James Surowiecki has been pushing the idea (first mooted by John Hempton) that since bank financing always involves non-recourse by taxpayer (via government deposit insurance), it’s no big deal that the Geithner Plan is built around generous non-recourse lending. Surowiecki:

There is one detail of the plan, though, that people are particularly bothered by, and that is the fact that the plan involves the FDIC guaranteeing loans to private investors. (The way the plan to buy pools of mortgages is set up, investors will be able to borrow six dollars for every one dollar they invest. If their bets go bad, they lose only the one dollar they invested—the FDIC is responsible for paying back all the borrowed money.) Paul Krugman, for instance, calls this the “central issue,” and argues that because the non-recourse loans are a massive subsidy to investors—which they are—the plan will distort the prices that investors are willing to pay for these assets, and therefore “has nothing to do with letting markets work.” Ezra Klein, similarly, argues that because the plan relies on these “non-recourse” loans, the prices it will produce will be in some way “artificial.” Their point is that the Geithner plan, among other things, is supposed to produce real market prices for these toxic assets, which will then give us a better picture of banks’ balance sheets and allow us to avoid valuing these assets at prices that the government thinks have become unduly low because investors are so risk-averse. But by creating a plan in which investors have only a small downside and a big upside, we’re supposedly creating fake prices.

There’s no doubt that the non-recourse loans constitute a big subsidy: while investors’ downside risk isn’t eliminated, since they can still lose all the money they invest, that risk is significantly limited, while their potential upside is significantly increased (since they’re leveraging every dollar they invest six-to-one). Yet for all the criticism of this subsidy, the truth is that the plan’s reliance on non-recourse loans is not an especially radical idea. In fact, it’s essentially the same kind of subsidy that the entire U.S. banking system has depended on for the last seventy-five years. What are FDIC-insured bank deposits, after all? They’re non-recourse loans to banks. You deposit money with a bank—that is, you lend it your money. The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it’s invested. All the rest of the bank’s losses are paid for by the FDIC. This is precisely the same arrangement — down to the loans being guaranteed by the FDIC—that the Geithner plan sets up. In effect, it just extends to outside investors, for the purpose of acquiring toxic assets, the same subsidy that banks have been receiving since 1933.

Surowiecki is right in a superficial way, but he misses crucial details. His analogy breaks down in ways that I think are informative.

Non-recourse financing involves bundling a valuable put option along with a loan. The value of that option hinges on the details of the arrangement: An “at-the-money” option is more valuable than an “out-of-the-money” option. The “moneyness” of the implicit put option in a non-recourse arrangement is determined by the degree of leverage the borrower is allowed. The Geithner plan permits a maximum leverage of 7:1 assets to equity. As Surowiecki points out, that degree of leverage is less than the leverage of a traditional bank.

But notional “moneyness” is not the only thing that determines the value of an option. In particular, options are most valuable when the assets that underlie them are very volatile. In order to limit the degree to which banks maximize the value of the deposit insurance option at the taxpayers’ expense, banks are supposed to submit to onerous, intrusive regulation that limits the riskiness, the volatility of the assets they can purchase.

Under the Geithner plan, the government will extend its non-recourse option to investors without preventing them from “swinging for the fences” on risk in order to extract value from the option. On the contrary, the government is insisting its loans be used to purchase assets that have already proved themselves unsuitable for purchase by a regulated entity, by virtue of being volatile and difficult to price. It’s as if an insurance company that ordinarily refuses to cover homes in hurricane states suddenly offered policies only to purchasers looking to build homes on Gulf-coast barrier islands.

Sometimes an option is costly to exercise. Exercise costs reduce the value of an option to its owner along with the expected liability of the option writer. The traditional deposit insurance option was very costly for banks to exercise. Banks were only allowed to exercise the option by being put out of business. That sharply limited the value of the FDIC option to bank employees and shareholders. Usually the “franchise value” of a bank is greater than its regulatory capital. In order to extract value from the option, bank stakeholders must take bets whose (probability-weighted) payoff in a good outcome exceeds not only the loss of regulatory capital, but also the value of the business as an ongoing concern. Moreover, if we are valuing the “traditional” FDIC option, we should go back just a few decades to when most banks were privately held and run by lifers. A typical bank’s owners and employees had an illiquid, undiversified exposure to the well-being of their institution. Calculating franchise value from the price/book of Citi pre-crisis would dramatically underestimate the value of a traditional bank to its controlling stakeholders. Exercise of the FDIC option used to be costly indeed for the owners and managers of banks. There were, if you’ll excuse the terms, “synergies” between regulation and a high cost of exercise: If triggering a deposit insurance payout is very painful, strategies designed to monetize the option need a fly-to-the-moon upside to be worth the risk. But spaceports are more likely to be flagged by regulators than an extra 100 bps on a “AAA” CPDO.

