Information is stimulus

Suppose that the Federal government were to offer sizable loan guarantees for any and all “green energy” companies. Any firm, including new entrants, would be eligible. The government would do some cursory due diligence, only to establish that the company in question would actually spend the capital it raised on real projects colorably linked to green energy (as opposed to, say, buying New Zealand dollars in a carry trade).

Wouldn’t such a program constitute a stimulus to the economy? If sufficient leverage is allowed, it would lead in short order to a bunch of entrepreneurs founding companies on just a shoestring of equity and a whole lot of cheap, guaranteed debt. Firms with even a small likelihood of success would constitute real options worth more than the sliver of private capital at risk, so arbitrageurs would rush to create them.

Such a program would be a pretty direct form of fiscal stimulus. Although politicians and financiers enjoy pretending otherwise, contingent liabilities are still liabilities, and offering loan guarantees to all comers for risky projects is, ex ante, just a way of financing a government expenditure equivalent to the expected losses of the program. We shouldn’t be surprised that an oddly financed stimulus would function as a stimulus.

But note that if, by good fortune, the artificially spurred new firms do surprisingly well and very few guarantees are actually paid, that wouldn’t eliminate the ex ante stimulus effect of the program. It is not the actual transfer of Federal money that serves as the stimulus. The stimulus comes only and precisely form the certainty the program provides to investors that capital spent will be repaid, with interest.

So, suppose that the government does nothing, but “the market” becomes certain (correctly or not) that green energy companies are a sure thing. As long as the cost of capital to such firms falls sufficiently, precisely the same dynamic would take hold. We’ve just watched it happen, twice. When capital became very cheap to internet firms, entrepreneurs understood (and discussed quite openly) that there was an attractive lottery on offer, so why not get in? During the structured credit bubble, the market became convinced that some classes of debt yielding more than the “risk-free” interest rate were certain to be repaid. Entrepreneurs (both speculative borrowers and financial engineers) saw the arbitrage, and found ways of offering those classes of debt. In both cases, if the market had been right, everyone would have been happy. But when the market was wrong, it was someone else’s cost. Many entrepreneurs walked away rich and happy. Others lost, but only a small amount relative to what they’d have made if things worked out differently. It was a good gamble for them ex ante.

Responding to Arnold Kling’s “recalculation theory“, Paul Krugman asks (as he has asked many times)

why [doesn’t], say, a housing boom — which requires shifting resources into housing — …produce the same kind of unemployment as a housing bust that shifts resources out of housing.

A housing boom, any kind of boom, is attended by an increase in certainty. Information is stimulus, confusion is contraction. A bust occurs when the market is unsure of everything, when market participants perceive better risk-adjusted return in holding government securities (or supply-inelastic commodities) than in financing real investment. Sectoral shifts per se have no clear implication with respect to variables like employment and output. But “hangovers” do happen, because powerful booms are periods when market participants make consequential decisions with great swagger and confidence, and busts are when we learn that despite their certainty, they were wrong. They are left not only impoverished and burdened by debt, but bereft of confidence in their ability to evaluate new opportunities. The best way to avoid the hangover is not to err so terribly in the first place. Easier said than done, perhaps, but that’s no reason to cop out. We can build a better financial system, one in which degrees of certainty are attached and removed from economic propositions dexterously, rather than clinging like giddy leeches until a collapse.

Information is stimulus. As markets become more informed, money will be created and lent into the economy as surely as if the government printed and spent it. And stimulus is information, since governments do not spend randomly but do so in accordance with their own revealed certainties, which may or may not turn out to be wise. Poorly chosen stimulus and asset price bubbles are covert twins — only the identities of the people making bad decisions are different. Conversely good economic choices by governments can lead to outcomes as salutary as a healthy market. (See this very nice post by Bryan Caplan, and the articles cited.)

Information is a behavioral attribute, not an attribute of the external phenomena to which it may ostensibly refer. To say that an agent is informed means she behaves differently than an uninformed agent. Her behavior is less random, more predictable. To be informed does not imply ones information is accurate. (In general, accuracy is unknowable, both ex ante and ex post.) Information increases the volatility of outcomes, because it provokes larger and more concentrated bets than uncertain agents would take, creating large gains and losses depending on how adaptive the informed behavior turns out to be. It is often better, as a behavioral matter, to be uninformed than to be poorly informed.

But we do not always have the option of remaining uninformed. We cannot afford to hedge all of our bets. Whether via a great mis-recalculator in the sky or a political establishment largely captured by certain interests, new information will be manufactured. (I think it probable that government stimulus will substitute for market-generated information in the near term, as chastened capital market participants are more conscious of the hazards of certainty than policymakers are.) We will be spurred to take some actions and eschew others, and the structure of the economy will shift accordingly. Let’s hope those choices are good, and do our best to help make them that way.



Update: While I was writing… Arnold Kling offers related and excellent “Thoughts on Probability and Uncertainty.”

Update History:
  • 12-October-2009, 5:05 p.m. EDT: Added bold update re related Arnold Kling post.
  • Changed “of things worked out differently” to “if things worked out differently”.

Vanilla afterthoughts

Note: I use the word “state” in this post to mean “the state”, government generally, not state as opposed to federal government in the US. Thanks to Richard Serlin for pointing out the ambiguity.

Tyler Cowen writes

Now it’s dead, everyone else has been blogging it

The first thing to note is that vanilla is not dead. State-defined vanilla products are not an idea narrowly applicable to this moment’s consumer finance challenges. They are, or could become, an important part of the regulatory arsenal in a wide variety of contexts. They are a tool whose development people with libertarian impulses (including, though you may not believe it, me) should view with cautious enthusiasm. At its core, the purpose of defining a vanilla option is to offer an additional choice, a well-understood default that helps consumers to weigh the purported benefits of exotic alternatives against the uncertainty costs they carry. Libertarians might reasonably object to a requirement that private enterprises offer vanilla products (although the objection is less compelling for industries that are and will continue to be state subsidized and regulated). But first and foremost, vanilla products are about cajoling into existence products that, despite their complexity, can be credibly certified as functional and nontoxic. The idea is in the “libertarian paternalism” / “nudge” tradition of not-exactly-regulation which, however objectionable, is less objectionable than the unqualified paternalism that may result from continued dysfunction and crisis. (Tyler might note a familiar form to this argument.)

The crucial question is whether governments could deploy vanilla products well. Both Tyler and Ezra Klein make the usual sad-but-true public-choice argument that, while vanilla might be a good idea in theory, what compromised politicians and bureaucracies actually offer might, in practice, not be so great.

They are undoubtedly right to be worried. But public choice concerns should always be the beginning, not the end, of a conversation. It’s both incorrect and intellectually lazy to frame the argument as many “pro-market” commentators do (not Tyler or Ezra!), that sure, markets make mistakes, but politician-run governments make “worse” mistakes, so we are better off letting imperfect markets have free reign.

Governments and markets are dissimilar in the form and causes of their mistakes, and the badness of their errors is not uniformly rankable. Imagine that “what is to be done” is a radio signal being sent over two channels, both subject to maddening (but nonidentical) interference. A dumb strategy for extracting the signal would be to just decide that one channel is cleaner, and then throw away the other signal. Smarter strategies combine the information from both signals, and using information from each signal to help correct the errors of the other. There are domains where history and reason suggests that even terribly flawed markets provide a better signal than government. There are other domains where terribly flawed political processes generate a better signal than status quo markets. We should weight the different signals accordingly. But we should always be alert for opportunities to exploit the different strengths and weaknesses of markets and governments to produce better results than either could alone. How to do so, in real life rather than radioland, is an art. But vanilla products have the potential to be a masterpiece of the form. We have to insist on just one point.

A vanilla product must be defined by a uniform contract that regulators write and publish and that varies in a single dimension.

Of course regulators would consult with industry and consumer groups, and of course industry lobbyists would struggle to capture the process and embed their spicy “tricks and traps” into our vanilla creme. But they’ll have a hard time doing so, as long as authorship and responsibility for the terms of the contract and its evolution over time rest with the regulatory agency.

