Lehaman Brothers and Washington Mutual Show Too Big to Fail is a Myth - A Myth that Prolongs the Recession and Retards Growth
David G. Tarr
August 23, 2010
Many economists have argued that it is necessary to reorganize big banks that require sustained subsidies or are close to insolvency. By wiping out the shareholders and giving haircuts to bondholders, the resulting reorganized banks will be financially sound and capable of leading the country out of recession. But there are fears that failure of large financial institutions, especially a key player in the counterparty operations, will cause systemic financial market failure, and they are therefore “too big to fail.” However, when Washington Mutual failed, it was 6-7 times larger than the previous largest US bank to fail; it was placed into FDIC receivership and reopened literally the next day as J.P Morgan Chase, with account holders having full access to their deposits and bank services. When Lehman Brothers went bankrupt, it was the third largest user worldwide of credit default swaps for mortgage backed securities. But the Depository Trust and Clearing Corporation (DTCC) serves as a “central counterparty” guaranteeing all contracts traded under its auspices. The DTCC unwound all of Lehman’s credit default swap holdings within four weeks with all parties receiving payment on the terms of their original contracts, i.e. there was no systemic impact from losses on the Lehman credit default swaps. Moreover, while the DTCC indicates that it and its subsidiaries process about 95 percent of all swaps, in order to assure swaps are covered by clearing guarantees, the new financial reform law requires all eligible swaps must be submitted for clearing.
Number of Pages in PDF File: 8
Keywords: too big to fail, credit default swaps, counterparty operations, financial crisis, bankruptcy, bank failure, bailouts, bondholder haircuts, receivership
JEL Classification: G00, G1, G2
Date posted: January 8, 2010 ; Last revised: August 28, 2010
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