Unlike deposit insurance, the non-recourse option offered to investors in the Geithner plan is completely costless to exercise, once it is in the money. Surrender of the collateral constitutes fulfillment of the lending contract full stop. Pace Megan McArdle, it is not like the non-recourse option implicit in the typical home mortgage, where exercising the option involves a hit to ones credit. There is no default of any sort involved in surrendering the assets rather than repaying the loans. The right to do so will be written into the deals.

Finally, the FDIC option didn’t used to be free. Banks paid a fee in exchange for the deposit insurance. Under the Geithner plan, borrowers will be charged a fee as well, but then they’ll be borrowing at rates dramatically lower than they could on their own. This works with Surowiecki’s story — banks borrow very cheaply from depositors because of the FDIC guarantee. But, as always, the question is price: Given the volatility and uncertainty surrounding the underlying assets and the near-zero cost of exercise, will the FDIC charge a fee high enough to cover the expected liability of the option? I’ll leave that for readers to decide.

Surowiecki’s analogy does work pretty well if we compare the Geithner plan not to traditional banking thirty years ago, but to recent practices of the industry. Thanks to hands-off government and structured-finance shell games, banks were recently able to amass high risk, high yield investment portfolios despite being ostensibly regulated institutions. Institutional changes, including changing norms about the length and terms of bank employment and dominance of the industry by large, heavily-traded limited-liability corporations, decreased the expected cost of exercise to bank employees and informed shareholders, making volatility maximizing strategies more attractive. The option premium, the FDIC fee, was severely underpriced (it was reduced to zero from 1996 to 2006).

If Surowiecki wants to argue that the non-recourse option embedded in the Geithner plan would basically reproduce the subsidy to the banking system offered circa 2006, I’ll readily agree. But it is not reasonable to argue that non-recourse loans offered on generous terms to unregulated investors for the express purpose of purchasing unusually volatile assets represent the “same subsidy that banks have been receiving since 1933.”

The Compulsive Theorist has written a truly excellent post on bank bailouts (ht Mark Thoma). I’ll excerpt a bit below, but do read the whole thing:

I sympathize with the point of view which says that the political window of opportunity is narrow and the need for action urgent, so let’s accept the bailout plan for now, and deal with… wider issues later on. But the very fact that political momentum is limited means that if these wider changes are to be brought about, the process has to begin in earnest at once. Does anyone seriously believe that in a years time, if following massive government support the banks are stable — or can be made to appear stable — there will be any political will to break up very large institutions, or any real change to underlying norms in the financial sector?

However, absent these deeper changes, it is entirely possible that we will see a replay of the crisis — but on a larger scale — in a few years time. Naturally, one cannot say with certainty that such a cataclysm (and if it were much larger than the current crisis, it really would be a cataclysm) will occur. But if it does, the resulting costs will be huge. Martin Wolf has written persuasively about the costs of major economic dislocation. Net of unemployment, political instability and even wars, the human costs of a sequel could dwarf even the current crisis. Then, the choice in the present between the “bailout” and “restructuring” plans hinges on whether expected cost (in the broadest sense), conditioned on the “bailout” strategy is higher than expected cost conditioned on “restructuring”. One could formalize this argument as a decision problem, but it comes down to a judgement call on the relative probability of such a cataclysm under the two strategies and the magnitude of the dislocation. My feeling, admittedly subjective, is that the gloomy cataclysm scenario is substantially more likely under the “bailout” than “restructuring”, and that the costs would be immense.

This case can be put very simply: if we do not use current political momentum to fundamentally reform a system which has shown itself to be unstable and even dangerous, a second opportunity may come at a very high price. And this is not a gamble I wish to see our leaders make.

I often wish I were Mark Thoma. If I were Mark Thoma, I could be smart and paying attention without being bitter.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Unfortunately, I have a darker temperament, a spirit less generous and optimistic than Mark’s. I am filled with despair, not because what we are doing cannot “work”, but because it is too unjust. This is not my country.

The news of today is the Geithner plan. I think this plan might work very well in terms of repairing bank balance sheets.

Of course the whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by legacy bankers.

