Tuesday, April 20, 2010

More on Moral Hazard

This is a follow up to this: http://tfideas.blogspot.com/2010/04/public-losses-and-private-profits-step.html

Another friend responded:
"I think something is wrong with your use of 'nationalization.' The British nationalization of RBS and Northern Rock was basically to demand controlling equity from the most distressed banks (RBS & NR) in return for bailouts. That's what Krugman is talking about. It most definitely did not crater the British economy depression-style. I'd say more the problem is the government as owner has been too passive and left too much of old management in place."

I responded:

That's what Krugman now claims to have talked about. That is not what Krugman was talking about [though controlling equity is pretty close to nationalization anyway]- I listened to his speeches and read his blog through the entire crisis, as painful as it was to listen to his blathering. [I cite links later in this post] He advocated the government stepping in and taking over Citigroup and BofA, and changing the managements directly.
The British example is a bit different... Europe's banks in general (I believe including Britain) actually were much worse off than the US banks were. Britain didn't have as much of a choice of what to do - for a number of reasons - but it's still a much crappier outcome. Setting aside for a moment the political pressure to be populist rather than intelligent in your lending decisions and bank policy, it dilutes the ownership of existing shareholders, and subjects them to a de facto government management with way less experience and incentives that aren't profit-related. More shareholders flee, driving down the value and requiring more government capital. You'd require way less government capital if you distance yourself from the actual management of the firm and just set the incentives right.

The US substantially did this - they took large common and preferred equity stakes in the heavily bailed-out firms (they still own some ridiculous percentage of Citigroup and GM, for example), just without major management interventions. They didn't walk in and try to reorganize the place themselves because they didn't want everyone who was still employable elsewhere to leave (then the banks would NEVER turn around). They also gave the bank an avenue for buying out the US government when it was able to stand on its own two feet again, which the British mechanism, I believe, is having more trouble with, though you're welcome to correct me. The securities pay a rate way above market - the government is in fact extracting its piece of flesh, as it should be, which is why the government is a) getting paid back at a much higher rate than anyone thought, and b) is actually $10 billion in the black on the bailouts. In fact, it's looking more and more like the only government bailouts that WON'T be profitable in the very end are GM and Chrysler, whose bailouts were more political than actual. AIG is the farthest away but the CEO promises it'll happen, and they're making progress. In sum, the US bailouts have been way smoother than Europe's for the most part, and you'll see them continue to outperform for a lot longer. Again, Geithner's direct interventions have been largely magnificent - how often do you hear me say that about a politician?

Also, I don't know why you say the government has been too passive in punishing managements - almost all the firms the US took into true receivorship had the majority of people leave (remember the AIG bonus debate? The part nobody realizes is that almost every recipient of a bonus had left between the payout of the bonuses and the announcement because they saw the writing on the wall.). The US had significant trouble getting anyone qualified to take over firms they took into receivorship (Fannie, Freddie) because nobody wanted to get paid half the amount to "manage" a company with perverse political incentives and get blamed for running it into the ground. In those cases, the firms threw out the babies with the bathwater in cleaning house, both intentionally and unintentionally. The more responsible companies (Goldman and JPM, etc) don't need their managements changed from the top-down; they were fine from the get-go.

You can't just wipe out GM's upper management because nobody would have any experience and nobody would know exactly what the company had and didn't have. The banks are 10x as complicated as GM. You'd just kill the company. There have actually been some great case studies done that show that the vast majority of successful CEO transfers of power come from within, because so many people from without don't have a great sense of what makes the company tick. There are exceptions, certainly (Alan Mullaly at Ford has been the best thing to happen to Ford in 50 years) but you don't really want a "clean house", more of a shift in thinking.
His response:
Hmm. What I took Krugman's argument to be was that the government should send a warning to the managements of banks by firing the top management when a bailout was required. In other words, punish both management and shareholders to avoid moral hazard. In general, I think the problem with what Geithner's done is that he hasn't done anything to prevent 2008 from recurring in 2018. So it looks good now, but it might end up going bad unless the regulation reform really changes the game.
Re: Britain, the big problem they had wasn't relative strength of the banks, but that Britain doesn't actually have an FDIC. So you could have a 30s-style bank run on retail banks in the UK. Nationalization had to both protect the London financial system and the depositors. [A decent point, I hadn't thought of it.]

It'll be interesting to see what happens with the FDIC-equivalent in Dodd's reform bill because of the risk of a big systemic crash. Would they really have been willing to wind down Citigroup, AIG, etc. in 2008 even if they had the authority?
I responded:
This is a hodgepodge of reactions I had to your email. There's a few parts of it, feel free to skip what you're not interested in.

1) Krugman's temporary nationalization plan, which is also relevant to the British plan.

2) Geithner's progression of steps (rescue to repair)

3) What we should be looking for specifically in the financial reform "next step" to Geithner's plan

4) More on Krugman and moral hazard for managements

5) Balancing dynamism with safety in any sort of financial system overhaul generally.

1) Management punishment was a critical component of Krugman's argument, though it wasn't even close to all of it - his plan was to wipe out functionally everyone - shareholders, management, and a large number of the creditors - if the government had to step in so that the government gets basically all the upside along with the downside. He understands that this means the government functionally takes over the whole system via the crowding-out mechanism from above, and he's fine with it, largely because he underestimates the difficulties associated with the government pushing out all private backing (that's more consensus than provable fact). The level of train wreck would have been incredible. Have you watched Iceland at all? As a quote posted on someone's blog, "Iceland's last wish: to have its ashes scattered all over Europe." Their system was in much worse shape, they didn't have much of a choice, but they're in a boatload of trouble. Their currency has collapsed to the point where McDonald's actually pulled out of the country because they couldn't offer food cheaply enough to be competitive.

