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Consequences of the Crisis

Assessing the Legacy of the Great Financial Tempest

One Year After Crisis, "Too Big to Fail" Banks Have Grown Even Bigger

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David Cho
Washington Post Staff Writer
Friday, August 28, 2009; 11:00 AM

Washington Post staff writer David Cho was online Friday, Aug. 28th at 11:00 ET to discuss where things stand on Wall Street almost a year after the credit crisis.

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As he reports in Banks' Growth Alarms Regulators, firms that were "too big to fail" have grown even larger and more interconnected.

A transcript follows.

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Fort Worth, Texas: Thanks for covering this issue; this is an excellent article. Here's my question: Why is there no substantive debate on stronger anti-trust legislation? It appears to me that the fundamental problem with too-big-to-fail is that financial institutions were permitted to grow so large in the first place. Rather than heavily regulating banks that grow to a certain size, why not simply prevent any institution from growing to such a size that it damages competition? Why hasn't this been part of the discussion? There is very little indication to me that anything other than business as usual is taking place in Washington and on Wall Street.

David Cho: There are a few economists who believe that the big banks should be broken up into pieces. Something like this happened in the telecommunications industry back in the early 1980s.

Most regulators say this would be difficult to do for a financial firm due to the complexities of its business. Senior Obama administration officials do not want to be involved in complex management decisions that should be left to private actors.

At the very least, however, you make a salient point. There isn't enough substantive debate on anti-trust issues in the financial industry. In my interviews, I found that many senior government officials were not following the impact on consumer issues, though Sheila Bair of the FDIC was an exception.

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Laurel, Md.: Before we even start, are you a columnist paid to have opinions or a reporter who doesn't?

It makes a difference if you're going to answer every advocacy question with "There are many people who think that."

David Cho: Thanks for the question. I'm not a columnist, nor am I trying to advocate for any side in this debate. I find the moral hazard problem a fascinating topic, however.

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Reston, Va: If the end-game is to have a handful of firms capture an entire market sector, then isn't capitalism itself defeated since competition becomes only an illusion?

David Cho: That's exactly the concern here. You can't have a free market if the government continues to favor big firms over small.

The senior regulators explained to me that they did not want to bailout the big banks, they felt like their hand was forced. The implication was this is a one-time deal.

They are hoping Obama's regulatory reform will bring free-market competition back into the financial industry. But it won't be easy. Even if the plan is approved by Congress, regulators would have to determined precise capital levels for the big banks. This is very difficult to do. Some economists said the implementation of the regulatory reform plan will be like trying to contrive a free market system, rather than allowing it to develop on its own.

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Ellicott City, Md.: Great Story! Please keep them coming.

Where do you see the regulatory reform legislative reform process going?

Sheila Barr seems to have Bill Seidman's brains and guts without the crippling ego. Will she be able to force true reform, not just some window dressing to appease the public as a way to cover up the return to business as usual?

David Cho: The regulatory reform process was moving full steam ahead earlier in the summer, but it has slowed down a bit as lawmakers have grappled with various parts. The House may not get to it until after health care reform. But I think Congress will eventually pass some version of the proposal.

The plan, which was primarily crafted by Tim Geithner and Larry Summers, does have some teeth. The consumer protection regulatory agency does have a lot of Wall Street banks worried. And adding more capital requirements to the big banks will help.

Sheila Bair, however, has been crusading about the too big to fail problem and is one of the leading voices on the issue. But she is wary of one part of the plan which gives the Federal Reserve the power to oversee broad risks to the financial system.

Some have criticized her as being too territorial since the Fed could cut into her agency's influence a bit (she's the chair of the FDIC). But she certainly is a crusader for regulatory reform.

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Washington, D.C. : Hi,

Thanks for the chat on this often overlooked issue.

At what point does some trust-busting need to happen for banks? Had these banks gone through bankruptcy as Lehman or other financial companies have, the good parts would be lopped off into separate businesses, and the bad parts would die.

