« Further Debate About Debt Collection Reform and Credit Availability | Main | New York Professional Responsibility Rules vs. Delaware Corporate Law? »

Sorry Paul, but the Bailout WAS about the Banks

posted by Adam Levitin

Paul Krugman claims that "Many analysts concluded years ago" that the big banks were not at the heart of the financial crisis and that breaking them up would not protect us from future crises.  Incredibly, his claim is linked to an article by ... Paul Krugman.  Maybe a Nobel Prize comes with a license to cite oneself as Gospel authority, but I don't believe that Krugman's Nobel Prize was for his expertise on bank regulation. 

So what's wrong with Krugman's claim?  Let's go piece by piece. 

Claim 1.  "Predatory lending was largely carried out by smaller, non-Wall Street institutions like Countrywide Financial."

Wrong.  The actual loan origination was generally not carried out by Wall Street institutions.  It was carried out by mortgage companies, mortgage brokers, and commercial banks (I can only think of only two large commercial banks that are "Wall Street institutions--Citi and JPMorgan).  But this is silly.  It's like saying that the banks didn't do the origination, their loan officers did.  The mortgage companies, mortgage brokers, and commercial banks were just origination agents for a Wall Street-based securitization machine.  The Wall Street institutions provided the funding for the predatory lending--warehouse lines of credit from commercial banks and then the ultimate funding from securitizations organized by Wall Street.  Absent securitization there just isn't that much predatory mortgage lending.  The proof is the disappearance of all of the subprime mortgage companies with the implosion of the securitization machine.  And for the cherry on top, let me note that Krugman ignores the direct ownership of some of the mortgage companies and commercial bank originators by Wall Street institutions.  Lehman, Bear Stearns, Goldman, AIG...all owned origination entities.  

Claim 2.  "The crisis itself was centered not on big banks but on 'shadow banks' like Lehman Brothers that weren't necessarily that big."

Wrong.  This is semantics.  Krugman seems to equate "bank" with depositary (which is not consistent with equating "banks" with "Wall Street").  That's not right.  For starters, many investment banks owned depositaries.  But more to the point, when people talk about breaking up the "banks," they aren't referring to "depositaries" but to large financial institutions of any stripe. The reason is two-fold.  

First is that if a large institution fails, the impact is greater than if a small one fails.  Breaking up large institutions means that any individual failure is less costly.  (There's a question about whether large institutions are less fragile, but that's a separate issue.) 

Second is a political reason with which Krugman and other opponents of a 21st Century Glass-Steagall refuse to engage (and I suspect it's because they don't have an answer.) Large financial institutions wield out-sized political power.  They use this political power to stymie their regulation in the first instance, and then, when they get into trouble, to force the government to bail them out. If we want to be able to regulate the financial industry we must clear the decks politically for regulators to do their work. Because of the political constraints on the system regulators have to resort to Rube Goldberg devices to achieve the ends they want--living wills, FSOC designation, and litigation settlements and non-binding "guidance" in lieu of rule making. Ultimately this is not good for our political system writ large. 

Krugman also implies that the "big banks" were separate from "shadow banking."  That's just nuts.  Lehman, Goldman, Morgan Stanley, etc. all had substantial exposures to MBS, CDOs, and various mortgage derivatives.  They also made markets in these products.  In other words, the big banks were not separate from "shadow banking", but were at the heart of shadow banking. 

Krugman also equates "crisis" with the failure of shadow banks.  But the crisis wasn't about the failure of some fly-by-night subprime originators or even the failure of larger thrifts like Countrywide and WaMu.  Nor was it about some hedge fund getting its position wiped out.   The only real non-bank entity at the center of the crisis was AIG, and AIG's counterparties were all...banks. The crisis was because a whole range of investment banks and commercial banks had gorged on securities and derivatives that in one way or another were linked to the housing market and that exposure presaged their failure.  The exact extent of these institutions' exposures to the housing market were unclear, as was the extent of their exposure to each other.  But there was good reason for their counterparties to think that some might be illiquid or insolvent, and that was sufficient to trigger run or panic conditions.  

The real crisis was the possibility that "serious" Wall Street institutions would fail--AIG, Goldman Sachs, Lehman Brothers, Morgan Stanley--and there was a run on these institutions until the federal government stepped in:  Wachovia and Citi both experienced depositor runs, and AIG and Lehman had counterparty collateral runs.  Indeed, according to Sheila Bair's account of the crisis--and she's someone who should know--the major driver of the government response was concern about the impending failure of Citibank.  Last time I checked, Citi is, well, a Wall Street bank.  The bail out--which is where the real problem of too-big-to-fail lies--was undertaken to protect Wall Street institutions because they are so heavily intertwined with commercial banks and the payment system and thus systemically important, as without payment systems the entire economy stops working.  The little mortgage banks were allowed to fail because they were unimportantly systemically...as were homeowners.  

Breaking up the big banks alone will not prevent all future crises.  And no one is claiming that. But by breaking up the big banks there will be the political room to regulate the financial system more effectively.  Too-big-to-fail is too-big-to-regulate.  And that alone makes breaking up the big banks an important goal. 