Here’s why. If the contract is written by the regulator, when consumers get screwed, they get screwed by the regulator as much as by the firm that sold them the product. Think about the politics of that. Suppose Struggling-Mom-Of-Four finds her credit card interest rate skyrocket because she missed a phone bill, and the industry had slipped a universal default provision in the “vanilla” credit card terms. When that story gets on the local news channel, it’s no longer a just a story about megacorp screwing ordinary family. It’s a story of the government screwing Mom-Of-Four, directly and on behalf of megacorp. When megacorp screws someone via a private arrangement, the populist “do something!” impulse is blunted by concerns about liberty and contract and personal responsibility. Citizens are genuinely divided about when government interference in private affairs is justifiable, so politicians get conflicting signals from their constituents, and unconflicted signals from megacorp not to interfere.

But citizens are not at all conflicted that the government should intervene to prevent the government from screwing people. If a contract written and owned by regulators has not-well-understood characteristics that leave consumers surprised and unhappy, representatives’ “constitutent services” lines will ring off the hooks. Politicians that refuse to intervene against well-publicized injustices will be quite vulnerable, since they’ll lack the usual philosophical justifications to defend inaction. So politicians will act. State ownership of vanilla contracts provide dispersed consumers a means to challenge concentrated industries for ownership of regulators, by virtue of the hypersensitivity of elected representatives to charges that they fail protect their constituents from rapacious government.

Another benefit of a uniform, regulator-owned contract has to do with the legal system. Every contractual arrangement is attended by legal uncertainty. A freshly written contract is quantum mechanical — words imbue a probability distribution that collapses to determinacy only when observed at the tip of a judge’s gavel. (Usually no cats are killed.) Vanilla contracts offer an economy of scale in dispelling legal uncertainty. Disputes over vanilla arrangements would be quickly adjudicated, by public courts, not private arbitrators (binding arbitration would be a political nonstarter). Since there would only be one contract, legal precedents would be portable across providers. The characteristics of vanilla contacts would quickly become well-settled and widely known.

Vanilla contracts may or may not be dead this cycle, with respect to regulation of financial products. There are many other policy domains where vanilla contracts might be useful. I’d like a bit of vanilla with my health care, thank you very much. The Washington Post has an an excellent article about the too-little-discussed problem of tacit cherrypicking by insurers despite a formal “community rating” requirement (ht Dean Baker). This bit caught my eye:

A straightforward way to reduce gamesmanship is to standardize benefit packages, Precht wrote in a July report. One issue lawmakers must resolve is how much latitude to leave insurers over what they cover and how.

Sound familiar?


Extra vanilla

I realize I’m on time-delay, and that this is all so very last week. (When I am only a week behind, it’s like living in the future.) Anyway, here’s my RSS reader’s dump of vanilla related links, in reverse chronologil-ish order. As always, if I’ve missed you, that’s my lameness, not yours:

For the econgeeky, be sure to check out Karl Smith’s piece (via Mike Konczal), which describes the costs of tutti-frutti into familar microecon diagrams, and this very nice paper by Gabaix and Laibson, that formally models much of the problem vanilla products are intended to solve (via Mike Konczal, via Tyler Cowen, via Christopher Shea who outlines the argument in accessible terms).

Update History:
  • 06-October-2009, 11:10 p.m. EDT: Added note clarifying that by “state” I mean “the state”, not state-level government in the U.S. (and thanking Richard Serlin for pointing out the problem!)

Vanilla is a commodity

Do we have no fight left in us at all? Mike Konczal and Kevin Drum are excellent as always, but must we really write eulogies? Is one of the best regulatory proposals so far dead just because a single well-bought congressman says so?

Extracting the vanilla from the CFPA is not, as Felix Salmon put it “the beginning of the end of meaningful regulatory reform”. It is the end of the end. Vanilla products were the only part of the CFPA proposal that was likely to stay effective for more than a brief period, that would be resistant to the games banks play. All the rest will be subject to off-news-cycle negotiation and evasion, the usual lion-and-mouse game where regulators are the rodents but it’s the rest of us that get swallowed.

Wall Street’s favorite comedian-politician, Barney Frank, was very savvy in framing the debate over the issue with his well-placed mischaracterization of vanilla products as “anti-market”. That is bass-ackwards. The vanilla option is pro-market, because it is procompetitive. Of course, that is precisely why banks hate it: Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price.

Ezra Klein is suitably depressed, but he’s wrong when he writes that “the ‘plain vanilla’ provision was never likely to do that much.” Vanilla products would be very popular, which is why they are so threatening. Financial services are an area where markets not only fail due to informational problems, but where participants are very aware of that failure. Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic “lemons” problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don’t take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.

The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will “voluntarily” participate in markets rigged against them for the privilege of being normal. And we do, every day.

But define a reliable vanilla option, and the dynamic flips on its head. Instead of tolerating rent-extraction as a cost of participation, consumers put up with one-size-fits-all products in exchange for peace of mind. Most consumers benefit very little from exotic product features, and I suspect that many are made deeply nervous by the complex contracts they can neither negotiate nor understand, but nevertheless must sign. Vanilla financial products would be extensively vetted and and their characteristics would soon become widely known. Inevitable malfunctions would be loudly discussed in the halls of Congress, rather than hushed-up in rigged private arbitrations. Vanilla products would face discipline both from private markets (no one is suggesting we forbid other flavors) and from a very public political process. Politics and markets are both deeply flawed, but they are flawed in different ways, and we should take advantage of that. In Arnold Kling’s lexicon, a market in which vanilla and exotic financial products coexist and compete offers the benefits both of exit and of voice. [Update: Chris Mealy notes in the comments that these terms are due to Albert Hirschman]

Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.

I’m sympathetic to the principled libertarian objection to having the government require that private parties offer a product they otherwise might not. No one should be forced to offer vanilla financial products. Small-enough-to-fail boutiques should be free to offer only the products they wish. However, if an institution wishes to avail itself of government-provided deposit insurance or to access Fed borrowing facilities, it is perfectly legitimate for the government to set requirements. The government can choose not to offer its safety net to institutions that don’t offer vanilla products, just as banks currently choose not to offer me a credit card unless I sign up to binding arbitration and unilateral contract changes. I fail to see why one is coercive and the other not. (The government has no monopoly on deposit insurance. Private insurers are free to provide similar insurance, and do so for many financial service companies already.)

An Economist anonobloggeer has some peculiar non-compliments about the vanilla products proposal:

The vanilla offering seems to be intended to substitute for sophistication or research on the part of the customer, but I’m just not sure that’s a good way to approach the issue. As best I can tell, the vanilla plan wouldn’t mandate the price of the simple option; just because a bank would have to offer a vanilla mortgage loan doesn’t mean it would have to offer a competitive vanilla mortgage loan. If that’s the case, banks could easily use high rates on the simple products to steer individuals toward the complex offerings. Or, the vanilla rule could actually serve to direct bank collusion toward high-priced, high-margin products.

Just because a commodity exchange standardizes the quality of corn that must be delivered into a futures contract doesn’t mean that any seller has to offer corn at a good price. So true! But sellers that offer commodities at above market prices don’t usually find buyers. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price. Banks are very, very good at forming tacit cartels, but colluding on complicated terms and conditions is easier and less likely to attract the antitrust authorities than fixing a headline price.

More from the econoanonoblogger:

To me it seems like the more effective solution would be to require that financial institutions explain, in detail, each and every fee they are assessing (or might potentially assess) to customers. That would inform consumers of what’s going on in the monthly bill, and it would create an incentive to reduce the number and complexity of fees, as lengthy explanations would be a hassle for all involved and would reduce business.

One of the great errors in modern policy is to confuse disclosure with information. It is not the case, currently, that banks secretly take your money without itemizing the charge on some statement. (Sometimes when they take your money they call it “service fee” or something equally nondescriptive, and it’d be nice if that practice went away.) Rather, banks intentionally define contracts in such a way that the cost to many customers of understanding and competitively shopping all the dimensions of the product seems higher than the cost of terminating the search and signing the dotted line. More detailed disclosure doesn’t eliminate, and can sometimes exacerbate, the real information costs customers face, which derive from the complexity of the required analysis and lack of information about alternatives, not from an absence of product data. Of that we all have pages, with more arriving every month. You might think there’d be a market for ostentatious simplicity, and there might be. But no bank’s lawyers would sign off on a single page, 12 point text, no-extratextual-incorporation-or-unilateral-modification contract. When routine contracts get more complex than that, it’s just gibberish competing with gibberish for people who have lives. Some financial products are necessarily complex. But one way of managing complexity is standardization. It may be worth it for consumers to carefully study the one contract they will probably sign in a way that it would not be worth poring through 100 freeform contracts, 99 of which they will never sign.