We saved the banks to protect the financial system, not the status quo. Is there any hope of breaking these companies up?

David Cho: Good question. I think there is little chance that the government will try to break these companies up. They are just too complex. And officials worry that the government will simply be trying to contrive a free market rather than allow it to develop on its own. Besides, who would you do this for? Just the top four banks? Just the top ten?

Bear Stearns, for instance, was not a big firm. It was simply interconnected in a lot of markets, so the government bailed it out. You'd have to figure out exactly who is too interconnected to fail, which is not an easy thing. Plus the systemic importance of firms could change very quickly over time.

I agree with you that the bailouts were infuriating, since these big banks caused a lot of the problems. Regulators say the alternative would have been much worse. They argue that we would have seen a repeat of the Great Depression.

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Philadelphia, Pa.: I recall learning about the interconnectedness of banks back as a Wharton student in the 1970s. What many people did not know what that most major banks had sizable stock holdings and ownership in each other. Thus, the banking industry stands strong as one, and can also tumble as one. How much ownership do major banks have in each other today?

David Cho: Banks are probably more interconnected than ever before, but not only because they own stakes in each other. There's now a shadow banking system in which hedge funds, pension funds, mutual funds, and virtually every other pool of money borrow and lend to banks all over the system. It's hard to even trace it all.

Financial experts call this "counterparty risk," that is the risk that one of your many partners, or the partners of your partners, could fail. That could cause a chain reaction of failures across the system.

This risk was a reason why officials felt they had to bail out firms such as Bear Stearns and AIG.

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Belfast, Maine: Less than a year ago we were hearing that we were possibly on the verge of another Great Depression. Was all that talk alarmist or have we just witnessed a miracle recovery?

David Cho: Very good question. I covered the crisis since the beginning of 2007 when subprime mortgages began to cause trouble to the system. Last year, when Lehman Brothers failed and even safe money market funds were collapsing, I thought a depression was possible. I mean if funds that were supposed to be as safe as deposits couldn't keep afloat, the country's financial system was in bad shape.

But it's hard to argue about what could have happened if the government didn't bailout all those banks. It's just not a satisfying answer. It's certainly not a politically feasible one.

One final note: There hasn't been a recovery... yet. Unemployment is going up. The economy is still shrinking. Consumer confidence is down. There is NO miracle recovery. All that has happened is the risk of a catastrophic failure of the financial system has passed. We are beginning to see the signs of the recession ending, but we haven't yet seen a recovery.

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Austin, Texas: "Meet the new boss, same as the old boss"

Where is any meaningful reform to prevent the same risk-taking by financial institutions that put us in this mess?

David Cho: Yeah, it's easy to be skeptical of what regulation can do given the phase we just witnessed.

Geithner told me that the administration has proposed several steps which I laid out in the story. In my view, the most important are higher capital reserves for big banks and the proposal to give the government the ability to take over and wind down a financial firm's businesses in an orderly manner.

The reason this proposal is important is because during the bailouts, none of the creditors of the banks saw any losses. If the government was given wind-down authority, these creditors could be penalized heavily. That makes a big difference in the market's perception of whether firms are too big to fail.

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Boston, Mass.: Who up on the Hill is representing the interests of the consumer regarding the financial community? There aren't too many Senators/Congressmen who are independently wealthy and/or in such strong positions electorally that they can refuse the campaign finance support and influence from the very large banks/insurance companies/etc. or withstand campaign ads against them.

David Cho: There are several lawmakers fighting for the creation of a new consumer financial protection agency, which is one of the core proposals in Obama's reg reform plan. But the industry and their allies on both sides of the aisle are opposing the idea.

The agency would have real teeth -- it could write new consumer rules and enforce them. Wall Street lobbyists have told me that they plan to go to the mattress on this proposal. They are really worried about it, which demonstrates how much power this new agency would have.

But I think too little attention was paid to what the consequences for consumers would be when the emergency mergers were arranged by the government last year.

