Federal Bailouts and the Buildup of Risk

Graphic credit: Federal Reserve Bank of Richmond

by James A. Bacon

The federal government plays a much bigger role in shaping the United States economy than is evident in its taxing and spending policies. Uncle Sam funnels credit to favored constituencies through subsidized credit programs like TIFIA transportation loans and the Import-Export bank as well as by protecting lenders from losses due to a borrower’s default. Members of Congress are exercised, as well they ought to be, by the dispensing of subsidized credits to corporate interests. But loan guarantees have a far bigger impact — and expose the federal government, and the U.S. economy — to far greater risk.

Sixty percent of the U.S. financial system’s loans are explicitly or implicitly backed by the federal government, the Federal Reserve Board of Richmond has found in its updated Bailout Barometer. That’s up from roughly 45% as recently as 1999.

The capitalist financial system is inherently prone to booms and busts. Busts lead to corporate failures, and big corporate failures can trigger panics, in which even financially sound firms get caught in the undertow. The U.S. has sought to alleviate this pain by providing loan guarantees. Some guarantees are self-financing, such as federal insurance on bank deposits. Other guarantees are policed by regulators, and yet others are implied but ambiguous and not spelled out in advance. But the end result is that actors in the financial system adjust their behavior — taking on more risk than they would otherwise — in ways that could create new, bigger problems in the future. As the Richmond Fed explains:

Implicit guarantees effectively subsidize risk. Investors in implicitly protected markets feel little need to demand higher yields to compensate for the risk of loss. Implicitly protected funding sources are therefore cheaper, causing market participants to rely more heavily on them. At the same time, risk is more likely to accumulate in protected areas since market participants are less likely to prepare for the possibility of distress — for example, by holding adequate capital to cushion against losses, or by building safeguarding features into contracts — and creditors are less likely to monitor their activities. This is the so-called “moral hazard” problem of the financial safety net: The expectation of government support weakens the private sector’s ability and willingness to limit risk, resulting in excessive risk-taking. …

The Richmond Fed’s view is that the moral hazard from the [Too Big To Fail] problem is pervasive in our financial system. The U.S. government’s history of market interventions — from the bailout of Continental Illinois National Bank and Trust Company in 1984 to the public concerns raised during the Long-Term Capital Management crisis in 1998 — shaped market participants’ expectations of official support leading up to the events of 2007-08. According to Richmond Fed estimates, the proportion of total U.S. financial firms’ liabilities covered by the federal financial safety net has increased by one-third since our first estimate in 1999. The safety net covered 60 percent of financial sector liabilities as of 2013. More than 40 percent of that support is implicit and ambiguous.

Bacon’s bottom line:

While the current financial regime did alleviate the pain of the 2007 market collapse, the system could be allowing even bigger risks to build up. Like generals fighting the last war, regulators are fighting the last panic. The new risks will not be the same as the old ones, and we won’t know what they are until they explode in the next financial debacle. But spurred by the Fed’s near-zero interest rate policies, investors are chasing higher returns by taking greater risks, and financial markets are concocting elaborate new financial instruments to circumvent the regulators.

The global derivatives market was calculated in 2013 to be roughly $1.2 quadrillion in notional value, or about 20 times the global economy. Admittedly, most of that is tied to interest rates, currency values and stock indexes, not the economic sectors guaranteed by the federal government. But it illustrates how arcane financial instruments can magnify or hedge risks in ways we mere mortals — and government bureaucrats earning low, six-figure salaries — can barely comprehend.

I don’t know what will trigger the next financial crisis. Most likely, it will come from a quarter that most people would never expect. I don’t know when it will come. But the history of capitalism since the South Sea Bubble of 1720 suggests that one will come along eventually. If a bunch of multibillionaire hedge fund managers lose multibillion dollar bets and wind up selling apples on the street, I will lose no sleep. But if those hedge fund multibillionaires’ losses are back-stopped by federal loan guarantees, effectively socializing their losses, I will have a deep and abiding rage.

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  1. larryg Avatar


  2. In the event of bankruptcy or a taxpayer bailout to avoid bankruptcy the bonuses paid to executives over the past 7 – 10 years should be paid back.

