Only One Domino Needed to Fall: The Interconnectedness of the Financial System

One of the fun things about the financial crisis was getting to see how interconnected everything was. Bear Stearns had to be saved because it had so many counterparties, though it was a smaller investment bank. Lehman should have been saved under the same sort of criteria, but the Fed didn’t step in and let it go bankrupt. What that meant was that even though the collapse had been going in slow motion from the summer of 2007, with Bear going under in the spring, unless you were really paying attention the financial crisis didn’t really start until mid-September.

The interconnectedness is because debt doesn’t exist in a vacuum. You borrow money, yes, but you borrow it from someone. That means that the debt you owe is sitting on someone else’s books as an asset of theirs. As long as you are making payments on that debt, the people you owe money to are receiving a revenue stream and it is working as anticipated. The problem starts when the debtor cannot make those payments anymore. Not only is the borrowing institution in trouble, as well as their capital holders and depositors, but so is anyone that has lent money to that institution. Bad debt can be passed on so that the lender who stops receiving their payments on the assets they hold, in turn can be seen as risky in whatever debt they hold. The more linkages like this, the worry stops being about the individual institutions but the system as a whole.

This is why back in there was a vocal and passionate minority of people who just wanted to see everything crash, echoing Mellon’s supposed words to “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system.” The problem is that everything would have failed, creating real human costs – and no politician facing reelection anytime soon wants to see real human costs for people in their districts. As amazing at it seems, this meant that the response was to reward institutions and the people who ran those institutions that had gambled with the stability of the system by recapitalizing those very institutions. In one of the most egregious instances, we can look at the insurance company, AIG. One small arm of AIG, their financial products division run by Joseph Cassano sold credit default swaps to everyone. All the people who bought these as insurance products against default, went on with their business thinking they were protected. Alas, Cassano and company were not holding enough capital to pay off these instruments. They were taking the revenue stream people were paying and letting it go to the bottom line, but not holding a buffer. Like so much in the run up to the crisis, it didn’t matter if you were lying to your counterparties or our auditors or your regulators, as long as you were making money. But then asset prices start to fall, and these linkages start to really matter. Institutions that thought they were insured were not insured, and AIG finds themselves being insolvent because of this one division. What’s the regulatory response? Do you shut down AIG, send Cassano to jail for fraud? No! You bail out the company, essentially nationalize it, and then you don’t bat an eye when they pay out six figure performance bonuses six months later. Of course, it was a bad choice, but at the time it was a version of the least bad choice. Then you step back and then make regulation to try to make sure that the next time will be different.