...Archive for March 2009

A think-nugget from Arnold Kling inspires a very long riff…

Arnold Kling offers a very concise view of the financial intermediation:

[T]he nonfinancial sector would love to issue risky long-term liabilities to fund investments, while consumers would love to hold riskless short-term assets to maintain liquidity. The financial sector intermediates by holding risky long-term assets and issuing riskless short-term liabilities. The more the financial sector expands, the more long-term investment is undertaken in the economy.

In order for the financial sector to do its job properly, it needs to enjoy the right amount of confidence from the public. With too little confidence, the economy suffers from credit scarcity and insufficient long-term investment. With too much confidence, the economy suffers from bubbles and excess credit creation, followed by crashes.

I think this is an eloquent statement of a very common view. It also beautifully isolates the problem with how we have constructed financial intermediation.

I am certain it is true that the nonfinacial sector would love to hold short-term risk-free assets, especially if they pay a high return. It is also true that businesses that invest in real projects and seek to minimize financial risk would prefer to issue long-term liabilities that try to match payouts to lenders with expected project cashflows. However, this gap is not, in fact, intermediable. An intermediary that claims to offer truly riskless assets against investments in risky projects must rely upon subsidy, subterfuge, or both.

An intermediary can “add value” by reducing investors’ risk in comparison to disintermediated investment, by for example, investing in a better-diversified portfolio than an investor would. An intermediary can very effectively reduce liquidity risks to investors, again by since idiosyncratic liquidity demands are themselves diversifiable. But risk reduction via these techniques can never reduce risk to zero. In fact, investing via an intermediary can never alter the fact that 100% of invested capital is at risk — business performance is not uncorrelated and projects can fail completely. Also, usually idiosyncratic liquidity demand occasionally become highly correlated, due to bank runs or real need for cash. Statistical attempts to quantify these risks are misleading at best, as the distributions from which inferences are drawn are violently nonstationary — the world is always changing, the past is never a great guide to the future for very long. Fundamentally, the value intermediaries can add by diversifying over investments and liquidity requirements is very modest, and ought to be acknowledged as such.

Furthermore, if diversifying across operation and liquidity risk was the value provided by financial intermediaries, they should have largely been competed out of the business, as investors can buy and sell diverse portfolios of liquid securities as easily as investing in bank deposits, either constructing them directly or purchasing diverse vehicles, like ETFs or ABS.

So, what is the “value-add” of the financial sector? Let’s go back to Arnold’s think-nugget. Investors cannot, on their own, create short-term truly riskless assets that pass through the returns of risky and illiquid busines projects. So, we can see why there’s demand for banks: They do give the people what they want, on both sides of the funding equation. But, as we’ve already seen, in reality they can’t give the people what they want without subsidy or subterfuge. Either some truly riskless guarantee has to backstop both liquidity and solvency risk, or intermediaries have to lie and pretend that their assets are riskless.

Note that insurance is an insufficient means of squaring this circle. If a bank purchases private sector deposit insurance or liquidity commitments, that is an asset purchase that may reduce its overall portfolio risk, but that cannot eliminate it, especially during times when correlations run high. A private sector insurance policy is a risky asset. Governments can offer riskless liquidity insurance and insurance against the nominal (but not real) value of financial sector liabilities. But it cannot do so at “a market rate”. Government is structurally the monopoly seller of this form of insurance for assets denominated in the currency that it issues. Further, the risks it must insure cannot be actuarially priced without heroic assumptions — the distribution of systemic risk is nonstationary, the future is everchanging and extrapolations always break eventually. (It’s fair to say, however, that zero is too low a price.)

