...Archive for December 2009

Norms of credit

Megan McArdle has responded to my earlier piece on strategic default. Before offering a substantive reply, I’d like to emphasize that my piece was not intended as a “slap down”. If there was anything uncivil either in tone or content, I apologize for it. I often disagree with Ms. McArdle, but she is a talented writer whom I’ve enjoyed for years. I’m pleased to be one of her “little chickadees“. I hope she’ll forgive that I chirp and peck.

Moreover, I think I share McArdle’s deep concern, that a collapse in the norms of commerce will leave us with more cumbersome and substantively worse means of regulating ourselves than we’ve had in the past. We disagree, I think, about who is responsible for the putative collapse, how far along it is, and what we ought to do going forward to regain a desirable equilibrium. I think that the collapse is already upon us, and that the proximate cause is a failure by businesses — especially though not uniquely in the FIRE industries — to live up to tacit social bargains. I blame that in part on a corrosive but remunerative ideology that denies those bargains bind at all. I suspect Ms. McArdle would tell a different story.

Communities regulate themselves via a wide variety of tools, ranging formal legal arrangements to unspoken social norms. Laws are much more visible than norms, but norms carry most of the burden of helping us get along. In the language of economists, norms make markets more complete, by rendering practical contracts too complicated and pervasive to be written and enforced by courts. If I lend a friend some money on a handshake, there are a thousand circumstances under which I would agree to delay in repayment, circumstances in which we would both agree that repayment has become justifiably impossible, and circumstances in which my friend might accelerate her repayment and overpay on the interest with gratitude. To delineate all of those contingencies in a formal contract would be impossible, and attempts to do so leave us with phonebook-length legal documents that make a mockery of the phrase “meeting of the minds”.

My view is that a “good society”, both in a moral sense and from the perspective of economic growth, depends much more on the depth and stability of its tacit norms than on its laws and formal institutions. But norms and laws are interrelated. If a society is to be stable, the two must reinforce one another. Norms and laws are complements at a macro level precisely because they are micro-level substitutes. Norms directly substitute for legal text. They “fill in the blanks”, permitting contracts and laws to be concise and intelligible, yet equitable under a wide variety of circumstances. Since legal arrangements that are unintelligible to those they bind cannot be legitimate, the capacity of tacit norms to stand in for textual complexity is an essential complement to a system of laws.

I think the fight over “strategic default” is really about a collapse in the normative arrangements surrounding reputable business. Ideas have consequences, as they say, and I do think that the theory of business that Friedman helped popularize were corrosive. I don’t condemn him personally for that. His views were sincere, and I was once enchanted by them. But we are where we are.

McArdle writes:

[W]e treat business behavior as different from personal behavior…. [W]e’ve lived in a world where profit-maximizing corporations operate by different normative rules from individuals for 150 years. It may be that the norms to which we hold corporations aren’t the right ones — indeed, in the case of things like overdraft fees and credit card rate games, I think it’s very clear that they’re not, and the banks have only themselves to blame when we decide to handle the problem legally instead. But that doesn’t mean that we should therefore abrogate the norms by which our personal lives are conducted.

I think that she is almost right, but she misses something. Businesses have operated and should operate under very different norms than individuals in their interactions with one another. We have, and have long had, the expression “it’s just business”. When spoken by one businessman to another in the context of even a tragic transaction, like calling in a loan that will force a firm to fold, we recognize the words as legitimate, a kind of apology. But if a businessman uses the same phrase while creating trouble for an individual in her role as customer, tenant, or borrower, it marks the businessman as, well, a jerk (to use McArdle’s very excellent descriptor). Behavior at the interface between businesses and individuals in those roles is supposed to be governed by interpersonal rather than intercorporate norms. Expectations of reciprocity still apply. There have always been businesses that sought every legal cover to profitably mistreat people. But such businesses used to be disreputable.

