The Econosphere

I despise the phrase “too big to fail.”  There are people all over the world who are constantly looking for the thing that is going to end life on this earth.  Global warming, nuclear weapons, pesticides, rap music, you name it, there is someone out there who thinks that something or other is going to end life as we know it.  Well, I am one of those people and I hate to break it to the anti-nuke crowd, but far scarier than a dirty bomb are those four dreaded words, “too big to fail.”

They’re just four words (we can even shorten them to something cool looking like 2B2F).  Someone probably just said them off the top of his or her head one day.  So easy to say, but once they were said and once someone put some TARP muscle behind it, it changed everything.  Four words threaten the one thing that allows us to prosper, our meritocracy.

Really, this issue isn’t new.  We lived with this for years with Fannie Mae and Freddie Mac.  Fannie and Freddie were set free, sort of, by Congress to live as private firms.  The problem was that no one ever believed that they were really on their own.  Despite their functioning as private sector mortgage servicers, the markets believed that their debt was backed by the federal government.  This implied backing meant that their money was cheaper than any of their competitors’ money, which is really the key to understanding the problem at hand. 

In the world of finance, there are only two ways to make above-average profits.  The first way is to have smarter money; the second is to have cheaper money.  Very few people have smart money (and Lord knows that Freddie’s and Fannie’s money wasn’t all that bright), but you only need one of the two, and they had cheap money.  Cheap bottomless money meant that Freddie and Fannie could grab market share at will, and they did.  Not only was that not fair to the competition, but it was an accident waiting to happen as their portfolios got larger and riskier (riskier not only because of scope and hubris, but also at the prodding of policymakers).

I was actually at a meeting in Washington DC years ago when the Treasury came to address the group and brought TV cameras with them.  Representatives from Fannie were in attendance, and the Treasury (I think it was the Assistant Treasury Secretary) gave a very angry speech for the cameras admonishing Fannie and swearing that the U.S. would not back its debt. 

Well, no one believed him for one second, and history has proven the doubters correct.  When the sh*t hit the fan, the Treasury was on speed-dial and both Fannie and Freddie were taken back into the government fold.  Not only did Freddie’s and Fannie’s implied government backing unfairly steal business from honest competitors for years, but it encouraged the kind of risk taking, concentration of assets and distortion of incentives that helped lead us into recession.

Keep in mind, Freddie and Fannie were not made in a day.   These were serious entities that formed over the years and were the product of a good deal of legislation, monitoring and debate.  They were a train wreck, but they were a slow moving train wreck.  Flash forward to today; 2B2F has created a fast-track to Freddie and Fannie infamy.  With just the utterance of a phrase, “too big to fail,” we have created how many new Freddies and Fannies?  Who knows?  In an instance, Citi is now a GSE (government sponsored enterprise).  Bank of America is a GSE.  GMAC is a GSE.  GM is a GSE.  Is Exxon a GSE?  Is GE a GSE?  Is Kraft a GSE?  Are all the S&P500 companies now GSEs?
 
If something is too big to fail (and let me go on the record as stating that nothing is ever too big to fail), will its money be cheaper?  Who will they be working for, their shareholders or their government backers?  Do we break them up?   Well where does the government find the authority to take something owned by shareholders and destroy it?  What a mess…and all because of just a few uttered words.

And yes, I know that the Treasury has gone on the record saying that there is no such thing as too big to fail.  But why should we believe them?  No one at that meeting in DC years ago believed the Treasury was going to back away from Fannie, even as they broadcast their anger over the networks.  So, why would anyone believe them now?   The answer is that they won’t.

With just a few words, we’ve created 500 Freddie Macs.  The horror.

This all kind of reminds me of another phrase that just about brought our meritocracy to its knees: “highly confident.”  It was 1985, I believe, when Drexel Burnham Lambert sent out their first “highly confident” letter.  At the time, Drexel’s Michael Milken just about owned the junk bond market.  He created it, and he controlled it.  As a result, Drexel’s money was the cheapest on the street, and no one doubted their ability to raise money in support of any hostile takeover.  So unquestioned was their access to capital that at some point, they realized that they didn’t even have to raise any money at all; they would just send a letter to the quarry stating that they were “highly confident” that they could raise the money on behalf of their client to finance a takeover.  Just the receipt of that letter would force the prey into the arms of their pursuer.

I never thought I would ever see another phrase as powerful and destructive as “highly confident.”  Well, we have one right now that puts “highly confident” to shame.  “Too big to fail” is the new “highly confident” and the U.S. Treasury is the new Michael Milken.  They put Milken in jail and Drexel out of business.  But what are we going to do with 2B2F?  I don’t know.