Bailouts on the Big Sur

Extinguishing forest fires is like bailing out banks. Like accumulating twigs on a forest floor, bailouts build up trouble in the banking system.

If you want to get from San Francisco to Los Angeles and you have a bit of time to waste, the road to take is Highway 1.

Highway 1 is the scenic route: it’s windy, windy, and narrow. It has cliffs, sea fog, big sunsets, and stinking-rich little towns such as Carmel and Santa Barbara.

Last week I was flying down said highway near Big Sur in a rented convertible without a care in the world, when I started to notice something a bit rum:

What was with all the emergency services? Why were all the exits on my side of the road blocked? What about the weird smell? And why were the hills visibly on fire?

I was lucky to get a place to stay for the night – the forest fires forced my original hotel to shut up. I found somewhere further up the coast. It was genuinely a bit scary. The place stank of smoke and I could see fire marshals dropping into reception every half hour or so with the latest news.

The fire on the Big Sur coast this year was a big one. It took about a week to get it under control, and the receptionist at my hotel said it had at that point destroyed 40 homes.

The thing about forest fires in places like California is that, for understandable reasons, the authorities try to extinguish them as soon as possible. Lots of people live on the edge of huge forests. So the fires are a big threat to their life and property.

But the other thing about forest fires is that they’re a natural part of the ecological cycle. I spent a week up in the High Sierra Mountains in King’s Canyon National Park. Up there, you could clearly see how fires fit into the landscape. The big Redwood trees are sort-of fireproof. They have thick sturdy trunks and tough bark. And fire clears the seedbed on the forest floor.

Here’s my not-very-clear photo of a charred, lightning-struck redwood tree:

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In King’s Canyon National Park the forest rangers have gotten wise to this natural cycle. Nowadays, their policy is to allow fires to burn wherever possible.

But forest fires aren’t such a big problem in the National Parks. They’re a problem in places like the Big Sur coast, which is full of trees and full of people.

To protect life and property the fires on the Big Sur coast are suppressed. But suppressing forest fires messes with the natural cycle. It causes more dry, dead twigs to accumulate on the forest floor. And eventually, it results in a giant fire that can’t be controlled. Like the fire I came across on the Big Sur coast.

Bonds = kindling

So, to my point: surpassing forest fires is like bailing out banks.

In the moment, it seems like a smart move for a government to bail out [Northern Rock / Anglo Irish / Continental Illinois / Long Term Capital Management / AIG]. Bank bailouts are a pain, but they’re less painful than the alternative which is a financial crisis. When faced with a financial crisis, governments have invariably gone with the bailout option. And like accumulating twigs on a forest floor, bailouts cause trouble to build up in the banking system.

After a couple of bailouts, the precedent is set. The markets get wise. Investors in bank debt learn that bank debt always gets repaid, even if a bank goes bust.

That’s how giant banks, already levered up to their necks, were able to fund themselves in the run up to the 2008 crisis. Investors basically offered them free money, because the investors knew it was a one-way bet. If the bank stayed solvent they’d get paid back by the bank. If it didn’t, they’d get paid back by the government.

As for bank CEOs, they were under pressure to take the free money. Chuck Prince, the CEO of subsequently-bailed-out-Citigroup said in 2008 “As long as the music is playing, you’ve got to get up and dance.”

In America, the first big bailout was the Continental Illinois Bank in 1987. Then there was the Mexican Peso Crisis in 1994. Then Long Term Capital Management in 1998. And then 2008.

It seems to me that the genie is out of the bottle now. No government can credibly promise it’s not going to bail out a stricken bank in the future. Since that’s not possible, tough bank regulation is the only answer.

Regulations and capital requirements have gotten a lot tougher since 2008, and that’s to be welcomed. But in Europe, you can see a crisis is coming. Some of the smaller banks in Italy are already in serious trouble. Bigger Italian banks, or perhaps even Deutsche Bank, could be next. Bailouts are on the way.

It was a gloomy thought as I wound along the curves of Highway 1. But such is the lot of a financial writer.

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