As McArdle acknowledges (I think) with respect to revolving debt, over the past few decades the financial industry has increasingly applied the norms of hard-nosed business to its interactions with customers. Certainly, a home mortgage to an unrelated party is too high value and dangerous a transaction to be regulated by social norms alone. Lengthy contracts are necessarily involved. But that doesn’t absolve a business from its responsibility to craft financial products in a manner that conforms to interpersonal expectations of fair-play. Along a whole variety of dimensions, the financial industry has increasingly violated those expectations. Lenders drafted contracts with fees and other “revenue enhancers” that borrowers are unlikely to fully understand, and profited when borrowers managed them poorly. They enthusiastically marketed loans to individuals whom they were perfectly able to foresee could not easily bear the debt, against collateral whose valuation they knew to be dodgy, then sold those loans via circuitous paths to investors who literally could not know what they were buying. Mortgage lenders suborned appraisers to soothe both buyers and funders with overoptimistic valuations. The normative breakdown went both ways: individuals preyed on businesses too. The gentleman receiving large commissions selling unsuitable loans, perhaps prodding the borrower to overstate his income, may have been betraying his employer (or not, depending on who was ultimately going to bear the risk of the loan). Certainly the ruthless flipper was violating interpersonal norms when she took a mortgage she knew she could not afford, gambling that a huge upside if prices rose was worth a downside limited by non-recourse or bankruptcy. But she was hardly alone, and she could be forgiven for believing that those norms no longer applied at the interface between banks and customers. They did not.

One group of people who did not violate traditional norms during the course of the credit bubble is the ordinary homebuyer who bought at the top of the market without forming an opinion on valuation, trusting market prices and professional advisors. Most homebuyers are not market timers: they purchase when the circumstances of their own lives make homeownership attractive, and take regional prices as given. Certainly the momentum of home prices affected Joe Sixpack’s (or G.I. Joe’s) buy vs. rent decision. Nevertheless, this group had the least culpability for the malfunctions of the credit market yet they are bearing a disproportionate share of the costs. McArdle thinks it would be desirable, from a social perspective, to reinforce norms under which borrowers have a moral obligation to pay. I would rather lenders ensure that loans where it would not be mutually advantageous for the borrower to pay are rare. To uphold McArdle’s norms on the backs of people who were drawn into a speculative bubble not of their making, whose “banking relationship” consists of a note that has been sold and resold multiple times, and whose risks are legally shared with other parties that have not hewn to any standard of good behavior, is simply unjust. Even if they could bear the cost. Even if they buy new furniture with the savings.

I’ll end on an irony. I think that underwater homeowners ought to walk away from their loans for the very same reason McArdle wants us to consider them jerks for doing so. We both want to see norms we consider valuable enforced. I think that banks violated a great many norms of prudence and fair dealing in their practices during the credit bubble, and that they violate the fundamental norm of reciprocity by fully exploiting their own legal rights while insisting that borrowers have a moral obligation not to exercise a contractual option. In order to strengthen norms I consider crucial, I hope transgressors face legal and social consequences (strategic default and reduced shame attached to default) that will alter their behavior going forward. McArdle values a norm that I think most of us share in interpersonal settings, that a person should make every possible effort to pay back money he has borrowed. She also wants to create consequences for transgressors, social costs via a consensus that those who walk away by choice be considered jerks. We have different preferences regarding the kind of world we want our normative frameworks to support: McArdle favors a world with both easy credit and easy bankruptcy. I favor the easy bankruptcy, but not the easy credit. I think that debt arrangements are hazardous and should be entered into only with great care. I don’t consider increasingly leveraged homeownership and aggressively accessible consumer credit to have been positive developments. As a practical matter, I think we must rely on creditors rather than potential debtors to differentiate between wise and unwise loans. So I consider it a feature rather than a bug that holding creditors accountable will encourage them to think twice before sending out convenience checks. Norms, like laws, are always contested. McArdle and I have very different worldviews, and that is reflected in the different norms we are each trying to reinforce.

Afterthoughts: McArdle suggests that in my previous piece, I misread or misrepresented Milton Friedman. I don’t think I have. Interested readers might review Friedman’s essay and decide for themselves. The piece is powerfully argued. Friedman does try to carve out exceptions for “ethical custom” and “deception”, but I don’t think those caveats withstand the force of his argument when there is even a hint of a shade of grey. I’ve written a bit more on this in a comment. (If you are new to Interfluidity, you may not know that the commenters here are far more insightful than the host. The comment sections on the two previous pieces on “strategic default” — here and here — have been excellent.) Also, a while back, The Compulsive Theorist had a couple of good posts on norms and the financial crisis, here and here. Several of the links above are to pieces by Tanta, whom I miss.