So how does the financial sector seem to offer risk-free assets against risky projects? I think “constructive ambiguity” is the right phrase. The government provides subsidies in the form of literally priceless deposit and liquidity backstops, but those are explicitly limited. Banks work to diligently to increase both the level of insurance and degree to which assets are perceived to be insured by becoming so large that social costs of a bank default on even notionally risky assets are thought to exceed the costs to government of paying out on insurance policies to which it never agreed. Even a very careful observer cannot tell a priori whether many assets offered are genuinely riskless or not, that is to what degree the risk-free status of bank assets is due to subsidy, and to what degree to subterfuge. But there is an ingenious tinkerbell aspect to the risk status of bank assets: If, with a bit of subterfuge, risky assets can be sold as riskless assets, then the social costs of default rise, since asset holders will not have privately managed the risk that the asset might fail. The increase in social costs created by a mischaracterization of a risky asset as riskless, however, alters the likelihood that an asset will be de facto insured. There is a game theoretic equilibrium, that works to the advantage of intermediaries and their customers on both sides of the funding stream, whereby banks offer assets in large quantities as though they are risk-free, and investors accept and treat those assets as risk-free, and by believing together in what is formally not true, they create costs to the sovereign so large if it is not true that the sovereign makes it true. This is an equilibrium, a predictable outcome, not an aberration. And it does happen all the time.

In theory, this is a repeated game, and governments might eliminate the bad equilibrium by committing to bearing social costs that are higher than the immediate costs of providing ex post insurance, in order to prevent the subsidy-extracting equilibrium from taking hold. That’s what people who’d like to see a lot of banks go bust due to “moral hazard” concerns think should happen. But, if governments are unable to credibly commit to accepting large social costs, investors, borrowers, and intermediaries will test them by trying to extract the subsidy of infinite insurance. In practice, it’s clear that governments have rarely been able to credibly commit to stick to the letter of their limited insurance commitments.

Alternatively, governments can accept the extraction of a de facto insurance subsidy, but supervise intermediaries to try to mitigate the cost of future claims. But that’s a difficult task, as all private sector actors, borrowers, lenders, and intermediaries, have an incentive to maximize the subsidy extracted from the state, and will collude in creative ways to do so. (Of course, eventually these actors pay taxes, but even if they are sufficiently far-sighted to consider that, the distribution of benefits from the extracted subsidy is not coincident with the distribution of expected tax liabilities or inflation costs.) As long as it is possible to create a situation where the social costs of failure imply a bail-out, creative financiers will work to capture the huge value of what is essentially an option on an entire macroeconomy (even a global economy).

So, what is to be done? Here are some suggestions:

  1. Eliminate the “constructive ambiguity” that permits private sector actors to offer apparently risk-free, instantaneously redeemable securities. Eliminate government insurance of deposits and all other assets except for direct obligations of the state. This is insufficient — AIG, for example, has extracted a very large bailout despite having never offered insured deposits, and there have been bank bailouts since long before formal deposit insurance. But banks’ ability to muddy the waters between explicitly guaranteed and other assets seems to facilitate the process by which investors naively or cynically confuse risky for risk-free assets. Banking crises are larger and more frequent than any other sort of financial crisis that compels a state subsidy.

  2. Keep financial firms small enough and sufficiently well compartmentalized from one another that a failure of one or several does not create social costs large enough to force a sovereign payout. Discourage portfolio correlation by creating a fiduciary obligation of independent evaluation that places agents who copycat or herd in jeopardy of investor lawsuits.

  3. When possible, disintermediate. Nonfinancial firms are subject to clear operational risks, which forces direct investors to manage risks privately. Risk-management by private investors reduces the social cost of failure that compels government bailouts. Nonfinacial firms sometimes succeed at extracting bailouts, but much more rarely and with a larger fraction of the costs borne by investors than when financial firms do so.
  4. Prefer equity to debt arrangements. All business risks must eventually be borne by investors. Debt financing concentrates enterprise risk among equity holders, and enables debt-holders to manage their investment risk less carefully. Risk-management by private investors reduces the social cost of failure that compels government bailouts.
  5. Vaccinate investors by maintaining some level of asset price risk. Governments should limit liquidity and promote short-term price volatility of risky assets, perhaps quite artificially, to ensure that investors are always provisioning to manage risk. Risk-management by private investors reduces the social cost of failure that compels government bailouts.
  6. Carefully ration risk-free obligations offered by the state. As Winterspeak likes to point out, states do not need to issue debt to fund themselves in their own currency. States can more equitably and transparently promote price stability via taxation than by borrowing and intervening in sprawling debt markets. Government debt ought not be viewed as loans to fund operations, but as a form of insurance offered by the state to private savers in strictly limited quantity, in order that people of modest means don’t have to perform the work and bear the risk of managing uncertain investments. Governments should strive to guarantee a near-zero, but always positive, real return on these obligations, permitting risk-averse savers to transport purchasing power into the future, but not magnify real wealth. Those who want a high return must do the work and bear the risk of achieving it. The state should not guarantee that.

