Tuesday, April 20, 2010

Public Losses and Private Profits? A step-by-step explanation of Moral Hazard

From a friend:
"The Banks on Wall Street came back roaring... with robust profits in the quarter.

The Government did make money on the investments it made in rescuing them.... but of course, nowhere near the amount to compensate for the $$ spent to rescue the economy.

Welcome back to the world of public losses and private profits,  heads I win, tails you lose.  Now that the market is back.... guess who's taking home the profits? 

Not the taxpayer. Moral hazard avoided? Hell no.

This would have been averted if the government took a direct equity stake, dollar for dollar, and recapitalized the banks as necessary  (as Krugman and others were arguing for)"
My response:
a) it's accounting profit, not real profit, because they over-recognized losses in the last couple years so they wouldn't need to take writedown after writedown. On a cash basis they're still way below anything they ever saw before the crisis. See here:  http://tfideas.blogspot.com/2010/01/media-incompetence-aigs-necessity-and.html . It walks through an example of precisely how it can look like banks are making lots of profits when they're actually still taking massive losses in any sort of economic sense.

b) The $ spent to rescue the economy is not all on the banks - we would have had a recession anyway, the question is how deep, and OPEC is a significant contributor to it as well.
c) Krugman and his supporters are backpedaling off of the nationalization position as fast as possible because as time has passed it has become more and more apparent that it was very, very dumb. It probably would have cratered the US economy, in the great depression sense. Krugman has come out and denied that's what he meant - seriously. Geithner handled TARP extremely adeptly, and nationalization could not have exceeded what happened in its best case scenario. Although there's no way of checking this, I'd bet dollars to donuts nationalization would have been way, way worse. Here's why:
Moral hazard has become the buzzword of the crisis, and thus is being used in every single context of reform right now where perhaps it shouldn't be. Moral hazard, for those of you who don't spend a ton of time on this, is the idea that if you create a safety net, it makes people act less responsibly. The best example is car insurance - if you have car insurance, you drive less carefully than if you didn't because you know someone else is picking up the losses. It's been observed in the driving context, it's been observed in unemployment (you work less hard to find a job while you still have unemployment benefits, with a spike in effort 2-3 weeks before they run out), it's been observed in health insurance (obesity and smoking rates are actually higher among the insured than the uninsured), and, in certain cases, it applies to financial firms. The best case I can think of is Long Term Capital Management in the late 90s.
The problem, however, is that it's never particularly appealing to apply measures to combat moral hazard when the recipient is in the state where he/she needs help. Nobody wants to deny the unemployed guy unemployment benefits, nobody wants to deny the guy with a heart attack health insurance, etc. This is entirely understandable. The better way to apply anti-moral hazard measures is when times are still good - make it clear that they won't be reimbursed if things go sour, and they'll be more careful to ensure things don't go sour.
That's the first problem with the "moral hazard" movement - they're trying to yank the health insurance from the guy just as he begins to need it, so you get the worst of both worlds - the guy lives unhealthily because he thinks he's covered, and then has to pay out of pocket when he really needs the help. It is undoubtedly better to bail out the banks than not bail out the banks, because not bailing out the banks collapses the country. You just don't want them to get into a situation where they need to be bailed out. Thus, applying "anti-moral hazard" mechanisms when they're weak (as they still are) is cutting off your nose to spite your face.
Deniz's response will be (and should be) "what about using them as an example so it doesn't happen next time?!". I'll come back to that in a second, because it's usually true to some extent, but there are some unique factors that apply to banks.
The major difference between a bank and a guy driving a car or eating badly is that banks can sometimes get into situations where they're all riding the same wave. If Bertha gets into a car crash, it tells you almost nothing about whether Ursula will get into a car crash. There are many circumstances, however, where banks all are riding in the same figurative car, so when it crashes, they're all in trouble.
When this is not the case, Deniz is entirely right - Long Term Capital Management was an isolated case, and thus should have died to teach future people a lesson. However, sometimes they really are all in trouble at once. Of course, just because they're all in trouble doesn't mean they're all in equal trouble - some (Citigroup, for example) were more irresponsible, while others (Goldman, for example) were far less irresponsible, which is apparent in their respective conditions.
The other unique feature of a bank is that a bank is entirely worth what people think it's worth. This is a weird concept.
If every person in the world decides Coca-Cola is a crap company and it's going out of business, and they all sell Coca-Cola's stock, it doesn't really matter (as long as Coca-Cola isn't trying to raise money). Coca-Cola will keep selling Coke until everyone realizes "wait a minute, they're not so bad after all", the equity will come back, and Coca-Cola will still exist as a company just as strong and vibrant as before.
However, a bank is a special case - a bank is worth only what its shareholders and creditors think it's worth. If every bank shareholder decides a bank is worth nothing and sell the stock down to 0, then the credit gets downgraded, it needs to come up with a lot of money to fill out its legally-obligated ratio of "cash to loans of each type" etc, and if it can't do that, it dissolves. Bear Stearns failed for this reason - it was weak, and maybe it would have died anyway, but Bear was still profitable when it failed! Usually a company can go for a long time being unprofitable as it borrows against its assets - think of how long GM has sucked and how long it took for GM to finally hit bankruptcy... Bear hadn't even turned unprofitable yet, but because everyone was worried it would, it died. That's the risk of being a bank - you're subject to sentiment as well as reality.
I hope a thought is beginning to crystallize as you're reading this: "If all the banks have the exact same problem, and the first one isn't rescued, then people lose confidence in the rest of the banks, and they all die". And yes, that is exactly the problem.
Hank Paulson, Bush's treasury secretary, would have gone down as the second worst treasury secretary of all time (Andrew Mellon, Great Depression) if he hadn't come up with TARP, for this reason: he let Lehman Brothers fail, making it quite clear that anyone who bothered to buy common equity - basically, normal stocks - would not be protected. I actually know a coalition that had been involved in trying to save Lehman Brothers 4 months before the government stepped in by providing common equity. They were wiped out. You'd better believe that when they were asked to do so again for another bank after Lehman Brothers failed, they declined, and the FDIC had to step in.
Thus, people stopped putting money into the common equity of banks. Then Paulson prematurely seized Fannie and Freddie (they may not have died at all), but to make things worse, not only did he wipe out the common equity, he wiped out the preferred equity - another kind of stock these things sell, making it clear that anyone who bothers to provide capital to banks through preferred equity would lose their shirt. Two weeks later, he wiped out WaMu, and not only cratered the common and preferred equity but half the creditors, too - you couldn't even lend money to a bank in debt form and have any confidence that it would be repaid. The next day, the corporate bond market froze and the stock market lost 25% that month. The seizure of GM and wipeout of the creditors there (which was so drastically unnecessary and favorable to unions at the expense of creditors that I believe it's in court now to see if it was unconstitutional, and it's at least a 50/50 chance that it was) just reinforced that not only the banks will be crushed, but everyone else, too. The entire market seized up. (This, btw, was all before unemployment even started rising, so you can blame a sizable chunk of unemployment on Paulson's attempted enforcement of the moral hazard principle).
Thus, when you enforce moral hazard on one bank, and all the banks are in the same boat, you basically tell people, "don't support the banks cuz you'll lose your shirt if they get into trouble". You ensure that the government then has to step in for EVERY bank, which is way, way more expensive than just bailing out the most irresponsible banks.
As you can see, moral hazard works differently in a collective system than in an individual-by-individual system.