Strategic default: a soldier’s perspective

Commenter “Indy” offered the following in response to the previous post on strategic default by underwater homeowners. I think it’s worth a read:

This is an issue I’ve been thinking about for over a year now. I recently returned to my Law / Economics student life from a deployment to Afghanistan with an Army Military Intelligence unit. Prior to the deployment, several of the other officers had been stationed at the height of the housing bubble at facilities located near D.C. in Northern Virginia. They lived in very modest homes which were removed from their workplaces by substantial driving distances, but these homes were nevertheless particularly pricey for someone with a family and on a military salary. The humble homes ate significant chunks out of those salaries as the commutes did to the (already scarce) time these men had to spend with their families.

Such are among the many sacrifices of military life even in peacetime. There are, it seems, a multitude of wealthy lawyers inhabiting the good neighborhoods in the concentric circles of significance around the capitol. There is real irony is how their bidding up of the prices of real estate in order to achieve influence over power has muscled out the very men who are entrusted by the nation to wield it.

Despite the high prices that dominated before the crash, when my friends had reported to their new posts they found the local branches of the nation’s largest bank chains exceedingly eager to “serve” them. The companies offered to loan them (well, “originate”) up to 100% of the asking price plus costs with a minimum of fuss, delay, paperwork, or any other prudent diligence. I had a similar, “Really, is that it? That can’t be right. Are you sure that’s all you need?” experience when I received my mortgage in 2005 from Countrywide. Those were the days.

The officers were also heavily encouraged to dabble in those now infamous Option-ARMs and other dangerous financial “innovations”. The temptation must have been intense, but the men were skeptical, conservative types, and they opted for traditional fixed-rate mortgages. The Army is a place where an officer is busy with planning half of the time and busy ignoring those plans the other half because all one can do is a kind of ad hoc improvisation and adaptation to constantly changing circumstances. In few other places will one learn more about the limits, almost futility, of planning for an unknowable future full of unforeseeable and defined by unintended consequences. The Army depends and thrives on the bravery of the Soldiers and the caution of their superiors. “Safety” is akin to an ideology and a way of life. Likewise, these were brave and safe men who chose safe mortgages that were “safe as houses”.

While we were away, about halfway through our deployment, the crash began and something mysterious had gone horribly wrong with the machinery of America. The small equity positions these men has invested in their respective residences were wiped out in a matter of months. By the time they were close to returning to these homes the men were all badly underwater by over one hundred thousand dollars and, what was worse, the Army had reassigned them. They would be required to move promptly upon redeployment. They were simply not in a position to hold out, wait for prices to go back up in the long term, and continue making monthly payments. Unfortunate professional timing had compelled them to buy at the top and sell at the “bottom”. Wasn’t the avoidance of precisely this “fire sale” scenario the purported rationale for the bailouts of the financial institutions? But no extension for families, it seemed.

So, as the depth of the murky trouble in which they were finding themselves became increasingly clear they all found themselves perplexed as to what to do. Their uncertainty had two dimensions – (1) technical and (2) moral. They asked for my assistance and I tried to explain the little information I had learned about short-sales, negotiated settlements, and other ways of dealing with their banks to offload their properties and debt obligations (Virginia is non-recourse). I explained what I knew about what the various consequences – for example to their credit scores – would likely be.

When they were presented with these various options one course of action usually stood out as an obvious winner when measured purely in terms of their financial self-interest. However, they still wondered which fork in the road was the right one ethically. They had each accumulated a small life’s savings over the course of their careers, and they could decide to hand over the entire family education and retirement fund to the bank or choose one of the legal options that would let them try and keep it. What was the right thing to do? Were their wives and children the “shareholders” of the family, the welfare (to include the financial well-being) of which the preservation constituted the highest ethical goal?

With these men, and with many others I would estimate, they sense a moral dimension that should be addressed in their decision-making but they don’t know how to conduct the ethical analysis. They look for guidance and advice in the words of their acquaintances and the acts of their community and national leaders.

Their instinct was that if they had borrowed money from a friend or a neighbor they would feel a deep, almost sacred, obligation to make good on their debt and pay it off in full plus interest as soon as they could manage it. It would be wrong to stiff the guy next door even if you were in trouble and the law would let you get away with it. Their first impulse was to extend the principle to all debts, including the one on their house. That was, after all, the “right thing to do” as they had been taught by their parents and grandparents.

But then the bailouts with taxpayer money started. The “too big to fail” talk began, and then the wave of foreclosures and layoffs and emerging scandals of the unjust excesses of the financial industry, and so on. And these men began to feel that from the personal scale of their little world, their family was also perhaps “too big to fail” by the forfeit of their hard-won life’s savings.

