“Too big to fail” is a phrase used to describe an institution that has grown, or rather been allowed to grow, to such a scale and scope that its failure will mean a systemic collapse. The banks had morphed from the regular Jimmy Stewart banks to market-based Wall Street megabanks, a financial overgrowth that had spread its tentacles into the houses of regular persons, their businesses, their education, their healthcare – all across the world, from the US to UK and Europe.

Their failure was deemed so destabilizing that they had to be saved at all odds. Institutionally, this revealed a peculiar logic: the national interest was in saving purveyors of high finance that had caused the crash. As Tooze writes, Geithner’s “commitment was to upholding the stability of “the financial system,” because without that, the entire economy was bound to fail. That was his key article of faith. The interests of America and the financial system were aligned.”

“Too interconnected to fail” describes the interconnected nature of banks such that failure of one of them precipitates a panic of failure of the entire banking system such that the policymakers find it imperative to save them. For example, globalized finance was deeply interconnected with the American mortgage boom through the shadow banking system. When the Lehman was allowed to fail, the costs in wholesale funding markets rose steeply due to risk of contagion in the interconnected banking system.

As Tooze writes, “The Fed and the Treasury misjudged the scale of the fallout from the bankruptcy of Lehman on September 15. Never before, not even in the 1930s, had such a large and interconnected system come so close to total implosion. But once the scale of the risk became evident, the US authorities scrambled.”

“Too Chinese to fail” refers to the fact that a large portion of the debt issued GSEs, Fannie Mae and Freddie Mac, were held by Chinese investors and Paulson “didn’t want them to dump the securities on the market and precipitate a bigger crisis…”, one that would jeopardize the ‘system’. As Tooze writes in the end, “what worried observers was the possibility of a mass sell-off of dollar-denominated assets by China’s reserve managers.

As the storm clouds gathered, holding China in place was the first priority of Paulson’s Treasury. And Paulson was willing to pay a high political price for doing so…. Nationalizing them helped to prevent a simultaneous Atlantic and Chinese crisis with consequences too awful to contemplate.” However, America was a big market for Chinese goods and “balance of financial terror held”. There was no Chinese dollar sell-off and “the crisis that followed was not an American sovereign debt crisis driven by a Chinese sell-off but a crisis fully native to Western capitalism”.

While the three phrases represent three different features of globalized finance, there also are big overlaps between them. These are not stand-alone characteristics.

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019

Repo is a repurchase agreement in which a bank buys a security and pays for it by selling it to an investor for a small period of time, with a promise to repurchase it back at a price. As Tooze writes, “The investment bank would buy $100 million in securities and repo them with a mutual fund or another investment bank, with the party repoing the paper paying a small interest charge to the investor it was repoing with. It also accepted a haircut. In exchange for $100 million in Treasurys, it did not receive full value, but only $98 million in cash. It would also repurchase them for $98 million. In the meantime, the haircut determined how much of its own money the investment bank would have to put into holding the securities, and thus the leverage in the deal. A 2 percent haircut meant that to fund the purchase of $100 million of securities and to receive the interest paid on those bonds, a bank would need $2 million of its own money. The rest it could get out of the repo transaction.”

This mechanism allowed for big balance sheets with much smaller capital, provided the repo could be continuously rolled over and the haircuts did not rise suddenly. Both these conditions reversed during the crisis. Trillions of dollars of collateral were posted in repo markets, with the private label MBS in bilateral repo market which was thrice the size of triparty repo market. When an investment bank suffered huge losses on its portfolio, the private label MBSs as an asset class lost confidence as collateral for rolling over repo – a general loss of confidence such that the banks found themselves shut out of funding. As Tooze puts it, “If any one of these investment banks was to lose access to the repo markets, at a stroke its business model would collapse, taking its entire balance sheet—not just its MBS business, but its derivatives book, currency and interest swaps—down with it.”

This was exactly what happened. In Tooze’s description: “When news of a new round of mortgage failures hit the markets in March 2008 and hedge funds began emptying their prime brokerage accounts, quite suddenly the haircuts Bear Stearns faced in the bilateral repo market steepened and access to trilateral repo funding was shut off. A bank that in early March had easily been able to raise $100 billion overnight in exchange for good collateral could no longer fund itself.” There was no price adjustment in the triparty repo market while funding terms were getting stiffer and stiffer in the bilateral repo market. This was the so-called ‘run on the repo’. Unlike the old-fashioned ‘bank run’ where depositors rush to get their cash out from their accounts, there were no queuing depositors to be seen but a withdrawal of liquidity from the repo market which precipitated the crisis.

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019