Banks that are Too Big to Fail get Preferential Governmental Treatment

The financial services industry played a significant role in creating the historic economic meltdown of 2008. The industry typically made significant profits on helping companies and countries obtain debt. The overselling/use of this debt was a key ingredient of the meltdown.

Large investment banks assisted countries increased debt with ever more sophisticated ways of selling bonds to a naïve public. When interest rates went up as risk of these countries’ default increased, the value of the bonds significantly dropped. This then placed major commercial banks in illiquid positions that required bailouts.

In addition, the major investment banks created collateralized debt tools such as CDOs (Collateralized Debt Obligations) to mask the actual risks included in the mortgage-backed securities. This led to artificially low mortgage rates, as well as the offering of mortgages to people who could not afford to repay them, especially in an inevitable economic downturn that would place downward pressure on housing values.

After causing the disruptions through bad business decisions, the normal action of capitalism is to punish the banks and their shareholders economically. However, when meltdown of 2008 occurred, the Bush administration with the backing of both political parties claimed that the banks had become too big to fail and they were bailed out through the TARP program.

Not only were the major banks not appropriately punished under capitalism, the bailouts had the effect of rewarding them for the bad business decisions to the exclusion of businesses that acted prudently. For example, in the first quarter of 2010, only one and one half years after the meltdown, the most powerful investment bank, Goldman Sachs’ (GS) earnings rose 91 with revenues increasing 36 percent to $12.78 billion. While technically GS did not receive direct bailout funds, they were beneficiaries with the government covering their counter-party trades with insurance giant AIG. Had the U.S. government not bailed out AIG with over $150 bil., GS stood to lose tens of billions. In addition, had the bailouts not occurred, the banking business would have significantly decreased, negatively impacting GS’s financial results for some years.

Today, six years after the economic meltdown, the banks that were once too big to fail are now even bigger. Professional managers at these banks therefore understand the government cannot let them fail in the future, which will lead to more imprudent behavior by the banks with the costs being ultimately born by the greater society.

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