They also started to question how the bailouts could make sense without some of the benefits flowing to innocent and responsible men such as themselves. They all knew some reckless nut next door who lied on his applications and bought six houses to “flip”, each of which more than double what he could conceivably afford. How could this crazy man be permitted to just abandon ship and mail the keys to the banks? And what about all the people who were getting the “shadow bailout” by “strategically defaulting” and purposefully living rent-free until the day of eviction, sometimes a year later? How is it just that these frauds would be the primary beneficiary of the foreclosure delay acts of the state legislatures? All of sudden, what had seemed moral now appeared foolish, even stupid.

And then it never seemed to end — bailouts for the car makers, countless earmarks, and a thousand inexplicable giveaways in the “stimulus”. And these gentlemen are not economists or political scientists and must distill the message of these actions through our hysterical and hyperbolic press which tells these stories in a way so as to make us terrified and irate.

And the point of all of this is that even the meekest law of real estate finance can have a profound effect on our cultural values. The whole moral universe, in regards to debt, has been overthrown for these good and righteous men with whom I went to war. They started out with an inclination as to what the right thing to do was, and then they were unsure. Then they questioned whether they were just being “suckers” and if there really was any kind of moral question at all given what was happening in the world around them.

I wonder what new moral lessons these men, indeed our whole generation, will now teach our children and grandchildren. I’ll guess that the content of these lessons will not include much sense of moral obligation or sympathy towards banks. Perhaps that’s for the best, moral intuitions being supportive of certain beneficial survival instincts in the modern dog-eat-dog financial world where ordinary folks need be constantly on their guard. I hope it doesn’t spillover, baby-with-the-bath-water-like, and create a generational animosity for a free market economy and open society in general. I also hope they find a way to preserve some space for social interactions involving money that aren’t “just business” and where, indeed, it’s sometimes worthwhile to make an non-mandatory personal sacrifice for no other reason than because its the “right thing to do”.

Strategic default and the duty to shareholders

Megan McArdle thinks strategic default by underwater homeowners is not okay:

I am afraid that I am one of those people who have no patience for people who refuse to pay their debts… There is a sizable school of thought that says why shouldn’t they? They made a contract with the bank under known rules, and as long as they’re willing to pay the penalties, why shouldn’t they just walk away, the way a corporation would? Well, for one thing, companies don’t always behave like this, and those who get a reputation for stiffing their suppliers run into trouble. But for another, because society doesn’t really work on such clean logic. The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible.

I would like to agree with her. I think that if we structured the economy so that I could agree with her, we’d have both a better world and a more prosperous economy.

But, in the world as it is, in this mess as we’ve made it, her position is beyond unfair. Businesses walk away from contracts all the time, whenever the benefits of doing so exceed the costs under the terms by which they are bound. McArdle is certainly right to point out that companies frequently honor costly bargains they could get away with breaking, because their reputations would be harmed by walking away. But, reputational costs are economic costs. They are a part of the cost/benefit analysis that firms use in making decisions. It is not virtue that binds them to keep their word, but medium-term self-interest. Similarly, homeowners consider the hit to their credit rating and potential loss of social standing prior to walking away.

The question is whether debtors should keep paying off loans simply because it is the “right thing to do”, even when, taking all financial and non-financial costs into account, they would be better off reneging. A human being can choose to be “upright” in this way, if she wants. But under the prevailing norms of business, managers of all but the smallest firms can not so choose. To do so would be unethical.

Let’s recall Milton Friedman’s famous essay, The Social Responsibility of Business is to Increase its Profits:

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers… Of course, the corporate executive is also a person in his own right. As a person, he may have many other responsibilities that he recognizes or assumes voluntarily… He may feel impelled by these responsibilities to devote part of his income to causes he regards as worthy… spending his own money or time or energy, [but] not the money of his employers… [T]o say that the corporate executive has a “social responsibility” in his capacity as businessman…must mean that he is to act in some way that is not in the interest of his employers…spending someone else’s money for a general social interest… Insofar as his actions…reduce returns to stockholders, he is spending their money. Insofar as his actions raise the price to customers, he is spending the customers’ money. Insofar as his actions lower the wages of some employees, he is spending their money. [H]e is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other… [He] is…simultaneously legislator, executive and jurist.

In 1970 when Milton Friedman published these words, I think they must have seemed a bit radical and weird. But today this view is triumphant, both in theory and in practice. Mainstream theory and law view a corporation as a “nexus of contracts” between consenting individuals. Firm managers are agents, employed to act in the interest of shareholders. Shareholders are imagined to unanimously share a single goal — maximizing financial value. When a manager acts in a manner inconsistent with that overriding goal, for motives virtuous or vile, she is imposing “agency costs” on her employers, expropriating resources which are not hers. She is behaving unethically.