    The real problem is that the money paid to bankers is often paid on annual results. Risk taking can pump up those results for years at a time. Then, it hits the fan and the bank goes under or needs to be bailed out. However, all that bonus money (and it is often an obscene amount) is kept by the executives who took the risks.

    The EU limits bankers’ bonuses. The Bank of England has the right to “claw back” bankers’ bonuses for 7 years.

    Of course, in the United States, the bankers and other special interests control our government. So, don’t hold your breath waiting for the government to regulate the risk taking of the banks they explicitly and implicitly guarantee.

    1. TooManyTaxes Avatar

      Agree with the claw-backs. Also, any company bailed out by taxpayers should have compensation restricted for its officers and management until the bailout has been repaid. Officers must be limited to the ES schedule and other employees to the GS schedule. Further, such companies should be compelled to display a statement that taxpayers have bailed out the organization on all company communications, including advertising and marketing pitches, pending repayment.

  3. Progressives seem to understand the utter failure of the Obama Administration in the matter of banks being too lightly regulated and “too big to fail”. They just can’t force themselves to criticize The Chosen One. Hopefully, these same progressives won’t be so timid when it comes to questioning Ole Private Email herself.

    “Avoiding another meltdown depends on the will of federal regulators to use the new powers they were granted in the Dodd-Frank Wall Street Reform and Consumer Protection Act,” said Jennifer Taub, author of the report and professor of law at Vermont Law School. “If they behave as if they are beholden to the banks, we will likely face a more severe crisis in the future.”


    Please note LarryG – bank regulators don’t work for the House of Representatives.

  4. larryg Avatar

    I thought Obama was in favor of Dodd-Frank, no?

    and in not mistaken – haven’t several big banks just been fined billions of dollar for their behavior during the meltdown?

    And hasn’t the US gone after UBS for their swiss bank accounts?

    so let’s be more specific – especially Mr. Bacon who lays out the issues but fails to get to specifics – like whether or not regulation is needed or not and if so – what kind.

    but also note – that we have over a trillion dollars a year in tax-expenditures – enough to pay off our deficit and buy down the debt and do you know what those tax expenditures are for?

    Number 1 is employer-provided insurance.

    and when Jim wants to talk about disrupting markets – he might focus on this one – because not only is State and Federal tax exempted – so is FICA tax.

    but’s it’s the rest that seldom gets addressed that is the real market disruptor:

    1. – the govt REQUIRES all insurers who provide employer-provided health insurance t not deny people insurance – they have to accept everyone .

    2. = not only that – the second rule is that the insurance company cannot charge more for a specific individual health status.

    these two things along – completely disrupt the health care system in the United States… and totally screw up the idea of “risk”…

    but to list out some more tax breaks:

    1. – IRA/401K income exemption
    2. – mortgage interest – no matter how many houses, rvs, second home and
    huge values – exempted – rather than one median-price home…
    3. – carried interest – stepped-up interest – billions of dollars in assets exempted from taxation…

    quite a few others…….. including college loans and charity deductions.

    now on to ethanol and crop subsidies

    and subsidized flood insurance for million dollar vacation homes…

    if we’re go

    1. TooManyTaxes Avatar

      Tax breaks for ordinary people would not be as necessary to protect if the constitutional amendment had been passed in its original form – an income tax not to exceed ten percent.

      1. larryg Avatar

        Flat Tax or Fair Tax – TMT? Isn’t the flat or fair tax essentially a change from a progressive tax system to where the tax rate is the same no matter how much income ?

        The reading I’ve read indicates that the tax burden would shift to the lower income earners and it would be far more than 10% – in fact far more than the current rates.

        perhaps I misunderstand…

        now BEFORE Don’s and the ” we already pay too much damn tax” folks weigh in – consider this chart:


    2. Obama supports Dodd-Frank but doesn’t enforce it? Typical.

      Banks pay fines with shareholder money. It wasn’t the shareholders who tanked the economy. It was the bankers. George W Bush put corporate miscreants in prison. Obama lets them pay with other people’s money. If his hands were any deeper into the bankers’ pockets he’d feel their socks.

