TOO INTERCONNECTED TO FAIL 9/12/2008

Federal bailouts, too big to fail, Bear Sterns, Fannie Mae, Freddie Mac, Lehman Brothers, General Motors, Ford, Chrysler… there’s so much in the financial press and national news regarding all of these that we’ve got to step back and consider what is really happening here and what could be at stake. So today, we’re going to discuss the ‘federal bailout’ and ‘too big to fail’ concepts and try to set some things straight.

The federal government, through the Federal Reserve and the U.S. Treasury, strives to maintain the stability of the US dollar and enough economic growth to fuel positive labor, real estate, and financial markets. Sometimes they get it right, and some times they get it wrong. When Chrysler sought federal guarantees for desperately needed loans in the 1980’s, the government bowed to the pressure, because losing Chrysler as a US employer and automobile manufacturer would have had tremendous rippling effects throughout the entire economy, and it just could not be risked. Chrysler wasn’t deemed ‘too big to fail’, but it was obviously too interconnected to be allowed to fail, and that’s the issue surrounding ‘federal bailouts’ today.

In a free market economy, there is no such thing as being too big to fail, but there is such a thing as being too interconnected with other vital aspects of our economy to be allowed to fail. Bear Sterns, Fannie Mae and Freddie Mac are prime examples of this. Bear Sterns corporate heft, in a global economy that includes more multinational conglomerates – behemoths - than we could even begin to list, wasn’t all that meaningful. However, what Bear Sterns represented to the US and global credit markets at the moment the Federal Reserve and Treasury agreed to back up its assets and finance JP Morgan’s acquisition, was tremendous. So a bailout, of sorts, took place and relative calm ensued.

Relative calm, as compared to what could have happened otherwise. Had the government done nothing the overall cost to the economy would have been horrendous, far outweighing the cost the taxpayers might actually come to bear due to the federal intervention.

Some have decried taxpayer resources being at risk when millions of dollars of market value was realized by Bear Sterns shareholders as JP Morgan acquired the company. Why didn’t those shareholders have to lose? They did. While they may have retained hundreds of millions in share value, they had already lost billions and at the end of the day, JP Morgan purchased a sagging company with questionable assets and will go on to pay hundreds of millions of dollars in corporate taxes each year. Ultimately, it wasn’t a bad trade off. Just like the government securing loans for Chrysler in the 1980’s – it wasn’t a bad trade off for the US economy, and after all, the economy is simply an amalgamation of taxpayers - all of us.

In the case of Freddie Mac and Fannie Mae, a similar decision had to be made. What would be the overall cost to the economy if these two primary real estate lending resources simply couldn’t lend more money for residential home purchases? We don’t even want to think about it; we likely couldn’t even comprehend the ultimate answer. So, once again, the government marshaled resources, and this time, took control rather than securing loans or arranging financing. Fannie Mae and Freddie Mac shareholders lost unspeakable value in the weeks and months leading up to this intervention and will only regain that value if these corporations can return to profitable, well capitalized operations in the future. The federal government now has more of a measurable equity stake, and as profitable operations return, it is possible that this whole endeavor will actually net a profit to the U.S. taxpayer, but don’t hold your breath or wait for your dividend checks. We’re talking about the government here.

Even if the taxpayers were to end up sinking billions into Fannie Mae and Freddie Mac, it would be worth every cent. Making sure that these organizations have sufficient capital to loan into the housing market was necessary to create a bottom in the real estate and credit markets. In the end, many more billions will likely be saved as people with good credit can once again purchase homes with stable values, and millions of homeowners may be saved from the financial disaster that has beset millions more beforehand. Fannie and Freddie weren’t too big to fail; they were simply too important to every one of us to be allowed to fail, and our government did what governments need to do - maintain a stable currency and protect economic growth.

So now comes Lehman Brothers. Treasury Secretary Paulson, though offering his condolences to shareholders, has not opened up the checkbook. Why? Because even though Lehman is important enough to the financial markets that it oughtn’t to be allowed to disappear, it still has enough capital to not need to borrow at the Federal Reserve’s emergency window, and there are other organizations with an appetite to purchase Lehman from its shareholders. Lehman’s ownership structure may change and its shareholders have already lost all but a pittance of their investments, but Lehman’s financial presence will remain and its connection to the capital and credit markets will most likely be merged with that of another investment bank or money center bank.

Seeing some of the ‘generosity’ offered through the Fed and Treasury, the big three automakers, General Motors, Ford and Chrysler, have thought to line up for some needed additional capital. After all, didn’t they usher in the age of federal bailouts? Certainly, we can’t forget them while distributing federal economic resources. Well, we can forget them. In fact so many of us have done so that our garages, driveways and parking lots are filled with extraordinary cars made by Toyota, Honda, Nissan, Lexus, Infinity, Acura, Mercedes Benz, BMW, Porsche, and too many others to mention. Manufacturers, many of which are owned in no small way by US shareholders, and employ millions of US workers. The big three automakers are not only not ‘too big to fail’, but they aren’t interconnected enough to the US economy to need to be kept from failure. Just as importantly, if failure is on the horizon, and at some point it almost certainly is for at least one of the big three, then some other manufacturer will step in and happily acquire the assets and continue to produce automobiles, employ workers, and pay taxes.

As is the case of the most US businesses, our free market system, with limited support for those corporations that are ‘too inter connected to fail’, will ultimately play out for the housing and financial markets, investment and money center banks and automobile manufacturing. The economy, perhaps even some in the federal government, may blink, but ultimately will not lose sight of the bigger picture - a stable currency and long term economic growth.