping containers and statues to use as projectiles. You can see a demo of the game above. The more interesting uses of the motion sensor comes

  • Hiker's dramatic video of two snakes fighting reveals rare sight
    Science
    CNET

    Hiker's dramatic video of two snakes fighting reveals rare sight

    Most hikers would hightail it upon spotting two snakes fighting on a path. Arkansas hiker Dawn Kelly decided to record the snakes on her smartphone instead, creating the kind of video most of us would rather watch from a safe distance. The unusual thing about this snake battle royale, however, isn't that Kelly managed to record it unscathed, but that the two snakes, a copperhead and a cottonmouth, shouldn't have been fighting at all. According to Alabama Auburn University herpetologist David Steen, male snakes often fight in something called a "combat dance" over female snakes. But until now, no one has recorded evidence of two different species of male snakes fighting, according to the BBC.

  • The Dumbest Legislation Ever Passed by Congress Will Bite the US Back
    Politics
    The Fiscal Times

    The Dumbest Legislation Ever Passed by Congress Will Bite the US Back

    The fallout from the decision by members of Congress to override President Obama’s veto of a bill allowing US citizens to sue the government of Saudi Arabia for damages related to the 9/11 terror attacks is already becoming apparent, and Thursday, Senate Majority Leader Mitch McConnell responded with some really extraordinary chutzpah. The Kentucky Republican blamed President Obama for failing to show enough opposition to a bill that he literally vetoed. On Wednesday, though, the Senate voted 97-1 to override the veto, and the House followed up shortly thereafter with a 348-77 override vote.

  • Star Wars Death Star's famed feature was a complete accident
    Entertainment
    CNET

    Star Wars Death Star's famed feature was a complete accident

    Most of us make mistakes like scraping our car misjudging the Starbucks drive-thru. When Colin Cantwell makes a mistake, legends are born. Cantwell, 84, was a concept artist and spacecraft designer on the original "Star Wars" film, at the time called "The Star Wars." That's certainly not all he's done, but for some sci-fi fans, that alone would be enough. In a Reddit Ask Me Anything on Tuesday, Cantwell discussed his contributions to space and sci-fi history, including a certain Death Star trench that turned out to be a happy accident for the Rebel Alliance. "George Lucas gave me the project of designing a 'Death Star,'" Cantwell wrote on Reddit. "I didn't originally plan for the Death Star to

  • News
    Bloomberg Video

    Hillary Clinton Rising in Post-Debate Polls

    Sept. 30 -- John Heilemann and Donny Deutsch discuss the results of the latest polls in some battleground states on “With All Due Respect.”

  • The One Bachelor’s Degree That Pays More Than a MBA (for Now)
    Business
    Money

    The One Bachelor’s Degree That Pays More Than a MBA (for Now)

    You don’t necessarily need an MBA or a PhD to get a high-paying job, but the job outlook for this bachelor’s degree also shows why it’s a bad idea to pick a career based on cash alone. PayScale’s College Salary Report reveals the degrees whose recipients

  • Business
    U.S.News & World Report

    Warren Buffett Finally Speaks Out on Wells Fargo & Co Scandal (WFC)

    Berkshire Hathaway (ticker: BRK.A, BRK.B) kingpin Warren Buffett was keeping mum on the Wells Fargo & Co ( WFC) -- until now, given recent speculation on his opinion of the company. Going to the board implies I've gone around [Wells Fargo CEO John] Stumpf, the guy who is under fire," Buffett said to CNBC. Buffett, who is arguably the best investor of all time, holds 320 million shares of WFC stock, or more than 6 percent of the company.

  • Two Big Biotechs Flash Bearish Signals
    Business
    Investopedia

    Two Big Biotechs Flash Bearish Signals

    Biotech funds have rallied to multi-month highs, but bearish price action in sector giants Celgene Corp. (CELG) and Gilead Sciences Inc. (GILD) is raising red flags, warning the group’s 8-month recovery wave may be coming to an end. Specifically, SPDR S&P Biotech WTF (XBI) broke out above 2-month resistance at 65 in the middle of September and is now testing new support while iShares Nasdaq Biotechnology ETF (IBB) failed to break out, turning lower at a corresponding range resistance level. Celgene topped out in the upper-30s in 2008 and sold off to a 3-year low in the high teens at the end of the bear market in 2009. The July high and August low have defined a trading range that’s contained price action for the last year.