    3. virginiagal2 Avatar

      Hi Larry –

      It is absolutely not accurate to state that requiring that employers who provide insurance (1) insure all of their employees, and (2) charge the same amount for each employee of a specific subscriber type (individual, individual plus one, family) screws up risk or disrupts the health care system.

      I don’t know how familiar you are with how health insurance is priced, but from your comments, I’m guessing not very.

      First, and pretty much speaking for itself, the employer insurance market is pretty healthy. It’s the individual policy market that has problems.

      Second, for group health insurance, risk is not measured at the individual level – it is measured in risk pools . The whole concept of insurance is to spread risk over time and many individuals, not to simply pay the claims of an individual during a short period.

      Third, for groups over about 50-100, the insurance company is almost always simply administering claims – the actual risk and funding is taken BY THE EMPLOYER and the premiums are based on THE ACTUAL PAYMENTS MADE PLUS ADMINISTRATIVE FEES.

      The insurance company also takes out reinsurance for claims over a certain amount, as those are rare, which reduces considerably the risk of any individual employee having very high claims. It’s a small charge, per subscriber per month, to insure against the risk that particular subscriber will get a very expensive problem, purchased from what is essentially a finance company.

      Employer based insurance does work, quite well. It works far, far better than the individual insurance market.

      Part of the reason is that the people in the risk pool are primarily people healthy enough to work, and part of the reason is that pretty much every employee gets insurance, so you have a wide and diverse risk pool.

      A claim that this screws up the health care system is totally untrue.

  5. larryg Avatar

    If Obama is not enforcing it then why is the GOP and the Heritage and the Competitive Enterprise Institute calls it the new ObamaCare?


    so which is it Don? Is Dodd-Frank a good thing or not?

    here’s a recent Bloomberg Article:

    Obama Seeks More Money for Agencies Enforcing Dodd-Frank Rules
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    (Bloomberg) — President Barack Obama is making a renewed push to boost funding for Wall Street’s top cops after regulators said budget constraints were keeping them from enforcing rules put in place after the financial crisis.

    The funding requests for fiscal 2016, released by the White House Monday as part of a broad spending proposal for the federal government, would raise the Securities and Exchange Commission’s budget 15 percent to $1.7 billion. The Commodity Futures Trading Commission, the main U.S. regulator of the $700 trillion global swaps market, would get a 29 percent increase to $322 million.

    The requests, which require congressional approval, set up a fight with Republican lawmakers who’ve resisted Obama’s past efforts to provide more money for agencies responsible for implementing the 2010 Dodd-Frank Act. Republicans now control both chambers of Congress and have made revising the financial-regulation law a legislative priority.

    Okay Don – so there you have it Would you like to revise your statement about who is for and who is opposed to Dodd-Frank?

    Whenever one of the right-leaning think tanks release a new report castigating regulation – Dodd-Frank is always their number one target and next the EPA…

  6. larryg Avatar

    Next up – on the issue of Government Subsidies – Flood Insurance

    Headline: ” Map changes mean more Portsmouth homes will need flood insurance”

    The City Council approved amendments to its flood ordinance Tuesday to comply with federal regulations, which means more homes will need flood insurance.

    The same homeowners might have to raise their homes 3 feet above the expected floodwaters.

    Premiums for a single-family, one-story home that sits 4 feet below the expected floodwaters could cost $9,500 a year, according to a Federal Emergency Management Agency document.

    Norfolk-based Wetlands Watch reported an average cost of $162,500 to flood-proof a home in Norfolk by elevation. In Virginia Beach, that cost is $185,000.
    Those who will be affected by the map are new-home builders or owners of homes with damage.”

    these kinds of changes are affecting every city on the coasts of the US and will over time – dramatically change the value of property – as well as the revenues to the city that accrue from taxing property.

    The more these flood maps are updated – the more widespread the impacts.

    We talk about the idea that people know better what to do with their money than the Federal Govt does – as a rational for not taxing people.

    What could be more unproductive for spending of one’s money than trying to maintain a building in a flood zone where insurance costs are many time the taxes on the house?

    A similar scenario is now playing out in Okalahoma and Houston and locales where floods are occurring a heights never before seen – and the Govt will be re-drawing flood insurance maps accordingly.