I think that critics of the Geithner plan are missing some of its tactical brilliance. My guess is that behind the scenes, Geithner has arranged a kind of J.P. Morgan moment. You know the story. During the Panic of 1907, J.P. Morgan locked a bunch of bankers in a room and insisted they lend to stave a panic. We’ve already seen one twisted parody of this event, when Henry Paulson locked a bunch of bankers in a room and insisted they borrow money from the Treasury. This second one is more clever. I don’t think the scandal of the Geithner plan is going to turn out to be the subsidy to well-connected investors embedded in the non-recourse loan put option. On the contrary, I think that Treasury has already lined up participants for the “Legacy Loans Public-Private Investment Fund” and persuaded them to offer prices so high that despite the put, investors will expect to take a major loss. My little conspiracy theory is that the Blackrocks and PIMCOs of the world, the asset managers who do well by “shaking hands with the government“, will agree to take a hit on relatively small investments in order first to help make banks smell solvent, and then to compel and provide “good optics” for a maximal transfer from government to key financial institutions.

Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner’s plan, PIMROCK’s $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK’s $10B is wiped out entirely, as is the Treasury’s investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss. But, as Calculated Risk, likes to say “Hoocoodanode?” These were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they’ve received assurances that if we can get the nation out of the financial pickle it’s in, there will be no haircuts on those bonds. “Shaking hands with the government” means that nothing ever has to be put in writing.

Welcome to America, 2009. Change we can believe in.

The scenario I’ve presented is a variation on this by Karl Denninger (ht Tyler Cowen).

I liked this post today by Matt Yglesias:

My biggest concern about the PPIP approach to the banking system is that even if it works, what it does essentially is return us to the pre-crisis status quo — banks that are so large that they’re too politically powerful to regulate effective and too systemically important to be allowed to fail. That’s a recipe for dishonest transactions that produce short-term profits at the cost of blowups. One appealing element of nationalization is that it can easily be made to end in a world in which there is no institution named “Bank of America” or “Citi” and no such gigantic institution.

On the bright side, I’m thankful that we have people like Paul Krugman, Simon Johnson, and Willem Buiter, who fight the good fight while being too eminent to ignore.

On the dark side, try here, here, and here.

The most troubling thing about trying to tax back jackpots paid by firms that are now on public assistance is that an effective measure would have to apply retrospectively. That is, the people who are responsible for the terrible decisions made at systemically important financial institutions have already been handsomely paid for their mistakes. Nearly all of them were paid well before December 31, 2008. A measure that only interferes with current and future pay would simply teach the next generation of “rational agents” that if they cash out fast and early, nothing can be done to them. That was precisely what the current crop of malefactors expected. The whole point of a tax clawback would be to violate that expectation, and to eliminate it going forward.

The House has passed a very poor tax clawback bill (ht Conor Clarke). It is almost prospective — the law would apply only to payments made from January 1, 2009 forward. But almost prospective is like half pregnant. The bill is retrospective for just long enough to clawback the politically fetishized AIG bonuses, while leaving those who made out during the thick of the toxic credit bubble completely untouched. It has all of the philosophical distastefulness of an ex post law, and no offsetting benefit whatsoever, other than punishing a few trophy miscreants from AIG. I would support a well-designed tax clawback, but this ain’t it. Hopefully the Senate comes up with something better.

I think a good tax clawback

• would apply to employees of all firms that have received public capital and that are unable to repay that capital prior to some reasonable deadline several months in the future (so that healthy banks persuaded by Paulson to accept money can be excluded).

• would tax compensation paid (or accrued) to individuals during the period of the credit bubble, maybe from January 1, 2004 to December 31, 2008.

• would apply to all forms of compensation (not just bonuses), but only above some fairly high floor. (In a previous post I suggested $200K, but I think that’s too low. $500K or $1M would be better.)

• would apply at a high rate, but one that is arguably not confiscatory or punitive. 50%, maybe 60%, would be reasonable. 90%? No.

• would be justified in terms of cost-sharing between taxpayers and highly compensated employees when weakness of a systemically important firm occasions public financial assistance.

Future compensation at firms already on life support oughtn’t be regulated via so roundabout an instrument as a tax clawback. Henry Blodget has an excellent post on how dumb the House measure is looking forward. If we want to control pay levels at zombie firms, the government should put them into receivership and manage them properly. Setting compensation policy via the IRS no way to run even a very bad bank.

Update: Oh, one other thing that Congress really needs to do already is to restrict the ability of systemically important firms, somehow defined, to file for bankruptcy without first providing an opportunity for the government to intervene. Obviously, a broader regime for resolving sick uberbanks (as called for by Ben Bernanke) would be ideal, but at the very least, firms ought not have the power to play chicken with the government by threatening a disorderly collapse. This is not a new problem, but it’s relevant here because if a serious tax clawback were to be passed, a ruthless CEO wishing to avoid the tax could return the TARP money and take a troubled firm into bankruptcy, provoking a large-scale panic.

