The ‘Too Big to Fail’ Problem

Alex Knapp poses the big question in light of the Fannie Mae/Freddie Mac bailouts, or rather impending bailouts:

Now that Freddie Mac and Fannie Mae have joined the “too big to fail” club, isn’t it high time we started thinking about how to avoid allowing companies and other quasi-private agencies to get into these problems in the first place? It seems that over the past few decades, the Federal government has pretty much given carte blanche for any large corporation to ignore sane business principles as long as their revenues are high enough. I’m not an economist, but I can’t hope avoid the thought that this history of bailouts does, in some perverse way, incentivize risky behavior by ensuring that there are no real consequences for your risks–as long as your failures are big enough.

Not to defend Fannie Mae/Freddie Mac, but these were instituations intially chartered by the federal government, but privatized (sort of) during the efforts to, well privatize, a fair amount of govenrment activity that should not have been federal activity. Had the privatization not occurred, arguably we wouldn't be in this mess.

Still, Knapp is absolutely correct. The key to government invervention is to make sure your failures are monumentally big and spectacular. But is size really the only thing that matters?

Let's look somewhere else. Assume for a moment that big oil was not making a profit, but was in such danger that the big oil companies were on the verge of collapse? Would the government step in to help them? Quite literally, our economy would come to a grinding halt if big oil stopped producing, refining, shipping and selling petroleum products. Would the government then be looking at a bailout?

What about internet services? Would the government bailout Yahoo, Google, Microsoft? The single largest buyer of Microsoft products is the U.S. government? If these companies failed, would be be looking at a bailout?

What about agri-business? Would Archer-Daniel-Midland get a bail out?

Of these three, I could see big oil getting a bailout, but no other industry? So the question is why big oil and the credit markets? What makes them so special that they would need saving?

Knapp's solution is this:

So having thought about this for a bit, the idea I think ought to be thrown around out there is this: if we have to bail a company out because it’s “too big to fail”, then the consequence a company should face for that bailout is to ensure that it doesn’t become “too big” again. In other words, if the federal government bails out a company, it ought to require that the company break itself up, preferably into at least three companies. That way, the company suffers consequences, but at least portions of that company will come under new leadership, and a secondary failure of one of the new companies is less likely to cripple the industry and economy as a whole.

Knapp essentially argues from an anti-trust point of view, i.e. break up the big beast to avoid the "too big to fail" syndrome.

But honestly, the syndrome will happen again. Nearly every industry goes through periods of growth by many companies, consolidation to make bigger profits and then sell-off and spin-off. The difference is that today, we don't get to the sell-off stage because the company cannot imagine doing so.

Here is what is interesting, though. We have a mechanism for this process already in place. It is called bankruptcy. A company in Chapter 11 bankruptcy is given protection from its creditors, allowed to continue doing business under the supervision of the courts and then must emerge with a plan to reorganize, including paying off its creditors etc. What this usually entails is the marshalling of assets and the selling off of those assets in order to streamline operations, make them more efficient and cost effective and then paying creditors. Is is a perfect system, no. But it does work.

Some companies go through Chapter 11 a number of times and perhaps that is an abuse of the process. But sometimes it takes a company a couple of trips before a bankruptcy judge to learn their lesson, and for others in the industry to learn their lesson.

So my solution, instead of a bailout, i.e. giving them money, I would suggest that the United States government consider involuntary bankruptcy proceedings, that is forcing companies into bankruptcy and then making them come out the other end in better shape, including the sacking of officers.