  • Wynn Shares Fall on Macau Management Reshuffle
    Business
    The Street

    Wynn Shares Fall on Macau Management Reshuffle

    A management reshuffle caused shares of Wynn Resorts ( WYNN) to tumble in Friday's session. The casino operator, a member of Real Money's Vice Squad watch list, replaced the president of Wynn's critical Macau businesses, Gamal Abdelaziz, with the resorts' President Ian Coughlan. As Real Money reported, Wynn and fellow Vice Squad member Las Vegas Sands ( LVS) bring in more than half of their earnings from Macau. The region is starting to show signs of accelerating.

  • Southwest Airlines flight attendants get (at least) one big break in new tentative agreement
    Business
    Chicago Business Journal

    Southwest Airlines flight attendants get (at least) one big break in new tentative agreement

    With just hours to go before a new tentative agreement between Southwest Airlines flight attendants and management is set to be widely distributed to some 14,500 rank-and-file FAs, some details of the new deal have begun to surface. Sources who have knowledge of the new tentative agreement predicted it may not necessarily be received with widespread applause by some of the thousands of FAs who resoundingly voted down a previous tentative agreement in the summer of 2015. But sources also are reporting that the new proposal does include some improvements, including no increase in the length of the duty day that was spelled out in the previous TA. That lengthened duty day in the previous TA irked

  • Wealth of people in their 30s has 'halved in a decade'
    News
    BBC News

    Wealth of people in their 30s has 'halved in a decade'

    Today's 30-something generation has missed out on house price increases and better pensions, according to research by the Institute for Fiscal Studies. The think tank found that people born in the early 1980s were the first post-war group not to have higher incomes in early adulthood than those born in the preceding decade. This generation's comparatively lower financial wealth was down to a combination of lower home-ownership rates, less access to final salary-type pension schemes, and stagnant wages, experts said. The IFS included in its definition of "wealth" property owned, financial assets like savings, and wealth held in private pensions - minus any debts a person may have such as student loans or credit cards.

  • Jack Bogle Sounds Off: 10 Provocative New Pronouncements from the Legendary Founder of Vanguard
    Business
    Money

    Jack Bogle Sounds Off: 10 Provocative New Pronouncements from the Legendary Founder of Vanguard

    Listening to Vanguard founder Jack Bogle speak is one of the highlights of the annual gathering of the Bogleheads investor community, dedicated to Bogle’s principles of simple, low-cost investing. Here are highlights of his comments on 10 topics of interest to individual investors. “Exchange-traded funds are fine just so long as you don’t trade them,” Bogle said.

  • Six of the last seven times this happened, stocks rose
    Business
    CNBC.com

    Six of the last seven times this happened, stocks rose

    After three winning quarters for the market, what will the fourth bring? If history repeats, stocks could be in for a sweet end to the year. In the last seven years in which the S&P 500 rose in each of the first three quarters, only in one of them — 2007 — did the index drop in the fourth. Actually, when one looks at the entire performance history of the S&P 500 going back to 1928 (which is available despite the fact that the index was technically created in 1957) one finds that out of the 19 years in which the market rose in the first, second and third quarters, a negative fourth quarter only followed five times. In these 19 years, the S&P's median performance was a 4.1 percent gain, according

  • This woman is behind Salesforce's global expansion
    Business
    CNBC

    This woman is behind Salesforce's global expansion

    Elizabeth Pinkham can point to the moment when her job at Salesforce.com (CRM) took its latest dramatic turn. As one of the software company's top 12 leaders and possessor of by far the longest title — executive vice president, global real estate, global strategic events, Dreamforce and executive briefing centers — Pinkham is a trusted confidant of CEO Marc Benioff. At last year's Dreamforce, the company's annual mega-gala for cloud businesses and app developers, Benioff and Pinkham were looking over the event's expansive presence in downtown San Francisco.

  • Entertainment
    Bloomberg Video

    Trump Surrogate McCaughey: Machado Controversy an Ambush

    Sept. 30 -- Former Lieutenant Governor of New York Betsy McCaughey, a Donald Trump supporter, discusses the Republican nominees’ Miss Universe controversy on “With All Due Respect.”

  • The man who called Deutsche’s decline has some gloomy predictions on what’ll happen next
    DBK.DE
    CNBC

    The man who called Deutsche’s decline has some gloomy predictions on what’ll happen next

    The strategist who predicted the capital concerns now enveloping Deutsche Bank (XETRA: DBK-DE) has told CNBC what could happen next in a saga that has seen the bank's share price fall by over 50 percent this year. In late 2013, Paul Gambles, a managing partner at advisory firm MBMG International, said that Deutsche Bank was over-leveraged and believed Germany's banking system was one of the worst in the world. These fears reached the wider investment community this year who think Deutsche Bank'll need to raise capital after the U.S. Justice Department (DOJ) suggested it pay $14 billion to settle a number of investigations related to mortgage securities.