    Keep in mind when we talk about govt subsidies and risk – that the private insurance market – long ago – decided that insuring buildings near waterways was too risky for them and that’s when the govt got into the business.

    The govt has a more compassionate policy that private insurance has. Private insurance just refuses to cover a property and that’s it. No insurance, no mortgage.

    The govt policy enables people to get a mortgage. It also gives them one bite at the apple – i.e. if you get flooded, you get the money -but no more insurance for that site. You can take the money and pay off the mortgage and move or you can plow the money back into the property and risk – essentially bankruptcy if you are flooded again but the fiscal damage is not isolated to the homeowner – it extends to the jurisdiction that uses tax revenues to provides services.

    What new FLood Maps do – is kick off a series of lowered valuations for tax purposes, in turn, leading to a cut in services, and/or an increase in taxes on houses not subject to flooding – and – eventually people leaving the area who cannot afford the increased costs of living in a place that has floods.

    This is going to get repeated over and over all up and down the Coasts of the US and the real irony here are the Climate Skeptics who say the “fix” would be more expensive than the damage…. and the obvious question is – is that true give what we are starting to see right now – with the simple redrawing of flood maps and the govt’s policy towards subsidized insurance?

    Perhaps an even better question would be – what if the Govt gets out of the subsidized flood insurance all together. Then what?

    who would pay for the flood maps then? what would various localities choose to do about flooding if the Feds did not impose rules? What would the private mortgage market do in areas subject to flooding with no standard Fed govt rules for building or insuring?

  7. larryg Avatar

    How about we get the govt out of employer-provided health insurance since it clearly has a huge regulatory impact as well as significant disruption of risk and markets?

    my point?

    we’re not serious about the issue. If we were – we’d address all of these things not just the ones we want to talk about and ignore the others.

    The top 3 tax breaks – employer-provided, retirement savings and mortgage interest – are 400 billion – enough to wipe out the deficit.

    but more than that – each of them has a slew of govt regulations that subsidize and disrupt markets…

    yet, whenever we hear from folks like Heritage, CATO, ALEC and the Competiive Enterprise folks – they never talk about these things.

    Ditto with so-called “conservatives” who decry subsidies and govt regulation and govt disruption of markets – … just crickets chirping on these 3 tax break/market disruptors.

    so .. what can we say about Conservatives and their anti-govt mantra these days when they just completely ignore the 3 biggest tax loop-holes with a rats nest of regulation and market disruption?

  8. Cville Resident Avatar
    Cville Resident

    “Socializing the losses”, what about “socializing the gains”? Here’s the deal: I don’t have any problem with the current system. Why? Because the “profits” are socialized as well. Without these guarantees, do you realize how much lower all of our standards of living would be? It’s not just “bankers” who get rich from the “bailouts” “guarantees” etc. It’s you and me. Banks use this leverage and implied bailout to fund loans to new and existing businesses. Those businesses make money (off the back of the guarantees, hypothetical bailout) b/c they can actually get credit at a decent rate. Stockholders of these businesses are benefiting from this as well (dividends, equity growth). If you’re a “stockholder” of J&J or any publicly traded company, you’re getting those “privatized gains and socialized losses” yourself. Your investment (J&J) benefits enormously from the credit environment offered by the banks. The banks wouldn’t offer anywhere near the great terms they do today if they weren’t allowed to “leverage” or have “guarantees” and implied bailouts.

    Also, as consumers, we benefit (privatized gains, socialized losses) from the leverage, guarantees, and implied bailouts too in the form of lower prices, easier consumer credit, and products/services that are created by the corporations due to the easy credit.

    As I posted a couple of weeks ago…today’s economy is simply too difficult for most to understand. The best analogy I can give is a Jenga tower. Everything’s connected, if one piece goes bad, the whole things goes bad. We’re not in an age of isolated banks, businesses, consumers, etc. no matter how much the idiots in the Tea Party wish it was so…. It’s simply not “It’s a Wonderful Life” anymore (which is probably how 75% of this country views finance to this day). I don’t even understand a lot of global finance, and I read the Economist and WSJ’s very good pieces that try to explain some of these intricacies.

