Failure should be an option

A good clue that a phenomenon has penetrated the public’s consciousness is when it gets referred to by shorthand, like “DVD,” or “Brangelina.”

The latest upward-scuttling concept bidding for popular mind-share goes by TBTF -- “too big to fail.”

It’s easy to identify the current crop of institutions considered so big that their failure would precipitate a nationwide, even global financial collapse -- it’s almost the same as the list of firms that received government bailouts. Think American International Group, Citigroup, General Motors, and you have the idea.

Propping up this hall of shame has already required an outlay from U.S. taxpayers of more than a trillion dollars. So no one should be surprised that the pages of financial journals and the hearing transcripts of congressional committees are brimming with proposals for preventing anyone else from joining the TBTF roster, or making sure that those already in the club don’t actually F.

Or at least that if any do F, they don’t set off a severe R or even a repeat of the GD.

Without taking steps to address the too-big-to-fail problem, Brookings Institution economist Robert Litan told me last week, “we’ll be back here in a few years.”

On the other hand, as Litan and his colleague Martin Baily told the Senate Banking Committee on Wednesday, “no company is actually too big to fail.”

As they indicate, the test is not sheer size: Neither Bear Stearns nor Lehman Bros., two putatively TBTF investment banks that failed last year -- Bear Stearns through a government-orchestrated sale, and Lehman through a bankruptcy that shook world financial markets -- were anywhere near the biggest in assets on a global or even nationwide scale.

Meanwhile, many even larger firms, such as Fidelity Investments or Vanguard Group, could go bankrupt without the international markets missing a heartbeat.

Some economists argue further that most TBTF concerns are overblown -- especially in the case of investment banks, the creditors and trading partners of which are typically grown-up institutions well able to take care of themselves.

By this reasoning, much of the bailing out undertaken over the last year by our government and others around the world has been merely handouts to the undeserving rich and the propping up of the undeserving imprudent.

That’s the view of Peter Wallison of the American Enterprise Institute, who warned the banking committee last week that a hint from government regulators that one firm or another is too big to fail confers a huge competitive advantage on that firm.

Because its creditors know in advance that it won’t be permitted to go under, they’ll lend it money cheaper than to its rivals. Meanwhile, its management will feel free to engage in excessive risk-taking, figuring that the government has their back, the very definition of “moral hazard.”

The prospect of a systemic financial meltdown is nothing to be complacent about. So it’s proper to think about what the institutions generally considered TBTF today have in common, and whether that gives us a signpost to avert being held up by them in the future.

One common factor certainly is excessive investing in highly leveraged securities --derivatives, especially custom-built ones such as mortgage-backed securities and credit default swaps. This paper creates obligations that can rapidly mushroom beyond the institution’s capacity to cover them. They make a mockery of what the banking sector likes to call “risk management,” because the risks often are unpredictable.

As it happens, we have a blueprint for regulating this behavior. It was drafted in 1998 by Brooksley Born, then chairwoman of the Commodity Futures Trading Commission.

Born warned that the trading of such derivatives outside of regulated exchanges had already gotten out of hand. She wanted them treated legally as futures contracts so her agency could keep an eye on them. Had her words been heeded, mortgage securities might never have gained their current official status as “toxic waste.”

The push-back from the financial industry and its house-trained regulators, the Securities and Exchange Commission, the Federal Reserve and the U.S. Treasury, was instant. Then-SEC Chairman Arthur Levitt reassured Congress that his agency took a “careful approach” to regulating derivatives.

He was backed up by then-Fed Chairman Alan Greenspan and Treasury Secretary Robert Rubin, all of whom should be summarily struck from the pantheon of Wise Men customarily summoned for congressional testimony and quoted by news pundits. Born’s initiative was stifled at birth, and we know how things turned out. We could do worse than resurrect her program.

TBTF firms also have loyal long-term bondholders confident that, in a pinch, the federal government will protect them from taking any losses. The recent record has, if anything, reinforced that smug assumption. The one time that the government left creditors twisting in the wind -- in the collapse of Lehman -- the international shudders were so violent that the feds made it clear they wouldn’t play that game of chicken again.

But bondholders subject to losses in the failure of a financial firm are the best safeguard against that failure -- they have an incentive to make sure that management is on the ball. Litan believes that a key to addressing the TBTF problem is for the government to make a convincing commitment not to bail out such investors in the future.

He also proposes that firms that grow beyond a certain threshold be subjected to especially stringent capital requirements and other regulatory collars. Financial firms gain great economies of scale from size, so they can afford a sort of super-regulation. The idea is to give regulators an early warning if a firm capable of provoking worldwide disaster is heading for trouble.

Whatever rules are implemented, the important thing is to put them in place now, stick to them when crisis approaches and back them up with market-based protections such as bondholder vigilance. As University of Chicago finance professor Raghuram G. Rajan observes, as the economy recovers and memories of today’s crisis ebb, “profitable banks will lobby hard” to weaken TBTF legislation.

The history lesson is crystal clear. For every Brooksley Born warning of shoals in the distance, there are many Arthur Levitts counseling that things are under control. How long before we forget the lesson again?

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Michael Hiltzik’s column appears Mondays and Thursdays.

Reach him at michael.hiltzik@latimes.com, read his previous columns at www.latimes.com/hiltzik and follow @latimeshiltzik on Twitter.