An individual, on the other hand, is not so conflicted. Her resources are her own. If she acts against her interest, she harms only herself, and most of us agree that there are times that virtue demands she do so (though we’ve no consensus on just when). McArdle can argue that individuals should pay obligations they’d be better off shirking, in the name of a larger, social good. But under the now prevailing view, she can’t ask that of businesses, because that choice is not firm managers’ to make. If managers or some shareholders wish that a costly action be taken in the name of social responsibility, Friedman helpfully reminds us that they “could separately spend their own money on the particular action if they wished to do so.”

In practical terms, exhortations to individuals that cannot apply to firms leave us with what Felix Salmon aptly describes as “the world’s largest guilt trip“:

The result is a system tilted enormously in favor of institutional lenders who exist in a world of morality-free contracts, and who conspire to lay the world’s largest-ever guilt trip on any borrower who might think about joining them in that world. It’s asymmetrical, it’s unfair… no one would expect a capitalist company to behave in the way that individuals are being told to behave…

Individuals must operate in a competitive economic environment dominated by entities constitutionally incapable of overriding self-interest to “do the right thing”. Virtuous individuals can expect no reciprocity from the firms with which they contract. They have two choices: live nobly and get screwed, or adopt the amoral norms of their counterparties. It has taken some time, but we are all coming around to the only supportable view. “It’s just business,” we shrug, even if we never wanted to be businessmen.

At this moment, the amorality of the transactional, profit-maximizing firm has seeped into most of our commercial relationships. This contributed grievously to the financial crisis: employees of Wall Street firms do not view themselves as morally bound to the fate of their employers, but as atoms negotiating the best terms that they can for themselves. When they found themselves able to enter into arrangements that offered irrevocable cash payments against uncertain accounting profits, they did so eagerly. When flippers discovered they could borrow huge sums of non-recourse money for real estate, and capture huge gains with little personal wealth at risk, they did that too. Asking flippers not to put back underwater property is precisely analogous to asking Wall Street whizzes to give back their exorbitant pre-crisis earnings. The latter won’t happen, so the former should not. Given where we are, every underwater homeowner should absolutely act ruthlessly in her self-interest. If that leads to further turmoil and collapse at the banks, so be it. I see no reason why deeply flawed institutions should be sustained on the backs of the virtuous, via a kind of stupidity tax.

It didn’t have to be this way, and going forward, perhaps we can find a way out. As I said at the start of this essay, I’d prefer to live in a world where I could agree with Ms. McArdle. It was not inevitable that we conceive of the firm as a nexus of contracts without agency for moral action except via implausible relegatation to shareholders. That is just one of many possible ideologies, and a rather idiotic one. The core notion that shareholders “own” the firms they fund is, in my view, a poor definitional choice.

But so long as the “social responsibility of business is to increase its profits”, the social responsibility of customers is to look to their own self interest. Even if that means dropping their house keys in the mail and renting the place next door.

Finreg I: Bank capital and original sin

I have always flattered myself that I would someday die either in prison or with a rope around my neck. So I was excited when The Epicurean Dealmaker invited me to write about financial regulation and crosspost at a site called The New Decembrists. But my views on the topic have grown both more vehement and more distant from the terms of the current debate (such as it is), and I’m having a hard time expressing myself. So I’ll ask readers’ indulgence, go slowly, and start from the beginning. This will be the first long post of a series.

Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence.

The essence of capital provision is bearing economic risk. The flow of funds is like the flow of urine: important, even essential, as one learns when the prostate malfunctions. But “liquidity”, as they say, takes care of itself when the body is healthy. In financial arrangements, whenever capital is amply provided — whenever there is a party clearly both willing and able to bear the risks of an enterprise — there is no trouble getting cash from people who can be certain of its repayment. Always when people claim there is a dearth of “liquidity”, they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture. Before the Fed swooped in to provide, 2007-vintage CDOs were “illiquid” because the private parties asked to make markets in them or lend against them perceived those activities as horribly risky at the prices their owners desired. There was never an absence of money. There was an absence of willingness to bear risk, an absence of capital for very questionable projects.

