2008-10-13

Too big to exist #2

Here you go, exactly what I've been saying:
“Prior to Lehman, there was an almost unshakable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default,” notes Neil McLeish, analyst at Morgan Stanley. “This confidence was built up ever since the failure of Continental Illinois (at the time the seventh largest US bank) in 1984, a failure in which bondholders were [fully paid out].”

[...]

This would seem to put the complaints about Fannie Mae and Freddie Mac, and their implicit government guarantees, in proper context. Everyone, or at least the big guys, was behaving as if there was no chance that the government would allow them to fail.

The rules will have to be torn up and rewritten after this is all over and done with. As things stand, there are plenty of too-big-to-fail institutions remaining. They must either be reduced in size to the extent that the government's promise to let them fail is credible, or they must become more heavily regulated, particularly where leverage is concerned. We simply cannot allow firms to grow large and vulnerable enough to threaten the economy and hold it for ransom, to be paid by taxpayers.
Emphasis my own. From The hazard in moral hazard, on the Free Exchange blog.

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