The most serious objection I know to vanilla financial products is that they would be harmful precisely because they would catastrophically succeed. The theory is that nothing is more dangerous than a commodified bank, and the evidence is May Day, 1975, when the SEC ended fixed stock trading fees in the brokerage industry. Some commentators (e.g. Barry Eichengreen) claim that by eliminating a stable, cushy profit center, the May Day deregulation forced gentle investment banks to become hungry innovators, that the financial system has grown progressively less stable because under cut-throat competition risk-takers dominate (until they self-destruct and take the rest of us down with ’em). I don’t buy the May Day story, but for the sake of argument, let’s suppose it’s true. Let’s suppose that, in the name of stability, the best policy would be to ensure banks easy profits so that they needn’t dabble in dangerous things. Then two conclusions follow:

  1. If we are going to strike a policy bargain whereunder banks get a nice sinecure in exchange for a promise of stodgy mellowness, it seems reasonable that they should commit to the stodgy mellowness. Dull, subsidized banks should be heavily regulated banks, or, to use the term of art, “narrow banks“.

  2. If we are going to impose a regime that ensures bank profitability, we ought to do so in a reasonably equitable way. Business models that hide profit generators in complex contracts, or that extract fees especially from the disorganized and naive, are not reasonable instruments of public policy for keeping banks healthy. If we do go with the coddled but heavily regulated model of banking (not my preference!), and we’re not willing to have the Treasury end the capitalist charade and just cut checks to its payment-systems subcontractors, then a decent approach would be to have narrow banks offer only vanilla products and provide monopoly rents by putting floors under fees and ceilings above deposit interest rates (as existed in the US until the 1980s). Under either a competitive or “regulated utility” model, the fairness and informational case for defining standardized vanilla products remains compelling.

I think people like Barney Frank, when they try to sleep at night, have been sold on the “we need healthy banks, so let’s protect their profit centers” story, although they’d never admit to it while scoring points comparing powerless people with furniture. I wonder if it even occurs to Mr. Frank that maybe something serious should be demanded of banks in return for state protection of market power at the expense of the weak and disorganized. But then Mr. Frank has already gotten very much in return.

Update History:
  • 27-September-2009, 2:30 a.m. EDT: Changed “contracts” to “contract” in a singular context. Replaced a “to” with a “that” in a sentence with too many “too”s. (No substantive changes.)
  • 6-October-2009, 11:50 a.m. EDT: Added update in text crediting Albert Hirschmann with “exit”/”voice” terminology. Thanks to Chris Mealy.

Echo chamber

Sometimes the blogosphere really is an echo chamber. I’d like to join in.

Brad Setser has been silenced, via the devious mechanism of, um, hiring him for a job at the White House.

I’ve admired Brad for a very long time. It is not an exaggeration to say his blogging altered the course of my life. I was a Java programmer curious about economics when I stumbled upon Brad’s original blog at RGE Monitor. I learned an incredible amount trying to make sense of his deep and intricate posts. I became quite the groupie, first as a silent lurker, then as a participant of annoying frequency in the incredible comments section he has always inspired. My thinking, and the changes in direction that my career has taken, owe a very great deal to that experience. In a just world, I would have paid Brad Setser a lot of money as tuition.

His disappearance from the blogosphere is a terrible loss. I have not been a fan of the current (or previous) administration’s handling of the financial crisis, and am terribly cynical about many key players in the economic policy establishment. Although I have often disagreed with Brad, I trust him very deeply, both in terms of the quality of his work and the concerns that drive him to do it. I’m not sure whether to be pleased or mad about Brad’s abduction to the corridors of power. That will depend, I think, on how carefully his colleagues listen to the irreplaceable voice they have deprived us of.

Thank you for everything, Brad. Now go save the world already. Goodness knows you’ve been trying for long enough.

Plastic fantastic

So I’ve belabored the distinction between transactional and revolving credit quite enough, I think. And I’m pleased, reading around the intertubes, that people seem comfortable with that distinction, and with the idea that it might be good public policy to treat these two forms of credit differently, despite attempts by credit card issuers to blur the lines. Yay!

But my previous piece seems to have left readers with two pretty big WTFs:

  1. Don’t we already have a ubiquitous and perfectly good transactional credit product called debit cards?
  2. What would be the point of having the government provide a charge card?

Let’s take those in turn.

1. Are debit cards good enough?

Debit cards are indeed a transactional credit product. Specifically, they offer overnight transactional credit which is automatically repaid from a designated bank account. Problem solved, right? Everyone should just use debit cards.

Debit card use is on the rise in the United States (and in other countries use of debit cards is often the norm). But very many of us — possibly even you, dear reader — have both debit and credit cards, but prefer the credit card, even though we pay our balances monthly. Why might that be?

Here’s a minibarrage of reasons. Using a credit card…

  1. is more convenient, since you needn’t keep track of an account balance unless you are very near your credit limit;
  2. is cheaper because it doesn’t require keeping a substantial buffer of funds in a zero or low interest checking account;
  3. is cheaper because you can get some of the interchange fee refunded via rewards programs;
  4. is safer, because it offers the opportunity to review and occasionally repudiate transactions prior to transferring funds;
  5. is safer, because stronger consumer protections are offered in the event of theft or fraud;
  6. is safer, because if the cardholder faces an unexpected liquidity crisis, she can shift from transactional to revolving credit. Cardholders have the option of making partial payments with little penalty.

If we want a purely transactional product, we’ll have to do without that last, the option to revolve. A competitive market for transactional credit might or might not offer kickbacks on transaction fees (American Express does). But to be conservative, let’s suppose not. That still leaves four pretty good reasons why an American-Express-style, pay-at-the-end-of-the-month “charge cards” are superior to debit cards. Banks have tried to address the consumer safety and dispute resolution issues that disadvantage debit cards, but there is still a big gap in perceived and I think actual safety. But the first two issues are the zingers. To get the same payment flexibility with a debit card that you would get with a charge card, you need to maintain a large checking account balance, which costs you in interest foregone. If you keep your buffer savings in an investment account, then you have to track your account balance carefully and transfer funds between accounts frequently. Even with a $95 annual fee (the going rate for a basic American Express card), most families would be better off earning interest on their savings and paying the fee than keeping substantial savings in a no interest account. (Right now this may not be true, because interest rates are so low that you don’t lose much by holding funds in a checking account. But it has usually been true when we’ve not been in ZIRP mode.)

There are arguably behavioral disadvantages to the buffered debit card strategy. If you spend unusually much in a month, there is nothing that forces you to replenish your buffer. But if your savings are held in a separate investment portfolio, transferring funds to cover a shortfall may feel like raiding the piggy bank. Avoiding that might encourage people to not spend more than current income. If you keep substantial savings in a debitable checking account, the mechanics of dissaving are indistinguishable from the mechanics of ordinary spending, and there is no third party demanding that you make yourself whole at the end of the month. With a charge card and a separate investment account, spending beyond income compels painful, explicit transfers from what you thought was savings, which might motivate you to replenish the overdraft quickly. (This entire paragraph is bullshit if you don’t believe in things like “mental accounting” — money in an investment account is viewed differently than ordinary spending money — or “anchoring” — once you reach a level of “savings”, it comes to define where you “ought to be”, and you will strive to maintain or recoup that level. Do you believe?)

A lot of debit card enthusiasts will find all this comparing of “buffered” debit cards and charge cards artificial: Debit cards, they will claim, are good because you can’t ever spend more than the cash you have. It’s as simple as that, right? But we keep wealth we may wish to spend in a variety of different forms, and many of us even have multiple bank accounts. Debit cards without a cash buffer don’t really do the job of transactional credit, that is letting you spend what you can near-term afford without having to much worry about how your (liquid) wealth is held. One might argue that extra friction is good. Perhaps people are so undisciplined that we should have to track balances and arrange transfers prior to even routine spending. That’s an argument for an electronic “cash only” economy, and I think it’s farther than we need to go. It’s a judgment call, but my sense is that people handle short-term transactional credit pretty well, and benefit from the convenience of it, while indefinite-term, low monthly minimum revolving credit frequently becomes a trap.