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SW Nebraska: Opponents of regulation, much like opponents to health-care reform, will bring fear into the equation. Maybe they will say that Obama is nationalizing all businesses and no one will be able to profit from their work. Have we become an oligarchy where corporations and the monied class have all the power to manipulate the fearful? Yeah, I'm really depressed over the way health-care reform has gone.

David Cho: Yeah, there's no question that consumers have a harder time lobbying on major issues like health-care reform and regulatory reform than big banks and big insurance firms which can donate a lot of money to politicians and get face time with them.

But at least in health care, the town-hall meetings appeared to make a big difference. In regulatory reform, the big banks do appear to be making strides in convincing lawmakers that the nation does not need a new consumer financial protection agency.

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Cameron, N.C.: As far back as I can remember, history classes about the early 1900s celebrated the trust busting Teddy Roosevelt. Over the past few decades I wondered how it was possible that all these large corporations were merging with or buying out competitors. In my naivete I thought that those in charge were vetting the process. I now understand that the trusts were back, and that the regulators were in the pockets of the corporations. My question is how do we get our country back from the robber barons? Where is Teddy's successor?

David Cho: I don't know if Teddy has any successors today. The financial industry is so complex that many of those that regulate the industry come from the industry because they are the only ones with the expertise to understand what's going on.

The staff at the Treasury's bailout, for instance, largely came from banks.

I agree that there was too little vetting last year when the government was arranging the mergers of big banks. But I also understand that they were under intense pressure to save the system. We came very close to a complete meltdown last year. And the actions taken last year probably helped the global financial system avert that danger.

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washingtonpost.com: The moral hazard issue is indeed interesting, because it seems it's not really quantifiable or measurable. Is there any way to grasp the true pervasiveness of this attitude, and how can Geithner and others even begin to change it?

David Cho: It is difficult to quantify. But the lower lending rates of big banks is probably the best measure of moral hazard. If you think about it, why should a small retailer have to pay more for the same merchandise as a big one? No small shop would survive. That's exactly what's going on in the financial industry right now.

I think the regulatory reform plan being promoted by Geithner may help the problem, but it may be difficult. I'm very curious to see how they will engineer the new capital requirements for big banks -- it's really tough to get these right. You could end up tipping the balance of the market even more in favor of big banks, or do the opposite. Neither is ideal.

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Rockville, Md.: "Something like this happened in the telecommunications industry back in the early 1980s."

And one of the parts (SWB) gathered nearly all the parts back and is now AT&T - again.

David Cho: Very good point. We certainly went through a long period of de-regulation in several industries, including telecommunciations, energy, and financial services. As I've looked into why this happened, the answers aren't all encouraging. There was a lot of lobbying and special interests involved.

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Chaska, Minn.: You know your biases are showing here. You seem to assume free market = no rules and regulations. The free market did quite well after the Depression with lots of sensible rules and regulations. Its only been the deregulated eras that have produced the bubbles that caused huge instabilities and abused and now a near total meltdown of the financial sector.

Logically it make sense. What would an NFL game look like without rules and referees? What extremes would folks go through to win?

Yet the financial sector with billions of dollars at stake is somehow immune to self interest, greed and fraud. Yeah, right.

Break up those companies. It would keep these Mega-corporations from gaming the system. It would allow competition to thrive instead of being stifled by Monopolistic practices.

It's time to admit the best way to keep capitalism healthy and productive is put real rules in place and enforce them. Yes and limit the size of the corporation. Companies that dominate a mature market space and squeeze out viable competition through price manipulation, manipulating legislation to capture market share, etc.... are not free markets they are captured markets.

David Cho: On the contrary, I think the financial crisis demonstrated that free markets cannot exist without smart rules and regulation. Those that promoted that view, for the most part, have admitted their errors. I think it was significant that Alan Greenspan confessed he had a flaw in his world view -- he assumed that firms could police themselves.

