Changing Market Perceptions of Who is ‘Too Big to Fail’ During the Financial Crisis of 2007-2008

The government support of financial firms through direct assistance and programs to improve market liquidity during the worldwide financial crisis of 2007-2008 is unprecedented since the Great Depression. Whether a given firm is ex-ante ‘Too Big To Fail' in the mind of government agents is not the principal issue for moral hazard, however. It is investor perception of ‘Too Big To Fail' that drives the economically inefficient reduced funding cost for the firm. This work examines the U.S. government's crisis actions as well as two international bank bailouts in a series of event studies employing both debt and equity returns. Other than in the case of private mortgage insurer, Radian, in response to explicit support of Fannie Mae and Freddie Mac, I conclude that only the largest of the banks and the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, already perceived to be recipients of explicit or implicit government guarantees, experienced any ‘Too Big To Fail' premiums in their debt securities. There is no evidence that these premiums extended to other large financial firms such as broker dealers, non-mortgage insurers or surety firms, in spite of the bailout of Bear Stearns. There is no evidence that letting Lehman Brothers fail was a surprise to investors. In addition, there is no evidence that AIG's large derivative exposures and their associated losses prior to and during the crisis led investors to infer it would be rescued. Federal Reserve programs to improve liquidity and extend lending to non-banks did not lead to ‘Too Big To Fail' premiums for firms