2. What would be the point of government provided transactional credit?

In the previous post, I suggested that the government could offer a “Treasury Express” card, supplying access to transactional credit as a public good. To my surprise, some people seemed to actually like the idea (e.g. Ezra Klein, Matt Yglesias, Doug Singsen). Others understandably dislike the idea of more state involvement in a sphere that has been traditionally left to the private sector. Kevin Drum just doesn’t see the point:

We already have “Treasury Express” cards: this is basically what debit cards are, and they provide the same benefits of transactional credit that regular Visas or Mastercards do. Why do we need the government for that?

That leaves us with the problem of limiting revolving credit, which is the same problem we have now. Do we need firmer rules on interest rates, fees, and penalties? Better bankruptcy protection? Bans on things like universal default? An end to tricks and gimmicks and fine-print-laden marketing come-ons? More sensible ways of setting credit limits? Maybe. Probably. But unless Steve is suggesting that we essentially ban credit cards entirely — and then create some kind of federal mega-authority to limit every other kind of consumer credit too — those are all the same issues we have now. I’m not really sure what his proposal would accomplish.

If it’s true that the differences between a pay-at-the-end-of-month charge card and a debit card aren’t very important, then Kevin’s right, and there wouldn’t be much point. But suppose that I am right, and people really value the efficiency, convenience, and safety of a charge card, even if they do not intend to run a balance. As things stand now, they have two choices: they can pay $95 per year for an American Express card, or they can get the same product for free with a credit card, as long as they accept a dangerous option not to pay in full at the end of the month. (If having to pay more for fewer options strikes you as odd, you are not alone. In two posts, the amazing Rortybomb tries to make sense of credit-card-pricing mysteries, including this one, using ideas we learned in finance class. Only his training in critical theory prevents a Scanners-style head explosion.)

A free basic transactional credit product would let people avoid signing on to temptation when all they want is a charge card.

A public option would also create political space for better regulating revolving credit. The obvious way to limit revolving credit to those most likely to use it well is to force rationing via price controls. In English, that means we should bring back usury laws. Credit card companies won’t offer cards to financially insecure customers if interest rates, penalties, and transaction fees are capped. Under the present terms of debate, that would be a bad thing, “limiting access to credit”. But the meaning of that phrase is very slippery. “Access to credit” is let to stand for participation in the modern economy, i.e. the ability to rent a car or hotel room, to make purchases or pay bills on-line, etc. If we unbundle those good things from credit cards, what usury laws would limit is “access to high-interest, high-fee unsecured revolving credit”. Put that way, it doesn’t sound so bad.

The existence of universal charge card accounts would offer some side benefits. Such accounts would provide uniform and convenient means for the government to make payments to citizens, rather than mailing out stimulus or social security checks. It would make it easier to implement flat transfers, which I consider a better form of fiscal policy than tax cuts or aggressive government spending.

Finally, it’s worth thinking generally about when public sector competition helps to keep the private sector honest. Critical industries that are prone to concentration due to network effects or economies of scale, that are informationally opaque, or that have high barriers to entry may benefit from the implicit threat presented by even inferior public sector competition. I am a huge fan of UPS and Fedex, and generally prefer their services to those offered by the post office. But I wouldn’t be at all comfortable disbanding the postal service, even though as a taxpayer I am forced to fund its losses. Perhaps I underestimate the magic of the marketplace, but if USPS weren’t there to put under a floor under the quality and price of service offered by the private couriers, the degree of concentration and barriers to entry in that industry would make me nervous. There are other examples: State schools offer useful competition to private colleges and universities. A “universal Medicare” option in health care would serve as a low bar that private sector providers would have to overleap. Consumer banking services may be an industry where public sector competition would be useful. We don’t want the government making fine-grained decisions about the allocation of business capital. There are good reasons to think that capital markets and profit-motivated relationship lenders do a better job of that than the state. But there’s little reason why the public sector shouldn’t provide basic transactional credit and checking account services. (Other countries have state-affiliated banks that compete with fully private institutions. A public/private banking ecosystem is not a radical idea.)

All that said, there are good reasons to oppose a “Treasury Express” card. I share the cynicism of libertarian critics. The only thing I trust less or want less involved in my life than the government are cartelized private corporations. To the degree that people choose to make payments with publicly provided cards rather than with cash or private credit products, the government would obtain detailed individual payment histories. This may (or may not be) worse than Chase or Citigroup having access to the intimate details of our lives. Universal access to transactional credit might do harm by altering the incentives of people on the margins of the economy. For example, someone who currently lives in the cash economy might max out, and not repay, their “Treasury Express” card. Even though the penalties they’d face for nonpayment would be mild, they would have created a new hurdle they’d have to overcome if they wish to reintegrate themselves into the mainstream. Dispute resolution might be a nightmare for a public program. Disputed credit card transactions leave either a customer or a merchant feeling screwed. What is now private cause to switch banks would suddenly become a contentious matter of public policy. The government might meddle in what people can buy and sell with the card, creating a nanny-state non-neutral form of money. Government entry into the banking sector with a limited, basic product could lead by increments of mission creep to a state-subsidized monopoly taking over financial services and credit allocation. These are all real concerns that would have to be addressed, if we were to give public sector transactional credit a try.

Neither this post nor the previous one has been intended as full-throated advocacy. A state-provided universal charge card is a speculative idea that merits further consideration. It might be worth doing. It might not be. But as we negotiate with the banking sector going forward, we will no doubt hear dire warnings about how this or that regulation will force thousands of widows and orphans into bartering chickens for shelter. We should keep in mind that if banks won’t provide the simple, consumer-friendly financial products we require, we can create other options.


By the way, if you haven’t read Felix Salmon’s candid correspondence with former industry insiders about credit card business models, do that now. It is remarkable. For more of the weekend’s credit card links, try Conor Clark on credit cards for college kids (and Richard Serlin’s response), Michelle Singletary, and all the other brilliant writers I’m sure I’ve missed.

Distinguish between transactional and revolving credit

Megan McArdle

[M]aybe it’s worth remembering that the tyranny that credit scores exercise over our imagination have everything to do with the fact that we’ve built a society so utterly dependent on credit.

Kevin Drum responds

[T]here’s nothing per se wrong with the fact that modern economies are so dependent on credit. Widespread use of credit really does make life more convenient, really does make banking more efficient, really does enable useful advances like online shopping, and really does allow easier access to goods and services that would otherwise be difficult to get hold of. Used in moderation, it’s good stuff. I sure don’t want to return to the days of hauling around travelers checks whenever I fly off to Europe.

Speaking for myself, my jeremiads against the credit-industrial complex have never been meant as an attack on widespread access to credit itself. Used reasonably, credit cards are a boon and credit reporting is a necessary part of providing credit responsibly in a big, complex world. That said, credit is critically important to everyday living now, and that means that it needs to handled fairly and transparently.

We won’t get very far in the debate about credit in the US economy if we fail to distinguish between transactional and revolving credit. These are two are fundamentally different products, and much ill has come from conflation of the two. All of the good things Kevin attributes to widespread credit access are benefits of transactional credit. Because credit cards have often bundled transactional and revolving credit together, it is easy to attribute these good things to revolving credit. That’s a mistake. Transactional credit is essential, and might even be publicly provided. Revolving credit is a double-edged sword.

Transactional credit is a means of decoupling the process of making payments from the form in which ones liquid wealth is held. More simply, if you have the money to pay for what you are buying, but just don’t want to carry cash or keep track of your checking account balance every day, you are making use of transactional credit. Many people only use credit cards for transactional credit. They pay off their entire balance each month.

Revolving credit is a different product. It provides a means by which people can spread the cost of purchases over an indefinite period of time. If you wish to go on a vacation, and can afford to pay for it from your next six months’ salary, but could not easily come up with the money now, you are making use of revolving credit.

Both transactional and revolving credit are useful, and conventional credit cards give consumers access to both. But revolving credit is much more prone to abuse than transactional credit. Though economists hate to admit it, it is a fact of life that human beings do not, in general, seem to have time-consistent preferences. If preferences aren’t time-consistent then people are prone to making short-term deals that they will seriously regret in the distant future. Revolving credit is like morphine: When used properly, it can be very useful. But experience has shown that it can cause great harm if used incautiously.

Revolving credit needn’t be bundled with transactional credit. The traditional American Express card, for which you are charged a flat annual fee and pay your balance in full each month, is a transactional pure play. Transactional credit has different characteristics than revolving credit. In particular, consumers can get most of the benefits of transactional credit with low credit limits, perhaps twice a typical month’s expenses. (If restricted to transactional credit, consumers may have to find other means of paying for occasional large purchases. They might need to put funds into a bank account in advance, and pay via debit. As long as such purchases are infrequent, this is not a terrible burden.)