When markets have no supervision, it's clear they can go wild. It's not a matter of more or less regulation. You have to have a smart regulatory system. We don't have that now.

You have five banking regulators, each with different rules, overseeing the financial system. You have nobody looking at derivative markets which are much larger than the stock markets. There are too many holes.

You can't solve this by making the rules tougher. You've got to redo the regulatory system in my view.

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Boston, Mass: You have to give President Bush and the government a lot of credit. A year after his TARP program was maligned by Republican partisans all over the media, the TARP plan is showing a 10% return, and has collected over $7 billion in dividend payments. It took guts to buck his party and do the right thing, but will anybody stand up and give him his props?

David Cho: I think most economists would agree that the TARP was effective in averting a major financial catastrophe. In covering this rescue on a daily basis last year, I observed, however, that the White House was hardly involved in the rescue effort. It was mainly Hank Paulson, the Treasury Secretary, Ben Bernanke, the chair of the Fed, and Tim Geithner, who was, at the time, the president of the NY Fed. Those three really were this decade's iteration of the committee to save the world.

In fact, many republicans were angry with Bush for supporting the bailout last year because it supposedly violated the views of pure free market advocates. But Bush did push hard to get the TARP legislation passed last year, and I think most financial experts who understand the danger we were in would give the former president props for those efforts.

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Dallas, Texas: So what has been done to curb derivative trading with regular deposits?

It's my understanding that one of the issues was that banks took general deposits and effectively made very risky investments with them. I can see a fund dedicated to doing this, but when I stick my money in the bank, its supposed to be safe, and I would think organizations like the FDIC would want to ensure that as well. If I am wrong please correct me. Thanks.

David Cho: Derivative trading was largely not done with ordinary retail deposits. But the administration's regulatory reform plan does propose forcing all derivative traders to hold more capital -- that would help them cover any potential losses. In the past, many of these traders borrowed money to trade. When they saw massive losses, they couldn't pay back their creditors. That caused a lot of problems for big banks, too, which had partnered with these guys.

The administration's regulatory reform plan also proposes to have nearly all derivatives trade on open exchanges, rather than within the "shadow banking system" that exists outside regulation.

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Hedgefunds: How much regulation will we see regarding hedgefunds? These seem like the thrifts in the late 80's or junk bonds.

And even if hedgefunds become regulated, will we just see a new Wild West banking tactic develop? It seems likes there's always some complicated banking vehicle born out of a legislative loophole exploited by Yale graduate so-and-so T. Rockefeller the III.

David Cho: If the administration's reg reform plan passes, all hedge funds would be required to register with the Securities and Exchange Commission. Big funds would have to submit to oversight to a new systemic risk regulatory.

I hear you on the Wild West concept. That is a real possibility, given the ingenuity of modern financiers. The administration wants the Fed to become a systemic risk regulatory and to have the empower to oversee any new market or product that develops. But this will require the Fed to be very vigilant over seemingly minor developments.

The central bank's record on this regard is mixed. They certainly had fewer failures on their watch than virtually any other bank regulatory. But they missed the boat on subprime mortgages which was partly their responsibility.

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Chaska, Minn.: You keep saying its so complex. Basically that is an attitude for doing nothing. Basic study of history says all this has happened before and we can fix it by following historical precedents. Trust busting should be the new mantra to usher in an era of prosperity for all.

David Cho: Well, it's not just that it's only complex. It's tough to determine WHO you would break up. It's possible, but you would certainly be contriving the market, rather than allowing it to develop on its own. It's not certain that breaking these firms up would be better than the administration's reg reform plan because smaller firms that are just as systemically important as big firms would not be broken up. And you'd still be left with the too-big-to-fail problem.

Besides, there are benefits to having big firms. In a crisis, the government relied on them to take over ailing banks in order to avoid a collapse of the financial system. What the government is worried about is that its implicit guarantee of these firms because explicit. That's the definition of having firms that are too big to fail. As soon as the government guarantees became explicit, it skewed the market in favor of the big. That's what's led to all kinds of problems.