I know that the political economy of these suggestions is, well, iffy. But one should never underestimate how much political economy considerations might change during the turbulence of a global financial crisis.

Update History:
  • 15-Mar-2009, 4:50 p.m. EDT: Fixed ungrammatical “so larger” that was embarrasingly quoted by Free Exchange. (Changed to a lovely “so large”.) Also eliminated an unwanted “if” in the same sentence (which had been caught awkwardly between two constructions.)

Trickle-up bailouts

This is a simple point.

Suppose the government is going to give away money to fix the economy. Yes, yes, I know. They are making “investments” and guaranteeing “undervalued” assets and all of that. But let’s cut the crap. They are giving away money on a vast scale. Even the Obamawonks estimate a net loss of 33% for every dollar “invested”.

So, the government is going to give money away to fix the economy. Consider three options: It can give money to the people who are owed money by troubled banks, for example by guaranteeing bank debt. That makes the creditors whole, but leaves banks and the debtors dangling on a fish-hook. We can keep giving money to banks, who will eventually find themselves reasonably capitalized (as long as the rate at which taxpayers supply net wealth is greater than the rate at which insiders steal or gamble it away). But that still leaves the people who owe the banks money high and dry, teetering between insolvency and personal bankruptcy.

Finally, we can give money to the individuals and firms that are in debt, so that they can repay the banks, which then become solvent as their toxic assets are made “money good”, which enables them to payoff their creditors.

We’re talking about the same amount of money in all three cases. But giving money to the ultimate debtors bails out three parties for the price of one.

Paul Krugman has speculated that one reason why World War II seemed to absolve the United States of its depression is that wartime austerity and inflation had cleansed the balance sheets of households and businesses. If we are bailing out various groups in order to jump start the economy, wouldn’t we want to repair as many broken balance sheets as possible on a per-dollar basis? Call it balance sheet bang for the bailout buck.

And don’t go all Rick Santelli on me about the injustice of paying for your asshole neighbor’s granite countertop. We are bailing out a banking system that served as a vast criminal conspiracy built around plausible deniability and limited liability. We are bailing out “savers”, who not only demand to be made whole by the government on risky loans they chose to make to banks for profit, but are smugly self-righteous about it, like it’s their “right” because after all they were the “prudent ones”. Of the three groups we might bail out, these crybabies and criminals are no more deserving than some nearly-broke bastard who believed his financial adviser, his banker, his mortgage broker, and the Wall Street Journal op-ed page when they told him that a cash-out refi was as good as money earned, and that granite countertops were a luxury that would pay for themselves. Don’t get me wrong — I’d rather we could bail out no one, just do a rip-off-the-band-aid kind of reset and let everybody take their lumps. But households and firms in debt are by far the most sympathetic villain in this horror show we wake up to every day.

In the end, it is households and firms that drive the economy, not financial intermediaries, and most households are not large net savers. If we’re going to spend large sums of money on bailouts, and we want an economy in which people have confidence enough to work and spend, and businesses the have ability to invest, why would we not give the same bail-out money to end-debtors, and let it trickle up to banks and their creditors, repairing broken balance sheets at every step along the way?

Reorganization vs. liquidation

Kevin Drum and James Surowiecki both take Richard Shelby to task for advocating “closing down” banks.”I don’t want to nationalize them; I think we need to close them,” said the Alabama senator. He wants to “bury some big ones.”