If we set aside “tricks and traps“, transactional and revolving credit products should inspire very different business models. Transactional credit resembles an insurance product, while revolving credit is like a traditional loan. The primary benefit a consumer receives from transactional credit is not the financing debt, but the option to purchase at any time without having to track specific account balances or coordinate transfers. This service is provided regardless of the size of any given month’s balance. Consumers should be (and historically have been) willing to pay a flat fee for it. Even very modest interchange fees more than cover the cost of capital on the loans, so fees can be quite low and might go to zero for some customers. (A 1% interchange fee amounts to a 12% annualized rate for a low-balance, 1 month loan. Conventional interchange fees of 2-3% offers exorbitant returns on 1-month loans, part of which may be rebated via rewards programs.) There is no reason why transactional credit can’t be a fine business, and it has been, both for American Express and every other credit card provider sending unsolicited offers to people whom they know pay their balances off monthly.

Revolving credit, when it is not about tricks and traps, is all about the interest rate. Revolving credit is prone to abuse, and should be made available cautiously, not automatically or indiscriminately. Credit card interest rates should simply be capped, which would prevent less creditworthy borrowers from gaining access to revolving credit lines. That is a feature, not a bug. In a world where agents have inconsistent time preferences, paying high interest rates for present consumption is prima facie evidence of selling out future selves for present goods. Rational high interest rate borrowers are either those who intend to default (thereby extracting a wealth transfer from the more responsible subset of the population), those who are financing goods that will yield benefits over time, and those who face an unusual emergency which requires the future be held hostage to the present. We want to deny credit to the first group, the rational defaulters. People who are financing goods that will yield benefits over time can usually get credit on much better terms by taking out securable, asset-specific loans. We should encourage the resurgence of secured vendor financing, because that form of credit can offer huge savings to less creditworthy borrowers, compared with ubiquitous unsecured plastic. Finally, the usefulness of high limit credit cards as kind of insurance is undeniable, but dangerous. Every day has its crises; that is the human condition. It is easy to err by taking on “absolutely necessary” debt today that leaves one absolutely destitute tomorrow. We should develop better forms of emergency insurance than unsecured debt. To the degree that we do rely upon access to credit as a reserve cushion, it shouldn’t be attached to our instrument of casual commerce. It should be special, and have a “break-glass-in-case-of-emergency” feel to it.

Access to revolving credit should be rationed, but transactional credit should indeed be ubiquitous. Not having to carry and count cash, deal with paper checks, or even worry about some particular account’s balance at the time of purchase are important benefits. Indeed, an efficient payments system is a public good. That’s why states are in the business of establishing currencies, right?

In fact, while transactional credit provision is a perfectly good business, it might be reasonable for the state to offer basic transactional credit as a public good. This would be very simple to do. Every adult would be offered a Treasury Express card, which would have, say, a $1000 limit. Balances would be payable in full monthly. The only penalty for nonpayment would be denial of access of further credit, both by the government and by private creditors. (Private creditors would be expected to inquire whether a person is in arrears on their public card when making credit decisions, but would not be permitted to obtain or retain historical information. Nonpayment of public advances would not constitute default, but the exercise of an explicit forbearance option in exchange for denial of further credit.) Unpaid balances would be forgiven automatically after a period of five years. No interest would ever be charged.

Let’s think about how this would work. For most people, access to various forms credit — transactional credit, auto and home loans, unsecured revolving credit, whatever — is worth more than $200 per year. Although people might occasionally fall behind, for the most part borrowers would pay off their government cards, simply because convenient participation in the economy is worth more than a once-in-five-years $1K windfall. However, people with no savings and irregular income (for whom transactional credit is a misnomer, since they haven’t the capacity to pay) might well take the money and run. The terms of the deal amount to a very small transfer program to the marginal and disorganized, and a ubiquitous form of currency for everyone else. People with higher incomes would want more transactional credit, or revolving credit, which they would acquire from the private sector.

I’ve posited that people often have time-inconsistent preferences. Am I, them, inconsistent to suggest that most people wouldn’t people take a free $1K today and be stuck without credit thereafter? No. The degree to which people underweight future costs varies between individuals, and is changeable. Most people do work to avoid present choices that will create future hardship. (Many people arguably overweight the future.) However, high-limit revolving credit is a particularly nasty trap for those who even slightly underweight future costs. One nice aspect of a low-limit, indiscriminate, mechanical public credit system would be educational. Many younger people would spend some period of time modestly in debt and shut out of the credit economy. This would provide a more gentle lesson than the current practice of running up revolving balances in college and working desperately for years to pay them down.

The notion of transactional credit as a state-provided public good is speculative. Maybe it’s a terrible idea. Regardless, the distinction between transactional and revolving credit is crucial. A modern economy probably does require widespread access to transactional credit. But revolving credit is a different story entirely, and we would be better off controlling it more carefully. We shouldn’t be shy about adopting policies that would curtail the provision of unsecured revolving credit, as long as transactional credit is protected.


Some of this was inspired by a conversation with the excellent keyholez over Twitter. (I have been playing on Twitter recently, and am still trying to decide what I think of it. If you’re into that here’s me and here’s keyholez.)

Update History:
  • 22-May-2009, 1:15 p.m. EDT: Minor fixes, took out overly wordy “role of” stuff from first para, fixed spelling of forbearance, clarified an apparent redundancy, “is variable…and is not fixed”.

Follow-up to “Continuous Bankruptcy”

I am continually amazed at the quality of comments that Interfluidity attracts. But commenters to the previous post truly outdid themselves. I proposed a “novel” security intended to make debt-to-equity conversions gradual and automatic, in hopes of avoiding disruptive “discrete” bankruptcies. Commenters quickly pointed out earlier work along the same lines, and some serious problems that I hadn’t considered. All in all, I remain convinced that “continuous bankruptcy” is a goal worth pursuing. But I’m equally convinced that the specific security I suggested would probably not quite do it.

First, it turns out that better minds than mine have considered debt-like securities that would convert to equity as firms became undercapitalized. The excellent Economics of Contempt pointed out two antecedents, Mark Flannery’s “Reverse Convertible Debentures“, and a recent proposal by the “Squam Lake Working Group on Financial Regulation”. The Squam Lake piece is a diamond in the rough, but Flannery’s ideas are carefully developed. Flannery considers and tries to address most of the problems I would have missed without help from the comments. He also includes a detailed review of related work.

Flannery’s Reverse Convertible Debentures and my proposed “IACCPEs” are both fixed income securities convertible to common stock at a price not set in advanced, but determined by the market price of the stock at the time of conversion. Commenters Alex R and Independent Accountant were reminded of the infamous death-spiral convertibles from the late 1990s. bondinvestor pointed out that a form of catastrophe bond, “catastrophic equity puts” are similar, in that they allow the issuer to convert a fixed income obligation to equity in the event of a prespecified bad event. (Here the bad event that would trigger conversion is running short of capital.) Thomas Barker and jck of Alea pointed out that these securities resemble Islamic “sukuk convertibles”. jck suggests that these, like the death-spiral convertibles, have mostly not worked out so well. (I’d like to know more about Islamic convertibles, both the theory behind them and their history in practice — if you know of a good reference, please do drop a note in the comments.)

The trouble with my proposal is that it failed to adequately consider how both investors and firms would try to game them. Alex R pointed out that investors shorted the hell out of “death-spiral convertibles”. Those who owned them gained if prices could be pushed downward, as lower stock prices meant ownership of a larger fraction of the firm upon conversion. Other traders had incentives to short as well, since dilution caused share prices to drop post-conversion. If the conversion trigger is predictable to investors, and the same dynamic might hold for IACCPEs. (beezer thought this likely as well.)

Also, Alex R and Awake noticed that conversions are effectively at the option of the firm, since “IACCPEs” are only convertible “in arrears” — that is, when a firm hasn’t paid a dividend owed on the preferred shares. Since conversions (under my proposal) are made on terms favorable to IACCPE holders and disadvantageous to incumbent equity, managers might insist on paying dividends to the bitter end, even if overall firm value would be enhanced by preserving cash. Shareholders might prefer to “gamble for redemption” rather than transfer wealth up the capital structure and adopt a more conservative strategy. (In other words, the option value of an undercapitalized firm might be worth more to the original shareholders than the expected value of their fraction of a better capitalized firm.) Further, the fact that convertibility is at the option of firm management creates an incentive towards opacity and surprise non-payment of dividends. Firms would want to skip dividends when shares are overvalued (so that conversion would be on terms favorable to existing shareholders), and would want to hide any possibility of skipping dividends in distress (so that short-sellers don’t front-run à la death-spiral convertibles. Modifying capital structure in a way that creates incentives for managers to reduce transparency and promote mispricing doesn’t seem like a good thing.