    But I imagine most Americans, if they could even understand the choices, would prefer the high standard of living afforded by guarantees, leverage, and implied bailouts compared to how our society would look otherwise….

    And if you think somehow that you avoid boom/bust without “guarantees” “bailouts” etc….All I can say is that you don’t know history. America was a laughingstock of global finance before Wilson’s Fed in 1913. The boom/busts were epic and the British (and the Morgans) implicitly rolled their eyes at how American banks and the economy was so fragile when the fundamentals were so strong. It was obviously due to the fragile banking system that had no guarantees/bailouts/regulators/etc.

    I’d advise reading about the Panic of 1837, or the Cleveland Administration, or Chernows great biography of the House of Morgan if you think the current system is bad.

    1. Cvile, is that really the choice — either the system we have today, with its massive moral hazard, or the pre-regulatory banking system of the 19th century, without any safeguards at all? I think you’re creating a false dichotomy.

      1. Cville Resident Avatar
        Cville Resident

        Well…..”it depends”…..on your thoughts on world gov’t. It wouldn’t be the choice if there was a global financial regulator with enforcement powers. But as we’ve seen since the early 1990s, with the enormous improvements in information technology, finance is globalized except for regulation. So, if you want to play “the game”, you’ve got to play the entire game. Very few are going to purchase your financial services (banks) if you don’t give them the ability to do what all of their competitors are doing.

        It’s no secret that everyone involved in finance (banks, i-banks, regulators, etc.) will tell you that the world needs a global finance enforcement/regulatory mechanism. That may give you more policy choices as you posit. But as the system currently stands, it’s awfully hard to say “our nation’s banks won’t do X” when the rest of the world is offering that leverage and their governments are willing to give an implied backstop. Money/business is too fluid nowadays. Look at what a joke “currency controls” have been in the last 20 years….again, it’s about the same issue: sovereigns aren’t sovereign over money/finance any longer. Look at what isolation from global finance has done to everyone in recent years: Venezuela is a poster child. The only way that finance regulation can really work is through a global mechanism. Otherwise, as we’ve seen in the past 20 years, it really is “a wild ride.”

        I don’t know. This is just my opinion. Maybe the U.S. can isolate itself and maintain a robust financial system. But I, for one, just don’t see it as a possibility. We benefit so much from the current system that any “pullback” would be pretty devastating. Most people have no idea how much value the dollar gives us as the world’s reserve currency. If we start to “pull back” from the leverage game on our own, I would imagine the dollar’s standing would plummet and a lot of us would suffer in a lot of ways (higher interest rates, less innovation and research funding, lower corporate profits, fewer loans for businesses, cars, etc.). Again, it’s that Jenga puzzle that globalization creates….one piece has such a big effect nowadays….

      2. larryg Avatar

        You make some good points – and you did not even bring up bitcoin which is already causing huge impacts – not recognized.. not well reported.

        but there is a 3rd choice between nation-only regulation in isolation and global regulation and that is global standards for finance.

        when the US banking system went down it had global impacts and if other countries banking systems go belly up -they can affect other countries also as we see with Greece and the EU.

        I had brought up mortgages before and will again – to illustrate a couple of things:

        1. – The banks in the US figured out how to profit from that moral hazard in part because the US held different parts of the risk –

        2. – not every country – in fact, most do not have mortgage deductions – Canada did not and was not affected directly but was affected collaterally.

        3. – a little off the central premise – but giving tax breaks for mortgages and not rentals (or none for either) is part of what drives some to buy single family detached … and essentially consider their home an accumulation of wealth rather than other methods.

        you can socialize risk – look at the OECD health care – everyone pays for insurance that pays the costs of the unlucky… and it works much more efficiently than our system which seeks to shift costs on others.

  9. larryg Avatar

    what I sort of got out of that but your probably did not in tend was:

    “everything is interconnected and if you change anything you risk breaking the entire system…”

    sometimes I need “explanation for dummies”… 😉

  10. larryg Avatar

    I’d be curious to know how folks feel about the export-import bank.

    It seems to have divided up along partisan lines..

    but who has thoughts on the issues?

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