Separate from that, however, I do observe too few officials are worried about the anti-trust implications of the mergers of last year. It's something that bears watching.

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Silver Spring, Md.: I just don't see how anyone can look at the U.S. economy over the last 70 plus years and say we've had a "Free Market" during that time? Seems a complete misrepresentation of the term.

David Cho: It's a good point. In my view, our markets exist on a spectrum of regulation. At some points we've swayed toward having less regulation; at other points we've gone the other direction. Certainly in the past decade or so, we saw a massive movement toward the former. Most economists now agree that the financial system went too far in deregulation -- even Alan Greenspan who oversaw that effort acknowledged its shortcomings.

I think the financial crisis demonstrated that the free markets need to continue, but with smarter regulation. This isn't an argument for quantity of oversight, just a smarter system.

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RE: Your Response to Reston, Va: Don't many regulators want a job in the "private sector" and might that desire cloud their judgment in performing their regulatory duties? How else could you explain the likes of Enron and Bernie Madoff getting away with their nefarious activities for so long?

David Cho: Yes, it does happen a lot. In fact, Jim Lockhart, who used to oversee Fannie Mae and Freddie Mac, is now headed to a distressed asset shop. Many Bush officials are working at financial firms. The compensation at these firms is just too great not to turn offers down.

And certainly firms like Goldman Sachs have placed a lot of their crew into top jobs -- just look at Rubin, Paulson, or Corzine to name a few examples.

There are exceptions, however. Geithner never worked at a Wall Street firm and Ben Bernanke came from Princeton's economics department.

But I agree with you. Paulson, for instance, never directly addressed his feelings about bailing out Goldman Sachs, the firm that made his career.

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Wokingham, U.K.: This is terrifying. We rushed to save the banks, they responded by living as dangerously as before only more so. The next time it won't be possible to save them or ourselves - will it?

David Cho: It's a BIG worry. Every regulatory I talked to said it's at the top of the list of issues that needs to be fixed. Folks like Geithner and Bernanke are pinning their hopes on the administration's reg reform plan. But it's far from clear whether this will fix our too big to fail problem.

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Silver Spring, Md.: "I think the financial crisis demonstrated that free markets cannot exist without smart rules and regulation." Not sure I agree. Yes, the Federal Government did "deregulate" a bit during the 1980's-90's. But it left in place access to easy money (low interest rates provided by the Fed) and promoted the idea that the Federal Government wouldn't let these firms fail. That led to the moral hazard. A Free Market would let the market set interest rates (which certainly would have been higher) and firms would have had to perform well in order to survive. Thus fewer firms would have taken such incredible risks. And those that did would have suffered the consequences, making room for other, smarter firms to take their place.

David Cho: That was the prevailing theory behind the deregulation of the last ten years or so. But even Alan Greenspan acknowledged a "flaw" in that worldview, which he held for many years. He didn't realize that the competition for yield would drive a race to the bottom and put all big financial firms and their shareholders at risk. He admitted that the accountability measures in the free market system proved to be a weaker disincentive for recklessness than he thought.

One other note, the market does not set interest rates in the U.S. The Federal Reserve does. It was Greenspan's Fed that left interest rates at near-zero for a year, which provided the fuel for the boom.

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Washington, D.C.: Wouldn't a simple way to help fix the too big to fail problem be to implement a bailout tax? What if you charged 10% of gross revenue of banks with over x billion of turnover and scaled that back to 0% for banks under a certain size? You could also eliminate deductibility of bonuses for banks too big to fail, that would allow smaller banks to get access to "the brightest and the best."

David Cho: A version of this thinking is in the administration's reg reform plan. It proposes putting higher capital requirements on big firms, reducing their ability to invest with leverage (borrowed money), and requires them to pay higher regulatory fees than small banks, among other measures.