Mark Flannery’s “Reverse Convertible Debentures” try to avoid gaming by managers and short sellers in three ways: First, RCDs convert automatically, at the option of neither issuers nor investors, based on a debt-to-market-equity trigger. Secondly, the securities are designed to avoid any transfer of net wealth from equityholders to creditors (or vice versa) upon conversion. Conversions would be based on the market value, not the par value, of the RCDs at the time of conversion, and the market price of the stock. In theory, this would make for a perfectly even exchange, so that no party would have strong incentives to game the trigger. Finally (as foreseen by commenter Bill) “triggered” RCDs wouldn’t all convert all at once. Only the minimal fraction required to bring a firm to a set level of capitalization would be affected, which again might make the threshold event less of an event worth manipulating.

I don’t think that Flannery has solved all problems of strategic behavior — both the “automatic” trigger and the effective conversion ratio are susceptible to gaming, and I don’t think it would be either possible or desirable to define terms under which investors would be indifferent to conversion. Nevertheless, Flannery’s paper makes a serious attempt to address the problem of gaming the trigger, which really is the achilles heel of this genre of proposal.

But let’s pull back. There might not even be a need for an explicit conversion scheme. Plain vanilla cumulative preferred equity has a built-in duality. As long as an issuer is paying out dividends, cumulative preferred equity is very debt-like. Investors expect a fixed coupon, and firms have strong incentive to pay it (so that common shareholders can take dividends, and because nonpayment of preferred dividends is taken as a bad signal by the market). When preferred goes “in arrears”, it suddenly becomes very equity-like: Its value becomes dependent on the promise of dividend payments at some unspecified future date, and the probability that dividends will actually get paid is sensitive to the operating performance of the firm. Cumulative preferred equity has already been invented. So why do we still have a problem?

The first, easiest, and most important thing we could do to reduce the systemic risk and deadweight bankruptcy costs caused by brittle capital structure is change the %*$%&! tax code to eliminate the tax preference for debt over preferred equity. Long-term debt and cumulative preferred equity are basically identical, except for two things: 1) Taxpayers subsidize the issuance of debt while 2) debt contracts are enforceable via socially costly bankruptcy. Taxing preferred equity dividends but not interest on debt is like taxing people for the privilege wearing seatbelts, then wondering in gape astonishment at highway mortality rates. It is bass ackwards. We can either make dividends (at the very least cumulative preferred dividends) tax deductible, or we can make interest payments non-deductable (as Richard Serlin prefers). But we have got to stop tilting the capital structure scales towards bankruptcy-enforceable debt finance. The status quo is absurd, ridiculous, untenable.

(I have yet to encounter even an attempt to justify why interest payments should be deductible but CPE dividends not. There are arguments by definition — expenses are deductible, obligatory payments are expenses, obligatory means enforceable by bankruptcy, q.e.d. But the tax code needn’t be slave to an arguable and legally alterable set of definitions.)

If cumulative preferred equity were not tax disadvantaged, firms might find that it is not much more expensive than debt. But there are two other problems with vanilla CPE as “natural convertibles”. First, there is the question of control. When a firm runs into trouble and then deep goes into arrears on cumulative preferred equity, economically speaking, the preferred becomes equity-like, while the common stock becomes option like. Unfortunately, control usually in the hands of common equity, whose incentives may be to maximize the volatility rather than expected value of firm assets. Secondly, as a matter of convention, financial regulators and analysts often treat preferred equity like debt. When a financial firm is in jeopardy of skipping preferred dividends, regulators become inclined to intervene their “prompt corrective action” mandate. Markets may view skipping preferred dividends as tantamount to a default, and question firm viablity, potentially leading to self-fulfilling distress.

The second issue may or may not be easy to address. Economists pay too little attention to the role of convention in shaping corporate finance, and even less attention to the dynamics of convention. If preferred equity is going to serve as a means of strengthening firm capital structures, we need to move to an equilibrium where occasional periods of missed dividend payments are normalized, and not taken as a death knell for a firm. Sure, skipping preferred dividends is usually bad news, just as it is not a good sign when firms cut common stock dividends. But a skipped dividend needn’t signal a death spiral for a well-capitalized firm. Perceptions might change naturally if preferred equity managed to shed its tax disadvantage. Firms might then lever themselves to the hilt with preferred stock, and over a period of time, investors would observe viable companies go into brief arrears and then emerge. Regulators could help quite a lot by treating preferred equity as equity full stop rather than as a kind of pseudo debt. For financial firms, regulators should commit not to intervene if preferred payments are skipped or threatened, so long as the value (primarily the market value) of a firm’s total equity base remains high. Regulators should treat preferred equity as high risk capital. Regulated insurers, pension funds, etc. should be required to invest as if preferred shares are no less risky than common stock. Regulators should make it clear that during resolutions, preferred shares would go to zero as easily as common if any payout is made on guaranteed liabilities.

Control issues may be more difficult to address, but not impossible. In one of several very helpful e-mails, Economics of Contempt pointed out that

[D]ebenture indentures have included a wide range of covenants over the years that were designed to serve as early warning systems (e.g., the negative pledge clause). No need to reinvent the wheel.

Debt covenants are the means by which divergence of interests within firm capital structures are usually addressed. Lenders do not explicitly exercise control over firms, but they can attach very stringent conditions to loans that limit the ability managers and stockholders to gamble with creditors’ money. Lenders hold a very big stick — if covenants are violated, they can demand immediate repayment of funds that will usually have already been spent. Debt covenants are violated quite frequently, but firms are not often forced to liquidate assets and cough up the cash. Instead, occasional violations allow lenders to renegotiate the terms of loans from a position of strength. So, even though lenders are not represented on a company’s board of directors, their interests are protected both passively (firm managers strive not to violate covenants) and actively (when a covenant is breached — and they are designed to be breached easily — lenders can intervene to actively shape firm decisions).

Preferred stock can include covenants as well, but how to enforce them is a tricky question. It would defeat the purpose of replacing debt with preferred equity if preferred shareholders could force repayment upon a covenant violation. I know very little nothing at all about how preferred stock covenants are written and work in practice. (Hint, hint, amazing commenters!) However, via Google books, I came upon the notion of “contingent proxy” in Raising Entrepreneurial Capital by John Vinturella and Susan Erickson. Apparently there is precedent for clauses that transfer voting rights as “a penalty for breach of covenant”. This idea could be very helpful. As preferred shares become more equity-like and common shares take on properties of options, control might be transferred quite directly to preferred shareholders without a formal debt-to-equity conversion. Transfers of voting rights could be architected so as to be gradual. They might be a function of the degree to which a firm is in-arrears, rather than the mere fact of in-arrear-edness, so that common shareholders would not much surrender control during occasional, brief lapses. Preferred shareholder control rights could depend upon the full mix of the solvency and health metrics typically included in debt covenants, so that there is little incentive by firm managers to game any one potential trigger. Formal options to convert to common equity could gradually be extended as well. Obviously, devils are in the details, and I don’t yet know enough to attempt an exorcism. But, as EoC reminds us, we don’t have to reinvent the wheel. Investors up and down firm capital structures have been eying one another warily for centuries. We have millions of paranoid legal documents to draw ideas from.

It seems to me that the right species of “trigger convertible”, in David Murphy’s coinage might well evolve from negotiation and experimentation, if fairly minimal changes in policy were made. First, we desperately need to level the tax playing field between debt and equity. At the very least, the differential treatment of debt and near-debt-but-safer cumulative preferred equity needs to be eliminated. Secondly, for financial firms, regulators should radically increase capital requirements for financial firms. Bankers will do what they do best, which is to seek the cheapest means possible of pretending to hold capital by inventing the most debt-like equity that they possibly can. Regulators should scrutinize these instruments carefully, but only to enforce two very simple requirements — that under no circumstances are dividend or principal repayments obligatory, and that no agreements made between the different classes of equity encumber firm assets or compel behavior that would compromise the interests of claimants higher in the capital structure. (Regulators, and creditors, would have to guard against “poison pill” arrangements, in which some form of “equity” is cheap because purchases have some means of sabotaging the firm if they are not paid. But this is not a new problem, see the negative pledge clause in EoC’s comment.)