2) Geithner's solution wouldn't yet stop a 2018 crisis because his solution isn't done yet - Geithner very rationally went about this with the idea of "fix the problems now, prevent future problems once we're out of the woods - it's not like they can really get themselves into many new messes in this weak a state anyway." That's exactly how moral hazard in this situation should be treated, and China notwithstanding, that's probably a reasonable assessment of the banks' situation for the last year and currently. We all want all the solutions laid out at once, but that probably wouldn't have been good - especially not if it were discussed publicly, because people would still panic - a particular criticism of a progressive "remake the world in one go" mindset. The next step - financial reform - will hopefully correct some of the issues for next time, as long as people can avoid the idea of "punish for past" and focus on "prevent for future" (doing both isn't easy because often the ideas are opposed - for example, with a bank tax). It's hard to know how successful that'll be because there are so many proposals for financial reform floating around that nobody knows what'll end up in it. If they do, I certainly haven't seen it.

3) In case you're interested in how I'll be judging that next step, I think I really like pre-funded bailouts and living wills - i haven't spent a ton of time working through the consequences, they'd have to be structured so they don't encourage banks to rely on them (perhaps once the fund is used, banks can't book any positive earnings until the pre-funded bailouts are replenished?) - and I really do think an accelerating bailout tax would be good, though I've never seen anyone promote it other than me. I like that flash trading was banned because it was unethical, I think the short-sale uptick rule should come back, I think mark-to-market rules need reforming, I'd love to see some way of reducing high-frequency trading. Putting things on exchanges if possible is not the panacea everyone thinks but it is a useful step in cases. I think "too big to fail" is stupid and potentially harmful, and the idea of capping bank size or splitting big banks will worsen things, not improve them. Tighter capital regulations will be very hard to implement well, because they often have some sort of unexpected negative consequence (Basel II capital regulations reduced the number of banks that took junior equity slices of the products they created because it made them not count in the capital structure, even though the bank having a junior piece made the actual structuring of the products more risk-averse). A pure transactions tax or a bank tax seems to have perverse effects and could even work to worsen crises. Oh, and while I'm playing judge and jury via email, this SEC investigation into Goldman looks initially like a very weak and possibly politically-motivated case based on early details, and I'm surprised that they chose this molehill as a basis to attack Goldman instead of the actually unethical drama over how Goldman helped Greece hide its debt.

4) And because I'm not done with Krugman (again, hodgepodge, sorry):

just searching for "nationalization" on krugman's blog yields all of these:






among many, many others - i got sick of copy and pasting.

However, this one stands out:


The banks in fact did earn their way back to adequate capital ratios, which wouldn't have been a given under nationalization.

Punishing management is fine as a threat ex-ante, because it changes behavior for the better. Enforcing a clear threat is reasonable. Implemented after the fact with no warning beforehand, it just drives talent away from the firms that need it most. Not everyone at Citi or Lehman, etc. is an idiot. You'd be cutting off your nose this time for no particularly good reason - it's clear you're going to change these rules for next time anyway.

5) Finally, and most generally, the notion that "another collapse like this" can be avoided is questionable, no matter how you structure regulation. There will always be irrational people making bad decisions (the banks in this case), there will always be a few unethical people trying to make a quick buck (the predatory lenders/mortgage brokers like Countrywide, and a bunch of the "houseflipping" consumers), people will always be overoptimistic about their ability to pay (consumers more generally) and the government will never focus perfectly (both Congress and the Fed over the last decade). This happened in the tech bubble, this happened in the junk bond mania of the 80s, this happened in mergermania in the 60s, this happened with stock trusts and all that in the 20s, it happened with Dutch tulips, it happened in Japan in the 80s, it happened in Spanish real estate concurrently with us, it happened in Dubai, it's happening in China right now... it's hard to have a dynamic economy that isn't prone to some sort of excess.

It raises the question of how far you should be willing to go to avoid this type of collapse. You could bring the US back to the banking system of the early 1800s and never have a bank collapse, but you'd probably end the US as a dynamic economy in the process - both because of reductions in credit availability and risk hedging/risk management, and also because the decline in the money supply to tighten capital controls would implicitly just end up being some absurd asset tax (the government functionally would be issuing a 1 time tax of 75% of assets across the economy - it's not direct, but to print the money that's what would happen).

The availability of credit from post WW1 til 1929 or 1980-something til now has fueled a lot of very real growth that wouldn't have happened in a more regulated, less dynamic regime. It lends itself to collapses like we had now, but that doesn't mean we're better off than we would be if we hadn't had that expansion and partial collapse. The US did a lot of growing and credit spawned a lot of very worthwhile innovation, and when we recover, it will hopefully continue to do so. Even Japan, the worst case scenario (which I don't believe will happen to us because of structural differences in the ratio of consumption : investment - maybe to China moving forward?), I don't think they'd trade their 60s, 70s and 80s growth to take back the last 20 years of stagnation. They still need to fix their economy (and they've done an awful job of it) but avoiding that bubble probably would not have been optimal. Paul knows more about this than I do, I don't know if he's still reading. That's something not enough people pay attention to with financial reform.

You want some sort of cost-benefit analysis - how do we minimize the size and impact of a collapse without sapping the system of its dynamism. There are certainly improvements to be made, but a conservatism (in its most literal sense - conserve the parts that have been working, which is most of it) is useful. Focusing only on minimizing downside isn't necessarily the smartest system, either.
(btw, decent point on the FDIC equivalent. Hadn't realized that was the case. I'm guessing Britain probably implements it, and the US probably increases the cost of FDIC insurance. There are other structural reasons why much of Europe nationalized but my specific knowledge of Britain is far more general than yours, I'm guessing.)

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