Go Ahead, Put All Your Eggs in Our Basket

A simple homily illustrates the folly of letting Wall Street govern itself free of restraints so that a handful of financial firms could become indispensable to our nation’s economy: “don’t put all your eggs in one basket.”

One of the precursors of the financial meltdown was the combination of zero enforcement of the antitrust laws and the repeal of Depression-era safeguards against allowing banks to engage in speculation in the stock markets. That created a handful of financial institutions that were individually and collectively so interwoven with our economy that when the crash came last year, we were told that they had to be rescued or else their collapse would take down the entire system. These giant firms were so important that, we were told, they were just “too big to fail.”

As befitting any Washington institution, the concept has been accorded its own acronym: “TBTF.”

There’s a well-known philosophical dilemma here: if a firm’s executives, employees and investors realize that they are TBTF, then what’s to stop them from behaving recklessly, knowing that if they take a risk and succeed, they reap all the benefits, but if they fail, they get rescued? Answer: nothing. The economists call this by-product of TBTF “moral hazard.”

The financial crash illuminated the TBTF problem; the bailout has made it worse. The banks that have survived, thanks to the taxpayers' largesse, have used bailout money not to re-lubricate lending but rather to bolster their own resources and buy out other, not so lucky, banks. The result: even fewer firms in the marketplace, each of them bigger than ever before. I guess you could call them “TBTF times two.” Would that be TBTFTT, or maybe TBTF2?

So all our eggs were sitting in one basket last year when the Money Industry got tripped up by its own greed and the basket hit the deck along with all of our eggs, including many Americans’ nest eggs. We’ll be cleaning up that mess for years.

A paper (PDF) published in August by the Consumer Education Foundation and Essential Information looks at the downsides of the single basket strategy in more detail, and it’s worth a read because it highlights that the current calamity actually had its roots in decisions made decades ago.

The study, by Jane Arista, a research associate with the Political Economy Research Institute at the University of Massachusetts, points out that by the mid-1980s, “less than one percent of the total number of banks, securities firms and life insurers accounted for half of the total resources” of each of those sectors in the economy. The concept that a firm would be TBTF eventually obtained government support. In 1991, Congress authorized federal regulators to rescue banks and cover deposits - even if they were uninsured – if regulators decided that the banks’ collapse would imperil the economy.

It’s not just the increasing concentration of financial power in a smaller number of firms that has proven disastrous, Arista notes. She points out that Wall Street began putting most of our economic eggs in a single kind of asset: derivatives –  complex securities that, in retrospect, nobody really understood. This had a direct and deleterious impact on small businesses. After 2001, Arista explains, banks stopped lending to small businesses. Instead, banks started to offer loans to small businesspeople who agreed to use their homes as collateral. This was more profitable for banks because they could package home loans like those into derivatives and then sell them off to speculators, freeing up capital for the banks to make more such loans. Because home prices were inflated, this worked okay for a while. But once housing values dropped, so did the amount of money small businesses could borrow. “Many are now struggling to save both their businesses and their homes,” Arista observes.

Finally, Arista points out a new dimension of TBTF. The financial sector itself has grown to become a dangerously large proportion of America’s economy. That is, of all the industries that contribute to our economy, finance (banking, investing, speculation) accounted for 41% of the nation’s corporate profits at its height in this decade.

Instead of being the lubricant that keeps the economy going, the Money Industry came close to becoming the economy itself. As a result, the entire financial sector is so crucial to our nation that when it shoots itself in the foot, the rest of us bleed from the chest.

Like so many other aspects of the Meltdown, the solution to the TBTF problem is a matter of common sense: break up the firms so that none of them are TBTF. Even Alan Greenspan, the former chairman of the Federal Reserve who lovingly presided over the bubble, now says, “if they’re too big to fail, they’re too big.”

Restoring the Glass-Steagall Act – the 1933 law that kept banking and investment separate until it was repealed in 1999 – would require the big financial conglomerates to spin off parts of their operations. The idea has gained currency among many observers – even the former chairman of Citigroup!  But the current denizens of Wall Street do not support that form of competition and the idea that their firms might have to struggle to survive like everyone else is anathema. So for the moment at least, breaking up the TBTF is DOA in DC.