For the record, I agree. I think that both Surowiecki and Drum are not being fair to the good Senator. Here’s Surowiecki:

[I]t seems clear that what he’s advocating is liquidating these troubled banks—shutting them down, paying off the depositors via the FDIC or selling them to another bank (though it’s hard to imagine any other bank coming up with the money right now), and then selling off the assets piecemeal, with the proceeds going to pay off as much of the banks’ debts as possible. In this scenario, the banks’ shareholders would obviously get wiped out, and its creditors would also be forced to take a massive haircut. In effect, he’s recommending something like a more orderly version of the Lehman Brothers bankruptcy.

I don’t think that’s clear at all. The question of whether creditors other than insured depositors are paid off by the government is entirely distinct from the question of whether a bank in receivership should be managed as a going concern or liquidated. There’s little dispute that under any nationalization scenario, some or all uninsured creditors would have their claims guaranteed by the state. Whether or not to impose haircuts on junior claimants is a tough call, trading off moral hazard and justice against systemic stability concerns. But even saber-rattling moral-hazard fetishists like me acknowledge that we can’t force all creditors of broken monsterbanks to take the losses or debt-to-equity cramdowns they deserve. Sometimes you have to swallow and pay the ransom. But you don’t have to be nice about it.

Citi, for example, is a recidivist source of systemic risk (not to mention other corrupt dealings). Three times in three decades it has been on the verge of insolvency and required forbearance. Two of those three times, rather than being chastened, it became a turnaround story someone could gloat about. That shouldn’t happen a third time. Citi should be closed and liquidated. The bank should suffer the equivalent of corporate capital punishment, pour encourager les autres. Three strikes.

That doesn’t imply that creditors necessarily takes a loss. It doesn’t imply that all of its operating assets get sold for scrap, or even that all of its employees get fired. It does imply, first and foremost, that the brand goes away, that Citi, like Continental Illinois, becomes a historical cautionary tale rather than a gigantic but still scrappy comeback kid one more time. Secondly, the pieces in which its assets are sold must be small relative to the buyers, so that successor bits are put under the control of larger firms rather than representing mergers of near equals. Corporate culture matters, and some corporate cultures don’t deserve to survive.

Surowiecki has argued on a number of occasions that moral hazard concerns are overstated, that punishing banks usually fails to punish the agents who run banks, and the costs of being punitive outweigh any possible benefit. It’s worth pointing out that there are two sorts of villains: governments and creditors who make available funds without supervision, and the bank employees who steal and squander that money. I agree, unfortunately, that we can’t be as punitive towards creditors as some of us would like to be. But we can deal more roughly with the people who run large banks aground. We have banking crises about once a decade. Each time, it is the same story: mistakes were made but lessons have been learned. Obviously, the bankers say, we would never do this again. Just as obviously they always do. They play the same basic game in subtly different ways.

In a different post, Drum points out that

The fact is that these people did what they did not because they’re stupid, but because the system practically begged them to act the way they did. That’s what’s broken.

That’s true, but it’s not exculpatory, and it isn’t anything new. Subprime loans and CDOs are just a new twist on traditional real-estate booms. European banks are reliving our Latin American debt crisis in Eastern Europe, just hypercharged. This is a nightmare that comes at us over and over and over again. Each time we’ve paid the ransom and shrugged it off.

Drum is right when he argues

[Fi]xing it depends mostly on what kind of new financial regulations we put in place going forward. I guess we’re still in firefighting mode and don’t have time to address that right at the moment, but I’d sure like to start hearing more about it sometime soon. In the long run, figuring out an effective way to regulate leverage, wherever and however it appears, is probably a lot more important than deciding which bureaucratic solution we should use to clean up the corpses currently littering the battlefield.

But you know what? Once the fire is out, the very powerful people who still run the show both on Wall Street and at Treasury, despite having misdirected and skimmed trillions of dollars, will resist structural change. I hope that we do the right thing, and quite sever the guaranteed deposit and payments function of banking from the business of taking investment risk that oughtn’t be guaranteed. That would eliminate the root of the problem, the incentive to take ever greater risks with funds supplied on risk-free terms. But getting rid of a huge subsidy to a well connected constituency is likely to prove difficult. If the structural changes don’t happen, I’d at least like to see a few of the architects of this mess disgraced, and the empires they built turned to dust. It won’t solve the problem, but it might buy us a decade or two. It’d be much better to create institutions whose incentives are aligned with the public interest. But if we can’t do that, we can at least counterbalance temptation with punishment. Neurotic banks are better than pathological banks. Consider it a kind of insurance.