No economic risk is borne by insured bank depositors. We have recently learned that very little economic risk is borne by the allegedly uninsured creditors of large banks, and even equityholders — preferred and common — have much of the risk of ownership blunted for them in a crisis by terrified governments. The vast, vast majority of bank capital is therefore provided by the state. Prior to last September, uninsured creditors of US banks were providing some capital. Though they relied upon and profited from a “too big to fail” option when buying bonds of megabanks, there was some uncertainty about whether the government would come ultimately come through. So creditors bore some risk. During the crisis, private creditors wanted out of bearing any of the risk of large banks. Banks were illiquid because private parties viewed them as very probably insolvent, and were unsure that the state would save them.

The US banking system was recapitalized by precisely three words: “no more Lehmans”. All the money we shelled out, the TARP, the Fed’s exploding balance sheet, the offered-but-untapped “Capital Assistance Program”, mattered only insofar as they made the three magic words credible. At this moment the Fed and the Treasury are crowing about how banks are now able to “raise private capital” and about “how TARP is being repaid” and “losses on TARP investments will be much less than anticipated”. That is all subterfuge and sleight-of-hand, flows of urine while the beast lumbers on. The US government has persuaded markets that it stands behind its large banks, that despite no legal right to such protection, all creditors will be made whole and equityholders will live to fluctuate another day. Banks have raised almost no private capital, in an economic sense. They have attracted liquidity on the understanding that the government continues to bear the downside risk.

It’s unfair to say that the government now supplies all large bank capital. Stockholders still suffer price volatility and there is some uncertainty that the government will remain politically capable of being so generous. But the vast majority of large-bank economic capital is now supplied by the state, regardless of the private identities and legal forms associated with bank funding arrangements. So long as the political consensus to support them is strong, American megabanks are in fact exceedingly well capitalized, as the US dollar risk-bearing capacity of their public guarantors is infinite. But that is not a good thing.

No iron law of economics ensures that those who bear the risk of an enterprise enjoy the fruit of its successes. Governments have the power to absorb the downside of formally private enterprises (and the libertarian so principled as to refuse a bail-out is very rare indeed). But they have no automatic ability to collect profits or capture gains from organizations that they economically capitalize, but do not legally own. Bearing the downside risk of a project with no claim on the upside is the circumstance of the writer of an option. Private parties who write options, either explicitly or implicitly via credit arrangements, demand to be paid handsomely for accepting one-sided risk. Governments do not. Banks pay deposit insurance premia, but only on a fraction of the liabilities the government guarantees and in a manner that does not discriminate between the prudent and reckless (which creates a public subsidy to recklessness). When governments have lent to banks during the crisis, they have lent at well below the rates even untroubled, creditworthy nonfinancial borrowers could obtain on the market, so that the implicit option premia embedded in credit spreads were somewhere between negligible and negative. Governments paid banks for the privilege of insuring their risks, or to put it more accurately, they acknowledged that they had already insured bank risks and found ways of paying out claims via subsidies sufficiently hidden as to be politically palatable.

As we think about how to regulate banks going forward, we must first be clear about what we are doing. We are negotiating the terms of options that the government will offer to bank stakeholders. It is important to understand that, for both practical and philosophical reasons. As long as the state substantially bears the downside risks of the financial system, by virtue of explicit legal arrangements or de facto political realities, philosophical arguments for deregulation are incoherent. Deregulation is equivalent to a blank check from the state. If you are philosophically in favor of free market capitalism, you must be in favor of very radical changes in the structure of banking, towards a system under which the state would have no obligation to intervene, and would in fact not intervene, to support bank stakeholders even when their enterprise threaten to collapse. The “resolution regimes” currently proposed do not restore “free market” incentives, because those proposals codify rather than forbid state assumption of risk and losses in the event of a crisis. A free market resolution regime would allocate losses among private stakeholders only, and prevent any loss-shifting to the government. For the moment, such a regime, and the structural changes to the banking system that would be required to make it credible, are politically beyond the pale.

So, the options written by government to bank stakeholders will remain in place. All that remains, then, is to negotiate the terms of those options. Framing bank regulation in terms of option contracts underlines a reality that is tragic but true: options are zero-sum games. One party’s benefit is another party’s cost. Very deeply, there is no confluence of interest we can seek between our best and brightest financiers and the public good. Terms that are good for banks are bad for taxpayers. Negotiating the terms of an option with a wealth-seeking counterparty is an inherently adversarial affair. When President Obama is on the phone with Jamie Dimon, do you think he keeps that in mind? A fact of life that our President seems not to enjoy is that while sometimes there are miscommunications that can be resolved via open exchange, sometimes there are genuine conflicts of interest that must simply be fought out. Bank regulation, alas, is much more the latter.

