What People Still Don’t Get About Bailouts
Good financial-crisis management is about doing what it takes to stop the contagion.
It doesn’t seem fair, does it? Just 15 years after our financial overlords went on a bailout binge, showering bankers with trillions of taxpayer dollars, they’re once again riding to the rescue of the rich while the public watches in horror. Did they learn none of the lessons from the 2008 meltdown?
Actually, yes, they did. The government’s financial-crisis managers clearly studied the lessons of 2008, which is one reason the collapse of Silicon Valley Bank a week ago doesn’t seem to have created another cataclysm, at least so far. It’s the public that’s never understood those lessons, which is one reason the public is likely to draw the wrong conclusions about the SVB mess too. And the most important lesson is the hardest to understand: Good financial-crisis management isn’t supposed to seem fair.
That’s because managing a financial crisis, as the overlords of 2008 explained in a short book I helped them write, is like fighting a dangerous fire. Good firefighters don’t worry whether the burning building was up to code, or whether someone smoked in bed, or whether some friends of the tenants are trashing them on Twitter. They don’t ask themselves if maybe some of the bozos inside deserve to burn. They focus on putting out the flames, because fires can spread, and out-of-control infernos can be disasters for everyone.
During the 2008 financial crisis, there was no way to extinguish the flames without bailing out some of the financial arsonists, although it’s a myth that none of them paid any price, and the bailouts ended up turning a profit for taxpayers. The Biden administration’s more modest SVB bailout shouldn’t cost taxpayers a dime either, and so far there’s been no need to bail out any arsonists, although some depositors (including solar developers as well as wealthy tech bros) who wrongly assumed their building was safe were protected from losses. They weren’t protected because they were innocent or worthy or entitled to protection. They were protected to quell a panic, because panic is what turns local financial fires into systemic conflagrations.
Still, even a mini-bailout that doesn’t rescue villains or soak taxpayers is a bailout, and bailouts make people mad. Where’s our bailout? Why do the government suits always do favors for millionaires with connections? What kind of message does this send?
It sends the calming message that everyone should feel safe stashing cash in banks. But it definitely looks bad; bailouts always do.
The general weakness of the financial system is that it rests on a foundation of confidence. That’s why banks are called “trusts,” and why many of their buildings have giant pillars out front to convey stability. It’s why the word credit comes from the Latin for “believe.”
There’s also a specific weakness illustrated by the bank run in It’s a Wonderful Life: Banks don’t keep most of their deposits in the bank. They use deposits to make long-term loans, a great way to help individuals and businesses invest in the future that can become extremely not-great if a lot of depositors suddenly lose confidence and decide they want their money back. After bank runs helped start the Great Depression, the newly created Federal Deposit Insurance Corporation began insuring deposits—originally up to $2,500, now up to $250,000—to eliminate the incentive for freaked-out depositors to run. It’s an excellent confidence booster, especially now that a bank run no longer requires an actual run to the bank, just a click of a button.
But deposit insurance didn’t eliminate fear. In 2008, panic about sketchy mortgages and complex financial instruments backed by sketchy mortgages sparked a new round of bank runs—except this time, most of the runs were on firms that weren’t official FDIC-insured deposit-taking “banks,” so they had avoided strict oversight from banking regulators even though they borrowed short and lent long like banks. Countrywide Financial, IndyMac, Bear Stearns, Washington Mutual, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG all collapsed when their short-term creditors lost confidence and demanded their money back.
The government’s crisis managers tried desperately to eliminate incentives to run, first by making cheap liquidity widely available, then by guaranteeing trillions of dollars worth of liabilities, and eventually by persuading Congress to inject $700 billion worth of direct capital into the system through the Troubled Asset Relief Program to assure creditors that their money was safe. When ordinary Americans started to flee from money market funds, the government backstopped those too.
It took more than a year, but it worked. The panic subsided. The system recovered.
The conventional wisdom at the time, and still today, was that the government bailed out Wall Street while screwing Main Street. But the reason the government bailed out Wall Street was to prevent the banking crisis from turning into a second Great Depression that really would have screwed Main Street. The financial rescues of 2008 all helped stabilize the system; the fall of Lehman, which the government failed to rescue, is what nearly dragged the system into the abyss.
And remember, the shareholders of all those failed firms were totally or virtually wiped out. The CEOs lost their jobs. The government put a lot of tax money at risk, but it all got paid back with interest. And under President Barack Obama, Washington passed a separate $800 billion economic stimulus bill for Main Street, another subject I’ve spent too much time thinking about, that helped end the recession in a hurry.