Language is a problem. Big banks often means commercial banks, shadow banks often mean investment banks, though since the crisis they have all been made commercial in the sense of direct access to the Fed. Citibank was on the edge, but that is part of being on the edge means, edge in banking as well as liquidity. It does bring to mind when people talk size they never identify the measure involved.

Absolutely on target!! See Paul Krugman Propaganda Exposed and Debunked. http://wp.me/p1H9BR-1YL

So, if Paul is angling for a White House job and this is the advice he is touting or told to tout - we'd be in deep trouble if it's Hillary (we know its not Bernie and it sure isn't Trump he's trying to schmooze).

Big banks are fine if the regulators are on top of everything. Government is the weakness in any system run from top down by the government. That is what we have, and what heavy bank regulation is. It is not a market system, by which individual small bank failures convey information about optimal firm practice, hurting only those who deal with banks that fail, rather than the whole nation. We have a socialized system that now happens to too complex for the government to manage. Krugman's main problem is that he is not a lawyer. He is only an economist, and he is therefore blinkered. Plus he gives too much credit to government with his lefty-liberal bias. This is somewhat excusable since it is equally true that ideological anti-government rhetoric on the right led regulators to drop what the very, very heavy ball they assumed, after letting banking cartelize, and eliminating Glass Steagall so that trading profits could subsidize commercial bank weakness. They have now built incompetent behemoths packed with free-riders.

There was so much demand for high yielding, high rated (mortgaged backed) securities that the manufacturers of these products were willing to source them from very low grade if not fraudulent raw materials. It is a stretch to call the manufacturers of those products banks and kind of ridiculous to have such manufacturers anywhere near a socially critical function such as payment transfers and settlements.

Historically, investment banking was a high profit, high risk business carried out through private partnerships, which were self regulating insofar as partners' capital was at risk, and--given the risk--capital constrained and therefore size-constrained. Commercial banks were a low margin, high volume business built on low cost government insured deposits as capital, with the insurer as regulator vía periodic (or redundant) audits.

The grass being greener on the other side of the Glass-Stegall fence, investment banks envied the capital permitted the commercial banks and the commercial banks envied the profits of the investment banks.

Now I would like to see the "debate" move beyond campaign slogans like break up the banks and whether or not Paul Krugman is merely shilling for the Hil.

I think we have to admit that certain kinds of activity are best regulated except by self-interest and other kinds of activity are basically public utilities operating under licenses, and that these two types of activities therefore cannot be carried out by the same institution.

The public has no interest in bailing out either investment banks nor commercial banks.

Krugman's support for Hillary Clinton and attacks on Bernie Sanders have destroyed his credibility as a supposed "progressive".

Perhaps he wants President Hillary to pick him as her Treasury Secretary.

Despite his attempts to paint Sanders as a loon when it comes to banking, Krugman has actually published some pieces lately agreeing more with the Sanders position on trade than Clinton's. Krugman certainly doesn't advocate tariffs and trade wars, but he acknowledges that the alleged benefits of free trade and globalization aren't all they have been cracked up to be and that there has been real harm to the American worker. I still don't see Clinton picking Krugman for Treasury -- in fact, she is much more likely to nominate someone from inside Wall Street.

Homeowners not systemically important?

We, all 26 million of our households and trickledown friends and family, are in the process of giving back what we got:

Trump v Bush
Sanders v Clinton

...to quote Martin O'Malley at a recent New Hampshire housing conference -

"Pitchforks and Rocks." Politicly speaking, of course.

Given the way Krugstand is attacking everyone who isn't toeing Hillary's line, such as his smears of Gerald Epstein, there is no point showing where he's wrong because he's so far off base he isn't even wrong. The real question to ask is what he knows or should know he's lying about, such as positions he has taken himself but now condemns others for.

RE Claim 1: If the Wall Street banks are just receivers and repackagers of loan originations, why would breaking up the institutions lead to systemically safer environments? Breaking up banks doesn't stop CDO's from being created.

RE Claim 2: I'm pretty sure you do have to address in your first point that large institutions are not less likely to fail, or that it's not enough to offset the harms of a complicated bankruptcy. Regarding your second point, there's no reason this is unique to banks. The Federal Reserve did not need lobbyists to persuade them to bailout the banks, the harms to the economy were self-evident to them. When they tried to get TARP passed through congress, the first vote failed, so the banks' political capital evidently was not so strong. Wall Street banks certainly play a role in the shadow banks, but the question is why this role would not be fulfilled by a stand-alone investment bank post break-up.

Basic income funded on the Fed's balance sheet is the answer. The Fed backstopped world markets in 2008 and beyond. The Fed should backstop world individuals.

Fix unexpected, runaway inflation once and for all with full indexation of all incomes to price rises, so purchasing power does not decrease. Increase the pace of innovation and the production possibility frontier with challenges.

The comments to this entry are closed.


Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.



  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless ([email protected]) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.