Usually, the comments of the Bush administration’s Treasury Secretary during the last 7 years have been fairly insignificant. Unlike during the Clinton years, Bush’s men in charge at Treasury have taken a back seat to whomever has been in charge at the Federal reserve. Treasury Department has been a backwater under President Bush, since Bush’s economic policies can be described in one sentence:

Massive tax cuts for corporations and the wealthy combined with massive deficit spending, usually in the form of large no-bid government contracts to corporations who contributed to Republicans election campaigns.

However, last week, Secretary Paulson made public comments in London while meeting with the UK’s Prime Minister and Finance minister. The upshot of those comments could have significant effects on the future course of our economy since they indicate that the US government is anticipating the failure of many large banks and other financial institutions in the coming months. Here’s what he said (with what I consider the critical portions of his statement in bold text):

[W]e should create a system that gives us the best chance of foreseeing a crisis, including a market stability regulator with the authorities to avert systemic issues it foresees and providing the information, tools and authorities to deal better with unexpected events when they inevitably occur.

To complement this regulator’s efforts, we must have strong market discipline to reinforce the stability of our markets. For market discipline to be effective it is imperative that market participants not have the expectation that lending from the Fed, or any other government support, is readily available. Otherwise, market discipline will be compromised severely. I know from first hand experience that normal or even presumed access to a government backstop has the potential to change behavior within financial institutions and with their creditors. It compromises market discipline and lowers risk premiums, ultimately putting the system at greater risk. […]

However, today two concerns underpin expectations of regulatory intervention to prevent a failure. They are that an institution may be too interconnected to fail or too big to fail. We must take steps to reduce the perception that this is so — and that requires that we reduce the likelihood that it is so.

To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large complex financial institution. . . .

What does this mean? It means that the US government is walking away from its commitment to insure that critical, large financial institutions be propped up (i.e., not be allowed to become insolvent), a policy which essentially has been in effect since the days of the Reagan administration, and which goes by the euphemistically salubrious name of the “Too Big to Fail” Doctrine.

(cont.)

The Too Big to Fail policy is the idea that in banking regulation the largest and most powerful banks are “too big to (let) fail”, which ultimately means those banks would have less incentive to practice thrift and sound business practices, since they would expect to be bailed out in the event of failure. […]

The “Too Big to Fail” policy, as we know it today, arose out of a financial crisis in 1984 which occurred (and threatened to embroil the entire US banking system) when Continental Illinois, then the seventh largest commercial bank in the US underwent an insolvency crisis due to the collapse of the energy boom in the early 1980’s. Continental Illinois was heavily invested in loans to companies in the energy industry.

On May 9, 1984, Continental Illinois, Chicago’s largest bank and one of the top ten banks in the US, began a frantic battle to counter reports that it was on the brink of insolvency from a combination of bad loans and funding liquidity risk.

At the root of the crisis lay a massive portfolio of energy sector loans that had begun to turn sour on Continental when the US oil and gas sectors lurched into recession in 1981. The $33-billion asset bank had compounded its mistakes by lending large amounts to lesser-developed countries prior to the August 1982 start of the major LDC crisis of the 1980s.

With investors and creditors spooked by rumours that the bank might fail or be taken over, Continental was quickly shut out of its usual domestic and international wholesale funding markets.

By May 17, regulatory agencies and the banking industry had arranged billions of dollars in emergency funding for the stricken giant. And in a move that remains controversial almost 20 years later, the Federal Deposit Insurance Corporation tried to stem the bleeding away of the banks funds by extending a guarantee to uninsured depositors and creditors at the bank giving credibility to the notion that some banks should be considered too big to fail.

The emergency help was followed by a package of permanent measures, making Continental the largest bank in the history of US banking ever to be rescued by government agencies.2 The FDICs share of the bill was later calculated to be $1.1 billion.

(footnotes deleted)

“Too big to fail” does not mean that a bank’s shareholders’ investments in their stock will be protected, but in Continental’s case it did provide full protection for the bank’s depositors, even those who had deposits in excess of the legal limit that FDIC or FSLIC insurance could provide by law. The Federal Reserve’s recent intervention in the Bear Stearns collapse was premised on the same rationale that led to the Govenrment’s bailout of Continental Illinois in 1984, and to the savings and loan bailout of the late 80’s and early 90’s:

WASHINGTON – The Federal Reserve was scrambling to prevent a “contagion” from infecting the nation’s financial system when it took unprecedented actions to back a Bear Stearns rescue package and provide emergency loans to big Wall Street firms.

Given the financial markets’ fragile condition at that time, the Fed said it felt compelled to intervene because an “immediate failure” of Bear Stearns would bring about an “expected contagion.” […]

There was fear that other Wall Street firms could fall into jeopardy, sending problems cascading through the financial system.

Democrats in Congress and other critics contend the Fed’s actions are akin to a government bailout and are putting billions of taxpayer dollars at risk.

However, Bernanke has defended the actions, and in appearances on Capitol Hill has said he doesn’t believe taxpayers will suffer any losses.

The Bear Stearns “rescue” led many bankers, investors and financial analysts to conclude that investment banks are now covered by the same federal policy which has benefited commercial banks since 1984. Indeed, that was a reasonable conclusion to draw based upon the mounting evidence that the subprime/residential mortgage crisis, or credit crunch, (or whatever label you wish to employ) resulting from the collapse of the American residential real estate bubble was creating the possibility of massive financial failures at many of the world’s leading financial companies. Paulson’s comments last week fly in the face of those expectations. Which tells me that the financial analysts at the Federal Reserve and at Treasury now believe that a potential meltdown of the financial industry may exceed the ability of the Federal government to cope.

I can’t tell you that bailing out large financial firms, particularly in instances where federal regulation could have prevented or ameliorated the present crisis had those regulations not been discarded by both Republican and Democratic politicians of the DLC faction in the late 90’s and the early years of the Bush administration, is something I am happy about. It smacks of corporate welfare and special favors for the rich. On the other hand, the collapse of our major financial institutions would have far reaching consequences for our economy, and thus for all of us “little people,” not just the investment bankers and hedge fund investors on Wall Street. The fact that Secretary Paulson is speaking publicly now of acquiring “better tools” to manage “the orderly failure of a large, complex, financial institution,” tells me that he not only expects further trouble, but that he anticipates the problems presented by the large losses these financial institutions have incurred will exceed the ability of our government’s resources to prevent or mitigate in any meaningful manner.

We already know that the division of the Treasury department which deals with bank failures is hiring additional staff. Furthermore, Paulson ‘s further comments today regarding Fannie Mae and Freddie Mac the quasi-public companies which insure or hold approximately $5 trillion in mortgage debt, led to a drop in the stock price of both companies.

On Wall Street, investors seemed not to be reassured by Paulson statement. The government-chartered companies at times each lost more than 40% on growing speculation that a government bailout was needed.

Here’s a link to a graph which shows Fannie and Freddie’s share prices falling off the proverbial cliff. Paulson’s earlier comments suggest that sufficient government funds are simply not available to bail out Fannie and Freddie should they both collapse into insolvency amid the current crisis. And frankly that scares the shit out of me.