Finally, regulators would have to severely curtail the ability of regulated entities from holding preferred equity. All equity securities should be treated like common stock for risk-weighting purposes. No matter how the contract is writtem, when a security acquires a sufficiently high weighting in the portfolios of insurance companies, pension funds, and banks, it acquires an implicit state guarantee that issuers will aggressively exploit. One lesson of the current crisis is that the distinction between debt and equity has less to do with the legal characteristics of securities than with the political connectedness, financial interconnectedness, and risk-bearing capacity of the entities who hold them. Equity securities, preferred or common, must be restricted to parties whose losses the state would tolerate.

Continuous bankruptcy

I’d like to propose a financial innovation that I think would actually be good (besides the ATM). It would be a new security that firms could market to investors, just like CDOs and all of that good stuff. But rather than being a means of expanding the supply of credit (the questionable purpose of most “financial innovation”), this investment product would change the character of credit provided by investors to firms. It would provide an alternative to the customary form of corporate debt.

True believers might argue that if what I suggest were a good idea, a free capital market already would have discovered it. I’m not a true believer, but I’ll make common cause in part, and point out that securities like those I propose are presently tax disadvantaged, so capital markets have not been free to discover them. In particular, if dividends on preferred equity were tax-deductible to firms like interest, perhaps these securities would already be commonplace. But I’ll reveal my cruel, statist heart by hinting that since firm managers may be myopic in their preference for cheap financing, and since distress costs are in part external to firms, an active policy tilt in favor of more robust capital structures might be worth considering. [1]

I’m suggesting a new financial instrument. Here’s its catchy name: “In-arrears convertible cumulative preferred equity”, or “IACCPE”. (“Yak-pee” for short?) Let’s chop that aromatic mouthful into tasty, digestible chunks:

Preferred equity is a form of investment that is like debt, in that the issuing firm promises to pay an agreed dividend level (like an interest rate), rather than a share of a firm’s variable profits. However, preferred equity is unlike debt, and like stock, because if a firm for whatever reason does not pay the promised dividend, aggrieved investors cannot sue for bankruptcy. Preferred shareholders’ only means of enforcing payment is priority: common equityholders cannot receive dividends if preferred shareholders’ dividends have not been paid.

Cumulative means that if the issuing firm has skipped some dividend payments, the firm is said to be “in arrears”, and must pay preferred investors all past skipped dividends before it can make any payout to common shareholders. “Cumulativity” ensures that, unless a firm goes bust before ever paying another dividend, preferred investors will eventually get all the payments they were promised, although they may suffer from delay. Cumulative preferred equity is more “debt-like” than noncumulative preferred equity, in that noncumulative investors permanently lose claim to some dividends if a company falls on hard times and suspends payments, while debtors always have claim to interest owed.

In-arrears convertible means that while payments on the preferred shares are “in arrears”, when the firm had failed to pay some of the dividends that it had promised and not yet cured the failure, investors would have the option of converting the shares to common stock on favorable terms.

It’s the in-arrears contingency that makes this security novel and interesting (I hope). But the feature requires some explanation. Usually, a convertible security has a par value and a conversion price that fix the number of shares of common stock an investor would get for converting a share of the security. This means that investors normally convert only when a firm is doing well. Suppose you have a share of preferred stock that (without the conversion feature) would be worth $100, but that can be converted to 10 shares of common stock. You would never exercise that right when the common stock price is less than $10, since the preferred share is more valuable than the stock you’d get. You would only convert when the common stock is doing well enough so that the value of the stock you would get on conversion exceeds the value of your preferred share. [2]

An “in-arrears convertible” would be pretty useless unless the conversion price were very low, since firms stop paying their preferred stock dividends in difficult times, when their stock price is depressed. So rather than fixing the conversion price in advance, these securities would be convertible at a discount to the market price of the stock at the time the preferred dividend was not paid. [3] That is, by going into arrears on the preferred shares, firms would open themselves up to dilutative preferred-to-common-equity conversions, at the option of the preferred shareholders. If a firm does have long-term, going-concern value, but is simply unable to meet the cash flow requirements of its capital structure, preferred shareholders could convert at a bargain rate during the limited in-arrears period. If a firm is not likely to be viable as a going concern, preferred shareholders could choose to hold tight. They’d be paid out in preference to common stock holders at the eventual liqudation.

Firms could issue multiple classes of “IACCPE”, like they now offer multiple debt issues, each with a distinct priority in the capital structure of the firm. Ordinarily, these securities would be indistinguishable from debt, both to the firm and to investors. Investors would fork over a set amount of cash, and then expect to be repaid with interest (formally dividends) on a predetermined schedule. But in bad times, firms that fail to meet their obligations would be forced to offer equity, including control rights, to creditors on very favorable terms. (Non-payment of a dividend could also provoke a special shareholders meeting, and holders of the unpaid preferred could be given the right to propose replacement directors, thereby maximizing the value of converters’ control rights.)

Substituting this kind of security for debt in firms’ capital structure would enable a kind of bankruptcy in increments, an automatic and self-enforcing reorganization. I think this would improve value for all stakeholders compared to our present system. Chapter 11 bankruptcy was itself a great innovation, but it exposes even viable firms to large, indirect distress costs when capital structure and cash flows become misaligned. To the degree that a firm has widespread or important stakeholders outside its capital structure (customers, employees, financial counterparties, local governments, etc), Chapter 11 even at its best produces costly externalities, as stakeholders must provision for abrupt and unpredictable changes even when a firm is likely to survive and even thrive once arguments over who gets what are resolved. Because Chapter 11 bankruptcies (and receiverships for financial firms) are disruptive, governments sometimes intervene to prevent them or to the process with subsidies. The expectation of intervention causes investors in “systemically important” firms to over-lend and under-monitor. For large firms, the threat that contractually prescribed, preferred-to-common conversions might be triggered would be more credible than the threat of an uncontrolled bankruptcy without government subsidy. Investors would be forced to actually price the “lower tail”, rather than hoping it will be truncated by the state. Common stockholders would face a steep penalty for missing “debt” payments, but the extent of their dilution would be predictably related to the scale of the obligations they fail to meet.

IACCPEs wouldn’t replace or eliminate traditional bankruptcy, of course. Regardless of capital structure, firms that are not viable businesses will need to be liquidated. Sometimes firms have contractual arrangements other than straight debt that need to be modified if a firm is to become viable. Moreover, even if all “financial” debt were eliminated from firm capital structures (I think that would be a good thing), firms would still have transactional business creditors, for whom traditional “hard” debt makes sense. [4] This proposal does not directly address off-balance-sheet contingent liabilities or pension and health obligations, which are increasingly sources of firm distress. I think pension and health issues will have to be addressed on a national basis, that our employer-centric system of managing health and retirement issues will ultimately have to be, um, retired. But some contingent liabilities (uncollateralized derivative exposures) could and probably should be replaced by contracts that can be paid off in some form of equity (at punitive valuations) when they cannot be paid in cash.

Highly leveraged capital structures make individual firms, and networks of interdependent firms and communities, brittle. Replacing debt in firm capital structures with some form of preferred equity would serve as a shock absorber, allowing viable firms to survive transient cash flow shocks without affecting outside parties. It might be enough to simply level the playing field between debt and preferred equity by making preferred stock dividends tax-deductible for firms. But debt investors take some comfort in the fact that they have power, via the bankruptcy process, to enforce payment. That threat may reduce the cost to firms of debt finance. The sense of the present proposal is to define an instrument that gives fixed-income investors as much of the power they would have in a bankruptcy as is possible while reducing the likelihood of a “singularity” that creates far-reaching costs and uncertainties.


[1] The proposed “IACCPEs” would not necessarily be a more expensive form of financing than traditional debt: On the one hand, they take a weapon away from creditors, so creditors would want to be compensated for the additional vulnerability. On the other hand, by reducing the likelihood that a transient shock provokes an unnecessary bankruptcy, replacing debt with IACCPEs might reduce expected distress costs, and thereby increase overall firm value relative to a firm financed with traditional debt, which would be reflected in a lower cost of financing across the capital structure. Which of the two offsetting factors dominates would have to be an empirical question.

