It is unfortunate that apparently no member of the Financial Crisis Inquiry Commission grew up on a farm that raised hogs. If one had, the commission might have paid more attention to the cannibalistic behaviors of other Wall Street firms whenever one member of the herd gets in trouble.
On Wall Street, when one firm gets a whiff of another’s weakness, they begin short selling — basically, betting that the other’s stock will go down — and finding other ways to bet on the demise of their troubled counterpart. This has the potential for great short-term trading gains, but it increases the likelihood of a collapsing-domino financial crisis.
The FCIC did not adequately deal with this phenomenon. Friends who teach finance tell me there may be no good policy option to curb such activity, anyway. But our unwillingness or inability to confront the problem means that when another crisis threatens, as it inevitably will, such activities once again will intensify the effects of a crisis occurring for other fundamental reasons.
The farm-kid reference is to the episodic willingness of hogs to kill each other. As other farm kids know, hogs are by far the most intelligent of the common farm animals, with fascinating individual and group behaviors. Unfortunately, these behaviors include singling out one member of the group and, taking turns, chasing it and biting at its tail and ears until it dies of exhaustion. Once a herd has learned the sport, it often soon choose another pariah to persecute.
In hogs, this behavior is exacerbated by overcrowding, lack of exercise and mineral deficiencies in their diet. Once learned by a group, it can be hard to eradicate. Among financial institutions, such behavior has been exacerbated by a greater emphasis on short-term trading, by the conversion of investment banks from partnerships to publicly traded corporations and by the development of various modern financial instruments that give short-sellers many more ways to bet on the demise of some company than was possible even 20 years ago.
To stave off angry e-mails from other economists, I need to make clear that such ganging up and betting on the demise of other financial institutions was not an underlying cause of the ongoing financial debacle. Moreover, economists agree that speculators, including those who would profit if a firm goes under, can perform valuable functions. These include providing liquidity, allocating risk to those most willing or able to bear it and creating incentives for CEOs to manage their companies prudently so as to stay out of the troubled financial waters where short-selling speculators wait.
Nevertheless, anyone who studies day-to-day accounts of the last weeks of Bear Stearns and Lehman can see there were frenzies of speculation that accelerated their demise and arguably left their carcasses with fewer assets for long-standing creditors to claim. It is also clear that in September 2008, with two major Wall Street institutions down, financial sharks already were circling Merrill Lynch, Bank of America and Morgan Stanley.
Jimmy Cayne and Dick Fuld, the CEOs of Bear Stearns and Lehman Brothers, respectively, have whined about how their firms were innocent victims of rapacious speculators. Both, however, made myriad bad decisions that caused their companies to fail. And if the shoe had been on another foot, each of these firms clearly would have engaged in the blood-lust driven ganging up on some unfortunate.
Self-serving arguments by such failed CEOs do not, however, diminish the fact that such financial feeding frenzies multiply financial uncertainty and can poison the whole economy. Uncertainty breeds fear, causing longer-term investors to flee for safety and locking up credit markets.
Efficient-market enthusiasts will respond that any government action to restrain such bear raids can only make matters worse. Perhaps that is true. But if true, and if government interventions like those of late 2008 create further problems, then the need to solve the “too big to fail” problem becomes even more critical.
The 2010 election results show that many voters think the dangers of systemic collapse two years earlier simply did not exist and that if the Fed and Treasury had not intervened with the TARP program and other measures, all the dust would have settled quickly and things would be hunky dory. I don’t agree. History shows that financial dominos can topple and economies can suffer far more grievous damage than we have had so far.
We responded to the threats of “too big to fail” firms by making key financial companies fewer and larger. The provisions for orderly winding down of such large firms included in the Dodd-Frank bill are not credible. At some point, months or years or decades from now, we are going to face the failure of a mega-financial institution that would strike at the economy as a whole. Part of the threat inevitably will be speculators using whatever means they can to profit from the plight of the firm.
The only reliable way of neutralizing the threat is to break up big financial institutions. We have come out of 2008 with the political power of the biggest firms enhanced rather than decreased. There is little political support for breaking up big companies, but we will regret that failure eventually.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.