There are indirect as well as direct effects of option contracts, so maybe I’ve framed things too harshly. After all, we allow and encourage formal derivatives exchanges because, even though the derivative contracts themselves are zero-sum, they permit businesses to insure against risks, and that insurance can enable real wealth creation that might not have otherwise occurred. We claim that derivatives markets make indirect positive contributions to the real economy, despite the fact that their direct effect is simply to shuffle money between participants. Banking also just shuffles money around, but we generally think that it enables important business activity. So one might argue that banks and the public have a common interest after all, and smart regulation to evolve could from a more consensual process. But, one would be wrong. We all have a stake in the existence of a payments system, and banks provide one, but managing that is a largely riskless activity, conceptually separable from the lending and investing function of banks. We would also like our economic capital to be allocated productively. But the effect of writing a more bank-friendly options contract is to reduce the penalties for poor capital allocation while enhancing the payoffs to big, long-shot risks. Banks destroy Main Street wealth and create Wall Street crises by making foolish and indiscriminate use of the capital entrusted to them. If we desire a better banking system, we must limit the degree to which private stakeholders can expect to be made whole by the state. With respect to regulation, what’s good for Goldman Sachs is quite opposed to what is good for America. The point of regulating is to align public and private interests by imposing costly limitations on how banks can behave. Indirect considerations of public welfare reinforce rather than reduce the degree to which bank regulation is zero-sum, a fight that pits the health of the real economy against the distributional interests of bank stakeholders.

However, there is some light in the bleakness. Once we understand that we are negotiating option contracts, we can look to some guidance from the private sector. Option-like private contracts are negotiated all the time, and the issues that surround managing them are well understood. A compare-and-contrast of public sector bank regulation and private sector contracts will prove informative. That will be the subject of our next installment.

Acknowledgments: To be acknowledged by me is like being kissed by a putrescent semi-decapitated halitotic zombie creature. Nevertheless, I failed to weave many links into the above, and my thinking on these issues owes a lot to a bunch of people who are smarter and better smelling than me, so I feel duty bound to mention them. In particular, it was Winterspeak and Mencius Moldbug who fully disabused me of the notion that banks are intermediaries between private parties, which pushed me to think more deeply about the meaning of bank capital, and capital in general. Others who have the misfortune of having influenced my thinking on these issues include supercommenter JKH, Economics of Contempt, Wonkess, The Epicurean Dealmaker, James Kwak, Mike Konczal, and John Hempton. (I’m sure there are more I’ve missed: count yourselves lucky!) But the views expressed above are my own, and all of the people I’ve mentioned are far too sensible lend them any credence.

Good financial innovation: small business equity investing

Felix Salmon has been on a tear lately. If you haven’t already, go read his fantastic post on the appalling double standard whereunder human creditors are morally bound to repay all loans while business debtors have a duty to default whenever they find advantage in doing so.

In another great post, Felix quotes commenter Dan, who argues that rather than “lend to a nearly bankrupt and profligate entity” (he means the US Treasury), investors might “learn basics of business and investing and carefully loan out [funds] to local small businesses.”

I love the idea of small business investing, in theory. But I don’t do it, because, in practice, it is time consuming and fraught with economic, legal, and interpersonal risks. One of the sad ironies of our pseudocapitalmarkets is that it is easy for small investors to supply funds to firms that are large and distant, about which we have little unusual insight. But it is difficult to build a diverse portfolio out of local firms we know intimately and have a personal stake in. This is an area where regulation is more a part of the problem than part of the solution: it is prohibitively expensive for the brilliantly run café down the way to meet all the requirements of selling public equity via pink sheets, let alone getting listed on Nasdaq SmallCap and doing an IPO.

In any case, common stock is a poor vehicle for small business investing, because it is nearly impossible to value even with the most elaborate financial reporting, and offers minority investors so weak a claim that thieves and charlatans flock to provide. There is no easier business than selling empty promises for good money. So, in the world-as-it-is, only investors willing to actively participate in a small business (or at least to actively supervise) take equity stakes, while more distant third parties prefer debt, with its promise to pay on time, or else.

