Why (Financial) History Repeats

Resident fellow Alex J. Pollock explores the parallels between the recent government bailout of the investment bank Bear Stearns and the government’s 1984 rescue of Continental Illinois, the largest commercial bank in Chicago. Both banks were determined to be too intertwined in the financial system to be allowed to fail; consequently, creditors were bailed out, management lost control, and equity investors bore the brunt of the losses. History repeatedly shows that the government intervenes when faced with potential financial collapse.

What happens when top government financial officers, like Treasury secretaries and Federal Reserve chairmen, stand on the cliff of a market panic with a major financial firm about to go over the edge, perhaps to be followed by others? What will they decide to do as they stare down into the abyss of potential financial chaos? The answer of financial history is clear: they will always decide upon government intervention.

Nobody believes enough in pure market discipline to risk going down in historical ignominy as the one in authority who stood there and did nothing in the face of financial collapse. Nobody will, or should, take the risk of triggering the financial and economic destruction of a debt deflation. So they always do, and should, intervene.

Both Bear Stearns and Continental Illinois were dependent on short-term funding to carry long term assets, which proved to be much riskier than they thought.

Two notable examples are the bailout of Wall Street investment bank Bear Stearns this year, and 24 years ago, the bailout of the largest commercial bank in Chicago, Continental Illinois, in 1984. Continental Illinois also was bailed out 50 years before that, in 1934, but that’s a different story. That time it got new capital from the government’s Reconstruction Finance Corporation–but so did 6,000 other banks in the collapse of the 1930s.

Though a generation apart, there are remarkable parallels between the 2008 and the 1984 events.

Both Bear Stearns and Continental Illinois got caught up in an asset price and credit bubble: with Bear Stearns it was of course the great housing and subprime mortgage bubble of the new 21st century–the painful deflation of which we are now living through. With Continental Illinois, it was the great oil and energy bubble of the early 1980s.

Financial bubbles are always based on the at first optimistic, and later euphoric, belief in the ever-rising prices of some asset class–this time, house and condominium prices; then, oil and energy prices. This appears to offer a surefire way for investors, lenders, borrowers, and speculators to make money, and indeed they all do–for a while. As long as the prices continue to rise, everyone can be a winner; when the prices inevitably fall, the defaults, failures, and bailouts follow.

Both Bear Stearns and Continental Illinois had a long record of success in financing the assets that ultimately led to their downfall, and were considered experts in their markets. They both represent a moral lesson in the danger of sustained success that leads to overconfidence. As nicely summed up by Velleius Paterculus, writing a history of Rome in about 30 AD, “The most common beginning of disaster was a sense of security.”

Fraud always accompanies bubbles. Fraud in mortgage originations hyped the losses in the subprime loan pools bought by Bear Stearns; fraud in the oil loans it bought from Oklahoma crippled Continental Illinois.

Both Bear Stearns and Continental Illinois were considered by government authorities to be too intertwined in the financial system to be allowed to fail. With Bear Stearns, this included a global network of derivative contracts with market counterparties, who were at risk if Bear Stearns could not perform. With Continental Illinois, it included hundreds of smaller domestic banks at risk to their “money center” correspondent through the fed funds market, as well as many foreign bank creditors.

In both cases, all of the creditors were protected, and it was really the creditors who were bailed out. The equity investors, as is appropriate, took total (Continental Illinois) or huge (Bear Stearns) losses. The managements of both lost control and were humiliated, for Bear Stearns, in a forced take over by JP Morgan; for Continental Illinois, by having new management sent in by Washington. It was later taken over by Bank of America.

Both Bear Stearns and Continental Illinois were dependent on short-term funding to carry long term assets, which proved to be much riskier than they thought. When the providers of short-term loans refused to roll them over, and instead demanded their money back, the moment of either failure or bailout had come for both.

A typical pattern of bubbles is that using short-term funding enhances the profitability of financing long-term, risky assets. Indeed, after a long period of success, increased short-term funding comes to be seen by financial managers as not only safe, but as the noted theoretician of “financial fragility,” Hyman Minsky, put it, “a normal way of life.”

Normal, that is, until the short-term funding is no longer available. When the price of the bubble asset begins falling, with credit defaults and losses rising instead, the happy confidence of short-term lenders becomes fear. Then they all become conservative at once and withdraw from the firms now perceived as risky: the run of the wholesale credit markets arrives. The result is the same as an old-fashioned depositor run on a bank: the end.

If private credit disappears, it can be replaced only by government credit. That is what happened with both Bear Stearns and Continental Illinois: the government’s balance sheet and risk expanded to allow the private creditors to be protected. In both cases, the critics of the bailout argued that it would create “moral hazard” by convincing creditors that they could be less prudent because the government would protect them. This argument is doubtless correct, but in both cases the risk of a systemic collapse was viewed as greater than the risk of moral hazard. It always is.

Does history repeat itself? If it’s financial history, it certainly does.

Originally published by AEI and reproduced here with the author’s permission.

One Response to "Why (Financial) History Repeats"

  1. Guest   June 11, 2008 at 4:06 pm

    Running away is the better part of valor… but ’tis difficult to avoid populism