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KEITH HENNESSEY, DOUGLAS HOLTZ-EAKIN, AND BILL THOMAS 

TWO TYPES OF SYSTEMIC FAILURE
Government policymakers were afraid of large firms’ sudden and disorderly failure
and chose to intervene as a result. At times, intervention itself contributed to fear and
uncertainty about the stability of the financial system. These interventions responded
to two types of systemic failure.

Systemic failure type one: contagion

We begin by defining contagion and too big to fail.
If financial firm X is a large counterparty to other firms, X’s sudden and disorderly
bankruptcy might weaken the finances of those other firms and cause them to fail.
We call this the risk of contagion, when, because of a direct financial link between
firms, the failure of one causes the failure of another. Financial firm X is too big to
fail if policymakers fear contagion so much that they are unwilling to allow it to go
bankrupt in a sudden and disorderly fashion. Policymakers make this judgment in
large part based on how much counterparty risk other firms have to the failing firm,
along with a judgment about the likelihood and possible damage of contagion.
Policymakers may also act if they worry about the effects of a failed firm on a par-
ticular financial market in which that firm is a large participant.
The determination of too big to fail rests in the minds of the policymakers who
must decide whether to “bail out” a failing firm. They may be more likely to act if
they are uncertain about the size of counterparty credit risk or about the health of an
important financial market, or if broader market or economic conditions make them
more risk averse.
This logic can explain the actions of policymakers in several cases in :

• In March, the Fed facilitated JPMorgan’s purchase of Bear Stearns by providing
a bridge loan and loss protection on a pool of Bear’s assets. While policymakers
were concerned about the failure of Bear Stearns itself and its direct effects on
other firms, their decision to act was heightened by their uncertainty about po-
tential broader market instability and the potential impact of Bear Stearns’ sud-
den failure on the tri-party repo market.
• In September, the Federal Housing Finance Agency (FHFA) put Fannie Mae
and Freddie Mac into conservatorship. Policymakers in effect promised that
“the line would be drawn between debt and equity,” such that equity holders
were wiped out but GSE debt would be worth  cents on the dollar. They
made this decision because banking regulators (and others) treated Fannie and
Freddie debt as equivalent to Treasuries. A bank cannot hold all of its assets in
debt issued by General Electric or AT&T, but can hold it all in Fannie or Fred-
die debt. The same is true for many other investors in the United States and
around the world–they assumed that GSE debt was perfectly safe and so they
weighted it too heavily in their portfolios. Policymakers were convinced that