  • Technology
    Investopedia

    Cisco Scores a Major Internet of Things Win

    When CEO Chuck Robbins took the helm at Cisco (NASDAQ: CSCO) about a year and a half ago, he made it clear that the company's future under his watch would be less about old-school routers and switches, and a great deal more about burgeoning markets including the cloud and Internet of Things (IoT). In addition to acquiring cloud service provider CloudLock last quarter, Cisco is also making headway in its IoT efforts, as evidenced by its recent announcement it has struck a deal with Netherlands-based telecom giant Vimpelcom (NASDAQ: VIP). Vimpelcom intends to utilize Cisco's Jasper IoT control center to "implement, manage, and monetize M2M/IoT services, such as fleet management and smart metering, through seamless device connectivity." Vimpelcom boasts over 200 million customers across its global network, and by incorporating Cisco's scalable Jasper as the hub of its "machine-to-machine [M2M], IoT platform," it will have the capability to expand its revenue-enhancing capabilities as it continues to grow its customer base.

  • U.S. to OPEC: Don’t Drill, Baby, Don’t Drill
    Business
    Foreign Policy Magazine

    U.S. to OPEC: Don’t Drill, Baby, Don’t Drill

    OPEC, the dysfunctional cartel that has gifted case studies in the “prisoner’s dilemma” to business schools for years, unveiled an agreement to potentially cap oil production this year in what amounts to a last-ditch effort to shore up the price of crude after a costly two-year nosedive. If implemented — and all the details must still be worked out — such a cap on production could nudge crude prices higher. Since the OPEC oil embargo and gas lines of the early 1970s, the United States has tried to convince Saudi Arabia, Venezuela, Russia, and other big producers to keep the taps open so that oil remains abundant and affordable.

  • 'I interviewed over 100 people at Goldman Sachs, and this was the biggest mistake job candidates made'
    GS
    Business Insider

    'I interviewed over 100 people at Goldman Sachs, and this was the biggest mistake job candidates made'

    Before cofounding Solemates, a brand of women’s shoe-care products, in 2009, Becca Brown worked at Goldman Sachs for almost six years. Brown, who has a bachelor’s from Harvard University and an MBA from Columbia, spent a lot of time interviewing job candidates at Goldman, where she held various roles, including analyst, wealth adviser, and chief of staff. “I interviewed anywhere from 20 to 30 job candidates a year.

  • In Lawsuit, More Young Women Accuse Trump of Being a Sexist Pig
    Sports
    The Fiscal Times

    In Lawsuit, More Young Women Accuse Trump of Being a Sexist Pig

    Donald Trump’s tactically dubious decision to continue his attacks on a former Miss Universe over her weight gain following a disastrous performance in the first presidential debate have caused the question of his treatment of women to flare up yet again. The latest flare-up apparently prompted the Los Angeles Times to go digging through depositions filed as part of a class action lawsuit against a Trump golf club in California in 2012, where reporters unearthed multiple examples of former Trump employees testifying that Trump had, both personally and through the atmosphere he created at his property, engaged in extremely sexist behavior toward women, some of them quite young, who worked for him. The lawsuit, Messerschmidt v. Trump National Golf Club, was not actually about sexual discrimination or mistreatment, but about work hours.

  • Traders are betting big against this biotech stock
    Business
    CNBC.com

    Traders are betting big against this biotech stock

    Biotech stocks have been taking a beating, and traders see especially bad things ahead for one company. Questions about rising drug prices have hammered many pharmaceutical companies, with the rising price of Mylan's EpiPen putting that company in the crosshairs recently. That appears to have led to tough questions about the entire sector, according to Mike Khouw of Optimize Advisors. "Unlike Mylan, Teva Pharmaceutical doesn't have that specific sort of EpiPen controversy, but it's really the whole space.

  • Closing in on Retirement? Read These Tips
    Business
    Investopedia

    Closing in on Retirement? Read These Tips

    Many of the people who engage the services of a financial planner tend to do so as retirement approaches. This is natural; retirement is big step. From my experience in working with this type of client over the years here is a financial planning to-do list if you are within 10 years of retirement. Sock Away as Much as Possible For many retirement savers these are the highest income years of their careers. This is the time to contribute the maximum amounts possible to your employer’s retirement plan, IRA accounts, and the like. While these contributions will not have the years to compound as those made in your 20s and 30s, every bit helps. (For more, see: Financial Planning: It's About More than