If Drum is right that…

when it’s over, guess what? Pretty much all the same people will be in charge. A few senior executives will be out of jobs, but that’s about it. And the ones who replace them won’t be much different.

…then God help us. There is no amount of money we can throw at a banking system that can’t be “tunneled” or “looted” away. If we end up with similiar people, with a similar worldview and culture running broadly similar institutions, it won’t be long before the nightmare on Wall Street is back. No wonder Citi never sleeps.

We can pay off the creditors of these behemoths, because, by design, we really have no choice. But there’s no reason not to cut ‘em up and shut ‘em down after we do so. Let’s bury ‘em, Senator Shelby.

How to take back the money

Justin Fox has been asking how we might make the miscreants pay (and here). I have two ideas to throw out.

My first thought is an old doctrine. If we could get the people who supposedly represent the people to formally acknowledge the insolvency of the institutions we are bailing out, there is a wide-ranging doctrine known as “fraudulent conveyance” that might help. Payments by a bankrupt firm during the period preceding the bankruptcy are subject to challenge and reversal, under the theory that preferential transfers by insolvent firms to some parties rather than others are inequitable. I don’t know, from a legal perspective, how far back and how broadly the doctrine of fraudulent transfer could be applied to insolvent financials, but it’s possible that a formal insolvency (e.g. a nationalization or receivership) could put a lot of people who got paid by banks during the boom at risk.

Yves Smith pointed this out a while back. I think it’s worth taking a moment to wonder whether and how much the political resistance to formal nationalization is due to fears on the part of well-connected executives of being clawed-back via this doctrine. (Has fraudulent conveyance been aggressively pursued with respect to the Lehman bankruptcy? If not, why not?)

I hasten to add that I know very little about the legal details of fraudulent conveyance, whether it could in fact be applied to large, insolvent financials, what if any legislative action would be required to make the doctrine bite effectively, etc. I do know that even good-faith sellers of firms into leveraged buyouts are quite terrified of fraudulent conveyance, since even healthy firms become risky after the levering up and capital extraction that often followed these deals, and the former owners of previously viable firms can be made to take a serious hit. People who might know stuff about this (Buce?) are encouraged to weigh in. If we treated nationalizations as insolvency for the purpose of fraudulent conveyance, could we do some clawing back? Or is this a ridiculous idea?

Another way we could claw back is to simply enact a special tax on all recipients of income from firms receiving public support. Again, we are partially screwed by Hank Paulson’s cynical strategy of encouraging healthy firms to camouflage the rotten ones by accepting TARP funds. But we might set a deadline for the return of public capital, to encourage the healthy trend of banks returning unneeded public support. People who received income as an employee or contractor of banks requiring continued public support during 2004-2007 could be subject to a special, retroactive tax on that income. The IRS presumably has W-2s and 1099s by which they can identify those who would be liable.

This is obviously mean and unfair to many innocent bank employees, and cuts against the America tradition of eschewing collective justice. To diminish the meanness, the special tax could be progressive in the amount of income collected, so that janitors and tellers at Citibank wouldn’t be unduly hit. It could be spread over several years, to help people finance the unexpected charge. But, however imperfect, this sort of tax would be far better targeted than future taxes that penalize Americans broadly, or even forward looking tax levies on financials that (if we get our act together) might be very different from the dinosaurs and innocent of their sins. (Should prosper.com pay for the excesses of Citibank?) Administration of the tax should be straightforward and comprehensive, as even the sharkiest of sharks working for putrescent financials wouldn’t have seen this one coming a few years ago and contrived to hide the source of paychecks from Citi.