But those choices are too stark. Small entrepreneurs would like outside investors to share the risk of building and running a firm in this dangerously uncertain world. They’d like outside investors to make their enterprise more robust. But debt financing magnifies the risks of a living firm. Entrepreneurs share burdens with debt investors only via bankruptcy, or via painful negotiations to forestall bankruptcy.

Outside investors who are enthusiastic about a small business might well be willing to provide the flexibility that entrepreneurs would want, in exchange for a bit of upside. But again, common equity is a nonstarter for passive investors in very small firms. Conventional preferred equity doesn’t work either: preferred investors tend to view nonpayment of dividends as default, and the lack of a legal ability to enforce doesn’t make them happier. Entrepreneurs therefore find preferred equity expensive to raise (especially given the tax disadvantage! see here and here and here and here and here). Since investor expectations of payment don’t correlate with business success, it doesn’t really diminish entrepreneurs’ cash flow risk. Psychologically, since there is unlikely to be liquid secondary markets for microbiz preferred equity, investors won’t perceive much upside in small business preferred: the base case is that dividends are paid on time and as promised, the downside is dividends are skipped and/or the business fails, leaving them screwed. One could try to sell convertible preferred to create upside, but that’s complicated to value, especially given the deficiencies of small business common stock.

If someone devised an equity instrument that would offer stronger, easier-to-value promises than common equity, that would effectively disperse entrepreneurs’ risks while offering investors an upside, that could be efficiently offered in modest chunks small investors could incorporate into diverse portfolios, I think that would be a fantastic financial innovation.

And it wouldn’t even be hard to do. For all the billions Wall Street poured into “financial innovation” over the last decade, investment bankers simply never bothered to try to solve this problem. Keep doing God’s work, Lloyd.

Here’s a sketch, one of many possible ways this circle might be squared. We’ll propose a kind of variable-maturity zero coupon bond. (Zero coupon preferred, really.) Imagine that every dollar of a small business’ operating cash inflow were indexed. That first dollar bill that gets framed and placed on the wall? That’s dollar number one. By the end of the first night of business at the new pub ‘n grub, maybe dollar number 2000 would have slid through the register.

Suppose businesses sold numbered dollars. Dollar number 420,167 has just been rung in. How much would you pay for dollar number 600,000? If you pay 91¢ for that dollar and it takes a year for the business to bring the next ~$180K, you’ve earned a 10% return. If business is great, and it only takes 6 months reach that sales level, then you earn a 20% annualized return. ROI is dependent only on the briskness of sales, something that is tangible and observable, something that customer/investors can understand and estimate. These claims would confer no control rights upon their holders (except potentially when they are in arrears), so entrepreneurs, the residual claimants, would price their goods and services to maximize profits, not revenue. Holders of fixed income / variable term claims would be along for the ride. Assuming a non-wimpy business owner, investors’ best strategy for maximizing the value of their claims is to drum up business, which is a win/win for the entrepreneur and the investor. Investor repayments would naturally correlate with business success: when business is slow, few payments to investors would come due. When business is brisk, lots of claims would mature.

This is the sort of instrument a financial technology start-up could invent and popularize. There’d be lots to think about: you’d want to provide a standardized and trustworthy accounting system to count operating cash flow, you’d want entrepreneurs to state and the system to enforce limits on the “density” of claims that entrepreneurs could sell (to keep incentives intact), you might want to provide (opt-in or opt-out) automatic reinvestment of maturing claims. A firm might permit claims to be redeemed in services rather than in cash on favorable terms, at investors’ option. Etc. At least initially, this kind of scheme would supplement, not replace traditional forms of financing. Businesses would want backup credit lines in case redemptions exceed reinvestment leaving the business starved of capital. But selling dollars of future revenue is simple enough for retail investors, for customers and clients, to understand. It could be implemented cheaply, in a standardized way, that would allow individuals to build diversified portfolios out of small exposures in the businesses they know and patronize. For entrepreneurs, it would offer a means both of raising risk-bearing capital and inspiring customer activism on behalf of the business.

Maybe this is a workable idea. Maybe not. But I am sure that the problem it tries to address is not intractible, or even that hard. If the brilliant minds behind the structured finance revolution would devote one or two percent of their synapses to inventing alternative forms of small business finance, we might find that the self-induced catastrophes of the legacy banking system needn’t translate into depressions for entrepreneurs and small businesses and all the people they employ.

Update History:

  • 01-December-2009, 6:05 a.m. EST: I’ve made a bunch of small edits over the night — nothing substantive, but every time I read through this I think it’s terribly written and want to rework an awkward phrase or sentence.