So how do you make sure it doesn't happen again? You need a way of ensuring the banks don't get themselves into trouble without throttling them and making it impossible to provide credit. You also have a situation where regulators can't even begin to figure out how to do that effectively.
 My solution was an "accelerating bailout-outstanding" tax. Basically, anyone is welcome to a bailout if they need it, but the longer it takes them to repay it, the higher the interest rates get (and the faster they rise). Many companies don't need to take a bailout (JP Morgan, Goldman, etc). Many would need one but just because the market cratered, not because they were especially irresponsible, which means that as soon as the market comes back a little bit they can repay it (a large, large number of banks right now). Really, really irresponsible groups won't be able to pay it back early, end up paying colossal interest rates after a few years and die when they can't pay it back. However, presumably, their deaths will have been long since understood by the market, and they'd be dying during stronger conditions, so you don't rock the boat too much by letting them die.
By doing this you avoid the need for regulators and the Congresspeople who control them to actually understand what bubbles are going on (Sen. Phil Gramm argued in like February 2000 that deflating tech stocks was dumb and they were undervalued, not overvalued. Rep. Barney Frank argued in 2006 that it was ok for Fannie and Freddie to take a little extra risk in subprime mortgages because affordable housing was really important and it wouldn't have significant negative consequences anyway.). You also ensure that companies in general work to not become the most irresponsible member of their group, which kind of ensures everyone's in a reasonable bound.

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