Of course, it would set a precedent going forward, so highly-paid agents of firms capable of forcing a bail-out might seek get paid via squirrelly networks of special-purpose vehicles in order to evade future clawbacks. But that is a feature, not a bug. One problem with our financial system is that it was easy for basically decent people to engineer rapacious and fraudulent practices while persuading themselves it was respectable work. Acting in a manner that yields private short-term profits in exchange for catastrophic risk to taxpayers and the economy is not respectable work. People who find they have to launder their paychecks like drug dealers are less likely to get confused about that (and less likely to be dealt with mildly if they push us to the edge again).

If we do this kind of thing, we should make it clear that its purpose is to cover actual rescue costs, not to arbitrarily discourage risk-taking. (I’d view it as similar to how people who get stuck on mountains are sometimes billed for the cost of their search-and-rescue.) Agents of firms that are clearly small enough to fail could rest assured that the taxman would have no claim against people caught in private tragedies. Fear of such a tax might discourage managers and executives from building up large or insidiously interlinked firms and then capitalizing on an implicit “too big to fail” guarantee. Firms may be too big to fail, but the people who make them that way needn’t be invulnerable.

Update: Reader Paul Morelli directs us to the excellent Adam Levitin at Credit Slips on the subject of fraudulent conveyance and bonuses. See also the comments, in which Tom Grey suggests a “windfall bonus tax”.

Update 2: Skeptical CPA has a great deal about bankruptcies and fraudulent transfers, for example here. He also points to this interesting summary of bankruptcy scams. To reiterate the connection between this stuff and current events, if the government bails out an insolvent bank by making creditors and counterparties whole, that is like a bankruptcy, except the government steps into the shoes of creditors and takes the hit they otherwise would take. Conduct that would harm private creditors in a bankruptcy harm the taxpayer in a bailout, and in theory should be litigated just as aggressively by the aggrieved party, which is all of us. However, by preventing any formal declaration of insolvency, bailouts enable scavengers to avoid the whole skein of case law surrounding bankruptcy, which tends to put people who extract benefits from a firm while it is foreseeably bust in jeopardy.

Update 3: Buce weighs in on fraudulent transfer (and distinguishes them usefully from preferential transfers) in the comments. His conclusion? “…maybe less here than meets the eye.” Thanks Buce! Not too many comments on the tax idea, which I thought the more incendiary of the two proposals…

Update History:
  • 8-Mar-2009, 4:40 a.m. EDT: Added update re creditslips post.
  • 8-Mar-2009, 12:15 p.m. EDT: Updated with stuff from Sketical CPA.
  • 8-Mar-2009, 5:15 p.m. EDT: Added update re comment from Buce.

Rethinking subsidized finance

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won’t speak for CR, but some of us would disagree with JH’s presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH’s plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers’ put option and its “vega” — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry’s quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It’s as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

As even Paul McCulley, the PIMCO dude, acknowledges

it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost. Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms’ reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we’d like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.

In thinking this through, I don’t think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks. I challenge readers to make the case that banking, in its long centuries, has ever been a profitable industry, net of the costs it extracts from governments, counterparties, and investors during its low frequency, high amplitude breakdowns. Banking is lucrative for bankers, and during quiescent periods it has served a useful role in financial intermediation. But in aggregate, has banking has ever been a successful industry for capital providers? A “healthy” banking system is arguably just a bubble, worth investing in only if you’re smart enough or lucky enough to get out before the crash, or if you expect to be bailed out after the fall.

If banks were our only option, we might think of them like airlines — we’ve never figured out how to run the things profitably, but we do want commercial air travel, so we find ways to cover their losses. But at least with airlines, the costs are relatively modest, and we constantly experiment in hopes of hitting on a sustainable business model. Despite being catastrophically broken, the core structure of banking has been fixed in an amber of incumbency and regulation since the Pleistocene era. It’s long past time to try something else.

A hopeful way out

Call the President!

The indispensable John Jansen has hit upon a way of preventing the next teetering shoe in the financial crisis from going thunk. So far, we’ve heard surprisingly little from the long maturity financial intermediaries — insurance companies (excluding the counterfeiters at AIG FP) and pension funds. Apropos, JJJ notes

Metropolitan Life announced that in its holdings of corporate bonds they are sitting unceremoniously on $14 billion in losses. I suspect that they are now hoping that advances in medical science will render current actuarial assumptions void and vacuous and the time value of money will work in their favor.

