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[Time] 28:17
Puzzle about claim, besides example of Drexel. If the claim is that because of the reduced risk to creditors, these institutions became more risky, why did it take so long for it to blow up? Trying to predict in advance what will set off a financial crisis virtually impossible. Some people claim that they knew residential housing was in trouble, but calling the timing--that it would begin in August of 2007 as opposed to August of some other year--nobody really got all of that right and if they did, couldn't repeat that. Institution like Fannie Mae was inherently dysfunctional. As close as you could get to believing that the government would bail them out; bad set of incentives; had their own regulator; takes a while for that process to get corrupted. Couldn't have said when, but not unreasonable to suggest that it was unstable and would eventually blow up. Lots of regulators testified before Congress before the crisis; but no desire to do anything about it. Incentives: If I'm leveraged, say a 2 to 1 ratio between my investments and my capital, so half of what I have invested are my own and the other half are borrowed. Low level of leverage--huge cushion. If they fall very far, my lenders and creditors feel very good because they know I can compensate them. If I live in a world of too big to fail and if my creditors believe I'm likely to be bailed out, don't I have a natural incentive to increase that leverage as much as possible? The other people are comfortable; and I will increase my rate of return on my asset base, with riskier and riskier bets. True? Yes, but would emphasize the incentives or motivations of the creditors. Recognizing that they will be covered by the taxpayer, that's where the misplacing of risk comes in. They are willing to lend money to permit this company to lend out. Lack of market discipline. Creditors' expectations--as long as they are what they are, the problem will persist. One of the outcomes of the last couple of years is to more deeply embed creditors' expectations that they will be bailed out. What would a firm's optimal level of leverage be in a case of too big to fail? Puzzling why a firm would, like Bear Stearns or Lehman, be leveraged 30, 40, 50 to 1--putting in a dollar or two for every hundred being borrowed? When you do that, you put the existence of the firm at risk. What are they getting in return? Opportunity to make much larger bets, and will take riskier debts. These firms could borrow cheaply and saw investment opportunities. Given how cheaply they could borrow, they felt they would be well compensated for the risks they were taking on the assets they were acquiring. A lot of these companies survived; their stock didn't go to zero; had big return as their competitors were destroyed. Worst part of story--why could they borrow at such low rates of interest when they were putting those lenders at such risk? Standard answer is they just expecting housing prices to keep going up. Alternative answer is: they were lending to each other. So, their likelihood of being bailed out than if it were the Chinese lending to Fannie Mae. Except for Lehman Brothers, their bets turned out to be right.
Gary Stern on Too Big to Fail | EconTalk | Library of Economics and Liberty
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