[2] Usually you would wait quite a bit longer than that, because the option of converting at any time makes the convertible security as valuable as the shares, but the agreed-in-advance payments of the unconverted security provides protection should the stock price tank. Exactly when it’s worthwhile to exercise the conversion option on convertible shares is complicated, and in real life depends on the level of dividends paid by common shares and the relative liquidity of the market for common and preferred shares. In frictionless markets for a firm that issues no common dividend, it would only be worthwhile to convert an instant prior to maturity of the convertible security (if it is not perpetual). For our purposes, however, all that matters is that investors usually convert preferred stock only when the common shares are doing well.

[3] Getting the conversion option trigger right would be an important technical issue in defining these securities. Managers might try to manipulate their stock price around the time of the triggering nonpayment, in order to minimize the cost of dilution to existing shareholders (and themselves). The conversion price might be based on an average stock price over 30 days prior. Managers would not have very much scope to time the nonpayments, because they would be required to skip dividends on the most junior class of preferred shares, whose dividend schedule would have been set in advance.

[4] Broadly, “financial” investors should be expected to research and take some responsibility for the firms in which they invest, while customers and suppliers should be able to do business with a firm without worrying very much about its balance sheet. There is no bright line between transactional credit and financial debt, but it is nevertheless a distinction worth making, and even policing, in firms’ capital structure. The “cash efficiency” movement, which encourages firms to maximize their use of transactional credit as a source of cheap financing, is in my view pernicious. But that’s a rant for another day.

Update History:
  • 2-May-2009, 3:50 p.m. EDT: Reorganized a bit, changing the name “In-arrears contingent convertible cumulative preferred equity” to the more svelte “In-arrears convertible cumulative preferred equity”.

Meet Joe Peek

You just never know who you’ll run into here in blogland.

Joe Peek is a professor of finance at the University of Kentucky (where I am a very poor excuse for a graduate student). He has a guest post over at The Hearing.

Dr. Peek’s professional obsession is the Japanese banking system. He takes an unreconstructed view of the parallels between our response to the banking crisis and Japan’s, and is particularly unhappy with the recent softening of mark-to-market rules. Here’s a snippet:

Much like in Japan, U.S. policy makers have made efforts to avoid distinguishing among banks, for example, forcing all of the largest banks to accept billions of dollars of Troubled Assets Relief Program funds. The stress tests for the 19 largest banks provide policy makers with an opportunity for a “do over.” The results of the stress tests must be based on market values and whether the banks are truly economically viable. Government capital should not be injected into banks indiscriminately; only the strong should survive. We need disclosure, as well as closure, if a bank either is not viable or cannot raise sufficient private-sector capital to become viable.

The time has come for transparency to replace the “parency” of government support of non-viable firms, financial or non-financial. The “convoy system” did not work in Japan during their “Lost Decade,” and should not be expected to work here.

Do read the whole thing.

Value for value

Would it have been better if Timothy Geithner had had the power to guarantee all bank debt early on? As James Surowiecki reminds us, that was part of the Swedish solution. Justin Fox plausibly suggests that we might have avoided a lot of pain with a fast, full guarantee.

But that’s not the point. The question isn’t whether we could have avoided this crisis, if only we had cut a big check. We could have, and that was not lost to any of us debating these issues more than a year ago. (See e.g. me or Mark Thoma.) Had we done so, the near-to-medium term fiscal costs might have been less than they probably will be now. So, with 20/20 hindight, would it have been a good idea?

How you answer that question depends upon how you view the crisis. Is it an aberration, a shock to a basically sound financial system, or is it a painful symptom of an even more dangerous condition? Under what circumstances would our political system be likely to impose reforms that would prevent large scale misallocations of capital and shifting of losses to taxpayers in the future?

If you think that our financial system just needs some tweaks, some consolidation of regulators’ organizational charts and sterner supervision, then you should prefer that we had just cut a check, passed Sarbanes/Oxley Book II, and moved on. But that is not what I, or most proponents of nationalization temporary receivership for insolvent banks, believe.

If you believe, as I do, that we need a root-and-branch reorganization of the financial system, which must necessarily involve the dismemberment and intrusive restraint of deeply entrenched institutions, does that mean pain is the only way forward, “the worse the better” in the old revolutionary cliché? It need not mean that. But it does mean that palliative measures, like giving the banks money, would have to be attached to curative measures, like enacting capital requirements and imposing regulatory burdens that would force financial behemoths to break themselves up or become boring narrow banks. For almost two years, policymakers at the Fed and the Treasury, including Secretary Geithner, have offered bail-out after bail-out and asked for nothing serious in return.

Do I regret that Henry Paulson was not empowered to issue a blanket guarantee of bank assets early on, as the Swedes did? No, I don’t regret that at all. Why not? Because I think that “Hank the Tank” was a crappy negotiator, not only for taxpayers in a fiscal sense, but also for the economy and the polity more deeply. He would have offered the financial system sugar without requiring it to make the medicine go down. He may believe, quite sincerely, that a cure would be worse than the disease. He may believe that, but he is wrong. If we “get past this crisis” by restarting a consumer-credit-based, indiscriminate-investor-financed, current-account-deficit-making, income-inequality-expanding economy, we will have increased, not diminished, the likelihood of a major collapse.

You may believe that we have learned our lesson, that if we can just get some stability and comfort for a while we are prepared to do what must be done. That’s a respectable position. But I don’t share it, and neither do the majority of Americans who are unwilling to allow their representatives to sign off on any more expensive aspirin. We want value for value, an ironclad commitment of root and branch reform in exchange for the unimaginable sums of money we are being asked to hand over.

Surowiecki has in the past suggested that those of us who favor nationalization would criticize any alternative simply because it is not precisely the policy we advocate. But it is not we who have refused to compromise. We’ve seen variations on the same basic proposal over and over again. Geithner’s PPIP really does resemble Paulson’s TARP, besides the part about actually asking taxpayers for the money. Each latest plan from our incestuous cadre of economic Mandarins demands only symbolic concessions from the dysfunctional organizations we are asked to support. The “moderate” political class goes on and on about how Geithner and Bernanke have to go all Enron, funding the banks via off-balance-sheet guarantees and special purpose vehicles, because “populist, childish” Congress won’t put up the money. Setting aside how audaciously corrosive that sentiment is to Constitutional democracy, it is simply wrong. Congress would, because the public would, support large, explicit transfers, if they were attached to reforms sufficiently radical to prevent a recurrence, and suitably punitive towards the people who managed the system that brought us here. Value for value.

I am a true believer in American-style capitalism. So I would like to see people who earned profits lending to banks in good times bear the high costs of failing to monitor the organizations they funded. Investor fear is what is supposed to prevent the indiscriminate misuse of capital. To the degree that creditors have leaned upon “implicit” government guarantees, I think it would both be just and set a useful precedent if they were reminded that investors have to take responsibility for where they place the precious capital they steward.

That said, like Paul Krugman, I would be willing to hold my nose and tolerate a Swedish-style guarantee of bank creditors. I’d acquiesce to that even without formal nationalization. Nationalization is no one’s idée fixée. It is a means to an end, and the desired end is a world in which too big to fail is too big to exist for any financial institution that originates or holds credit risk in any form. Secretary Geithner could send a bill to Congress today that would put all banks with a balance sheet of over $50B into run-off mode, while clearing away legal obstacles so that larger organizations could arrange their own breakups over time. I’d fax my Congressman and support a $2T on-budget buyout of bank creditors as part of that bill, as long as it had teeth. (“Teeth” would include making sure that off-balance-sheet and derivative exposures were included in the size cap, etc.)

It’s not that us pitchfork-totin’ populists are unwilling to pay the bill. It’s that we want to know that in exchange for writing a very, very large check, the people that we are paying will actually deliver the goods. Given the behavior of bankers before the crisis and of shifty policymakers during, we have every reason to watch warily and to insist upon every precaution while we hand over suitcase after suitcase of freshly printed Federal Reserve notes.

Update History:
  • 28-Apr-2009, 1:20 a.m. EDT: Thanks to the excellent Nemo of self-evident fame for pointing out that I’d forgotten the tricky distinction between “to” and “too”. Fixed, I hope. From now on, I’m jus’ gonna write “2B2F”.
  • 28-Apr-2009, 2:40 a.m. EDT: imply include