Really, Mr. Obama, has there ever been a better time to fund a Manhattan Project to invent immortality! Kill two birds with one stone. It’s immediate stimulus, quick-start investment in a sector where the USA retains a comparative advantage, high-tech medicine. Plus it’s a nearly bottomless, um, well of employment opportunity for less skilled workers, who could comb the Lake Okeechobee environs in search of the Fountain of Youth. If successful — and of course it would be successful, this is America, can do, yes we can, shut up we can too — it would save the financial system from the slow tremors of unfunded baby boom retirements and unpayable life insurance obligations. No, Mr. Dole, building a better Viagra doesn’t cut it. However, an appeal to the patriotism of Dr. Carlisle Cullen might yield rapid progress.

Our financial system is not the same as “our” big financial institutions

I’ve just listened to NPR’s recent interview of Timothy Geithner. Adam Davidson did a great job of trying to get answers from Mr. Geithner. I felt sorry, at a personal level, for our Treasury Secretary, a very smart man imprisoned in a series of talking points, desperately afraid of the consequences of holding an honest conversation.

As an aside, we’ve come to take it for granted that policymakers ought to be circumspect for fear of provoking traumatic moves in the markets. But isn’t that dumb? Markets are supposed to be about aggregating and revealing information. In what sense is it “more responsible” to hide information or ideas so that markets do not move on them? And if markets do misbehave so wildly that public officials can no longer afford to be candid because of market consequences, does that suggest an incompatibility between the kind of financial markets we have and open democracy?

Anyway. Taking for granted the constraints of the interview, what struck me most was Geithner’s repeated conflation of our “financial system” and our “institutions”. Mr. Geither’s unspoken assumption is the fixing our financial system implies ensuring that incumbent troubled financial institutions are “strong”. But that’s not right. Our financial system is composed, in part, of financial institutions, but it is supposed to be larger and more robust than any specific firm. Three years ago, Mr. Geithner would have readily conceded that financial institutions are supposed to come and go, rise and fall, succeed and fail as a matter of market discipline, and that our system is made stronger by that flow of creation and destruction than it would be if some state-manged cadre of crucial banks were at its core. Of course, we all knew three years ago that some institutions had become “too big/complex/interlinked to fail”, but we viewed that as unfortunate, and would have foreseen that if any of those banks got badly into trouble, the goverment would be forced to intervene and resolve the bank at some taxpayer cost, as it had in the case of earlier TBTF banks. Three years ago, no one would have suggested that the strength of our financial system and the strength of Citibank are inseparable.

We should not let this verbal slip go unchecked. The idea that certain large, politically connected private firms are essential to commonweal and must be supported at all costs by the state is quite the essence of “Mussolini-style Corporatism“. Fixing our financial system is not the same as rescuing any one or several financial institutions. Household names can, do and should come and go in a capitalist economy, and it’s pretty clear that quite a few familiar financials have failed the market test. What’s good for Citibank is not what’s good for America.

Did you catch this bit from Warren Buffett’s letter?

Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

“Lemon socialism” has costs beyond the direct cost to taxpayers of socializing losses. It prevents assets from being shifted from inefficient to efficient firms, and penalizes healthy, well-managed companies by forcing them to compete against subsidized competitors. I don’t see how preventing healthy good banks from harvesting the organs of our megabanks “strengthens our financial system”.

I think it’s time to move beyond the nationalization/preprivatization debate and start talking about how to replace rather than reorganize failing firms. That doesn’t mean that we would shutter all of Citi’s branches. It implies having troubled banks continue to operate in a kind of run-off mode (something like Arnold Kling’s #2) while the government backstops some obligations and seeks buyers for the bank’s assets, operating as well as financial. In other words, it’s time to move beyond nationalization and talk about state-managed liquidation. I look forward to an America with a strong financial system. I think that’s more likely in a world where Citi’s logo goes all retro chic like Pan Am. Frankly, I think that’s all the (non-negative) “franchise value” that’s left in Citi, and several of its peers.