The problem is who you stick into this category of big firms. Some analysts feel that if you identify who gets hit with these measures, you are basically announcing to the world that these firms are big enough to get a government guarantee. In this way, you've only exacerbated the too big to fail problem, not solved it.

That's why moral hazard is difficult problem to solve.

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Evanston, Ill.: Why are those on the economic left (who normally deride market efficiency) so adamant for mark to market while those on the economic right (who normally preach perfect market efficiency) so opposed to mark to market? Is this an example of politics over economics?

David Cho: You could be right.

What's interesting about the architects of the bailout -- Paulson, Geithner, Bair, Bernanke and others -- is that they appear to have a strong belief in both free markets and regulatory reform. Paulson, for instance, did not want government making decisions that should be left to private bankers. He has been opposed to nationalizing banks outright, for instance.

And yet when it came to Citigroup or Bank of America, he went ahead and took those firms over for the sake of saving the financial system.

This group very much appears to be pragmatists above anything else.

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Mooresville, N.C.: Is there no prospect of establishing penalties and punishments for the entities and individuals that create these financial disasters? I am agog that financial institutions and their leadership can so blithely feed from the bonus trough after putting the nation on the hook for their collective greed and stupidity.

David Cho: It's definitely infuriating, no doubt about it. Obama's reg reform plan essentially penalizes banks for being big. But that doesn't get to the actors who got us into this mess in the first place. Some of them have joined firms that buy distressed and are making money as the financial system recovers.

And certainly the furor over executive pay on Wall Street, sparked by the bonuses paid by AIG, is fading.

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D.C.: ...and the sad part is the proposed Obama plan would make "too big to fail" banks even bigger. Once you have a list of TBTF institutions, their borrowing costs will decline, since neither this administration or the last were willing to let debtholders take losses. This decline in borrowing costs will more than off-set any additional regulation, allowing these TBTF firms to gain market share and under-cut their rivals. All only pretty much guaranteeing further bailouts. we don't need more fannie and freddie's.

David Cho: Yeah, this is an issue. And a lot of economists are worried about this "list." Geithner told me in our interview that it's mort important, however, to impose higher capital requirements on big banks than to keep the list secret. He said everyone in the markets will be able to figure out who is TBTF anyway, so why keep it secret?

An ever bigger problem, however, is what capital requirements you impose on the big banks. How do you determine the precise level?

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Kensington, Md.: There is already an "anti-trust" rule in place, and that is under the Bank Holding Company Act, no BHC can control more than 10 percent of retail domestic deposits. The idea is that no huge entity that fails takes with it the liquidity of a massive number of citizens.

Under the current pseudo-crisis, you might note that depositors were almost entirely unfazed. That is low-risk, liquid assets (deposits) are completely intact.

A previous commenter is completely incorrect about the exposure banks face from each other and even internally. There are strict rules about this to prevent prevent say some sort of affiliated insurance company form bringing down the retail banking side of an organization, and BHCs cannot play some sort of "shadow ownership" game by holding large amounts of stock in each other.

Anyway, the simple rule of thumb is that no financial entiy should ever be allowed to have a balance sheet larger than than the Fed's (in normal times). Logical. Right befor the crisis, BofAs balance sheet was somehting like 4-5 times larger than the central bank's. Lunacy. If this simple rule is fllowed, the Fed would never have ot make any sort of drastic, outrageous moves (in proportion to its own assets) to save a particular entity.

David Cho: All good points. During the crisis, however, the BHC rule on 10 percent deposits was waived. The DOJ's anti-trust guidelines were also waived, largely because the government felt it needed to arrange these mergers to prevent the system from collapsing.

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David Cho: hey everyone, thanks for chatting. Terrific questions today. Keep following our series on the consequences of the crisis. We've got some good stuff coming.

If you have more questions feel free to email me at chod@washpost.com.

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Editor's Note: washingtonpost.com moderators retain editorial control over Discussions and choose the most relevant questions for guests and hosts; guests and hosts can decline to answer questions. washingtonpost.com is not responsible for any content posted by third parties.


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