Way Too Big to Fail

When they say too big to fail, they're not kidding. The federal government today announced a bailout of Citigroup, including $20 billion in direct investment (on top of $25 billion) and $306 billion in loan guarantees. For those keeping score, the federal intervention in Citigroup alone totals 2.5 percent of U.S. GDP.
How did this happen? Good question. The New York Times offers a revealing look at how basic management oversight failed at Citi:

In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.
There, Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.
Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.
For months, Mr. Maheras’s reassurances to others at Citigroup had quieted internal concerns about the bank’s vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup’s huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.
Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.

I don't know how much these gentlemen were paid last year for their role in destroying the world financial system. I would guess that their compensation packages rewarded them for taking on such scary levels of risk without regard for the consequences.
The idea that that markets would keep everyone honest without the need for internal or external oversight has certainly been discredited. Last month, Alan Greenspan himself acknowledged that his benign view of magically self-correcting financial markets was wrong:

I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms," Mr. Greenspan said.

As for how to keep this from happening again, I find myself returning to the principle Floyd Norris proposed two months ago in his column in the New York Times:

Allow me to propose a simple principle that the next president and Congress could follow as they devise a new financial regulatory regime to replace the one that failed so badly: If an activity is important enough to justify a government nationalization to prevent a default, it is important enough to be regulated.