The mega-bailouts of 2008 did, in fact, protect some irresponsible financial gamblers from the consequences of their bad bets, which did, unavoidably, send a bad message about irresponsible gambling. That’s why Obama signed the Dodd-Frank financial-reform law in 2010, which essentially made the fire code much tougher and required more banklike firms to obey it. Dodd-Frank actually weakened some of the government’s firefighting tools, an understandable but dangerous response to the anti-bailout backlash. In general, though, it made the financial system much safer and ushered in 15 years of financial stability.
Financial stability, unfortunately, tends to breed overconfidence. I must confess that in 2018 when President Donald Trump signed a bill relaxing Dodd-Frank’s oversight rules for SVB-size banks, I didn’t think it was a good idea, but I didn’t think it was a big deal, either. (Whoops.)
More oversight would have been better because SVB was a disaster waiting to happen—a bank with 94 percent of its deposits uninsured, uniquely vulnerable to a run. It didn’t help that most of the deposits came from one gossipy industry, or that its executives were using them to place long-term bets on low interest rates. The whole debacle was reminiscent of the old Saturday Night Live ad for Bad Idea Jeans.
The early stages of a financial crisis can be tricky for the firefighters because it’s hard to know whether there’s a genuine systemic risk of the fire spreading. They don’t want to overreact to every sign of turbulence, because bailing out reckless risk takers can create “moral hazard,” which encourages more reckless risk taking in the future. At the same time, the natural instinct to punish irresponsibility can fan the flames of panic in real time.
But SVB was a classic bank run, and a pretty obvious contagion risk for similarly sized banks, so the crisis managers basically followed the playbook from 2008.
I’m embarrassed to say I had never heard of SVB until Friday morning, when a group chat I’m in with some Miami tech entrepreneurs and venture capitalists blew up. I guess I contributed to the panic when one of the VCs said she was torn about pulling out her money because SVB’s managers had been such good partners, and I said it didn’t matter because none of them would have jobs on Monday. (I’m also embarrassed to say I shared the not-very-reassuring “EVERYBODY STAY CALM” gif from The Office.) When confidence goes, it goes fast.
But this was an unusual situation where the Federal Reserve, the FDIC, and the Treasury Department could act quickly and decisively without creating serious moral hazard. They ousted the SVB managers who got the world into this mess. They let SVB’s shareholders lose all their equity. They didn’t even backstop all of SVB’s bondholders, even though the 2008 rescues protected just about all creditors to prevent others from running. But the government immediately made cheap liquidity widely available and guaranteed all of the uninsured deposits. The thing is, bailing out depositors who happen to park their cash in the wrong bank doesn’t encourage risk taking. Parking cash in a bank is supposed to be the opposite of risk taking!
Bailouts are inevitably suboptimal, and they inevitably make people mad. Critics of the Biden administration’s handling of SVB say the firefighters have done too much. But continuing problems at First Republic Bank and a few other regional banks caught up in the frenzy suggest otherwise—and some of the anti-bailout and anti-guarantee provisions in Dodd-Frank might have constrained the government’s ability to respond even more forcefully. The where’s-my-student-loan-bailout analogies whipping around the internet are beside the point; student loans, as burdensome as they might be, don’t have the potential to create global calamities when they don’t get paid back in full. As for the preposterous Republican complaints that SVB illustrates the dangers of “woke” banking, let’s just say it’s equally plausible that the countless institutions with similar rhetorical commitments to diversity that didn’t fail illustrate the benefits of “woke” banking.
Once this fire is fully extinguished, God and Fed willing, we should figure out why SVB’s supervisors let it play with matches, update our fire code (including the dollar limits on deposit insurance), and make sure our firehouses are properly equipped. But we shouldn’t delude ourselves that we can fully fireproof the system or ensure that it never requires another bailout. As long as financial institutions borrow short and lend long, they will always be vulnerable to runs. And risk will always migrate to the path of least resistance, especially in times of stability, when the risk doesn’t seem that risky.
Before last week, there weren’t many voices warning that SVB was about to erupt in flames. We should have the humility to recognize we probably won’t anticipate where the next fire will start either. Hopefully, it won’t happen for a while. And hopefully, the men and women with the hoses will have the guts to do the right thing again, because that isn’t inevitable at all.