Monday night, when I wrote about tax clawbacks, I was afraid that the idea would be written off too quickly based on an oversimplistic view of the law. Two days later, it’s like a movement. At least six members of Congress are on record as trying to craft some sort of tax clawback, Conor Clarke has Larry Tribe opining that a well-crafted clawback would be Constitutional, and widely read bloggers like Kevin Drum and Felix Salmon have considered the idea supportively. Tonight Bloomberg reports that

The senior members of the Senate Finance Committee from both parties proposed taxes totaling 70 percent on bonuses at AIG and other companies getting federal money during the U.S. financial meltdown. House Speaker Nancy Pelosi directed committees there to draft several alternatives and said her chamber may consider a bill as early as this week.

If we’re going to do this, and it looks like we might, we had better get it right. Regardless of the legal technicalities, a tax clawback does represent a kind of escalation. It sits awkwardly with norms and ideals that are less a matter of law than we think but that are nevertheless an important part of American political culture. In our better moments, we dislike “collective punishment” and try not to change the rules of the game out from under people midstream. On balance, I think the benefits of a well designed tax clawback could exceed its costs. But a poorly designed clawback would set a corrosive precedent for no other purpose than to salve and misdirect public rage.

The main benefit of a tax clawback would not be to punish bankers for the looting they have already done, but to set a precedent. Many commentators (e.g. Surowiecki) have pointed out that during the credit bubble, market discipline failed not so much because shareholders expected to be bailed out, but because the employees who run financial firms could cash out short-term gains regardless of long-term costs to shareholders and taxpayers. The precedent of a tax clawback would put future employees of systemically important financial institutions in jeopardy. They would know that if their mistakes provoke a taxpayer bailout, their personal wealth would be on the line. Eliminating their sense of inviolability, making it impossible for bankers to simply walk away from the losses they impose on investors and taxpayers, would, I think, result in structural changes to financial institutions. Risk-takers would congregate in definitely-small-enough-to-fail boutiques and hedge funds. Managers of systemically important banks would lobby for regulation to prevent competition from forcing them into risky practices that might provoke a clawback of their personal net worth when things go bad.

The dumbest possible tax clawback would be a punitive one-off designed to recoup the AIG bonuses. The brazenness of those bonuses has galvanized public anger, and served usefully as a tipping point, but in the scheme of things recovering less than half a billion dollars of a multitrillion dollar bailout will not matter very much. In order to set a useful precedent, a tax clawback needs to be broadly and rationally targeted. That is, employees of any and all institutions whose weakness necessitates a public bailout must be subject to the clawback. The Paulson Treasury, as a matter of insidious policy, made it difficult to distinguish between failing and healthy banks by forcing solvent banks to suck up TARP money along with the zombies. A good clawback proposal would encourage healthy banks to return any public assistance they’ve received over a period of several months, and then claw back funds only from employees of banks that are unable to return the funds without violating capital or liquidity requirements. (The law would have to address wrinkles like how to let banks “return” noncash assistance such as asset guarantees.)

A good tax clawback would not have to be very punitive. While getting back the money is an important purpose of a clawback, establishing the principle that the people who run financial institutions will be made responsible for cleaning up their own messes is far more important. Levying a 100% tax on bonuses might be satisfying, but so draconian a law would only pass if it were uselessly addressed to a single scapegoat rather than applied to financial institutions broadly. I’d recommend a 50% tax on compensation above maybe $200,000 in any year during the four years prior to the public assistance. Since this tax would represent an unexpected expense to the people it would affect, I’d allow the liability to be spread out over a period of several years. In general, the law should be structured and justified as a means of having the parties responsible for a financial disaster bear part of the cost of the cleanup, not as punishment.

One might worry that if the tax is too mild, future bankers might not be discouraged from taking foolish risks at critical institutions. If a big bet can get you a $10M bonus this year, but you’d have to return $5M if things go wrong next year, it might still be worth taking the bet. I think there’s less to this than meets the eye. Once a firm precedent is established that previous years’ compensation is fair game to pay for a taxpayer bail out, bankers would have to keep in mind that tax rates can always change, and that legislators might be less reticent next time around, when the use of clawbacks would not be novel and controversial. The law might even establish a higher tax rate for future failures.

In order for an ex post tax to be Constitutional, it should apply broadly and have some legitimate purpose besides just punishing someone. Kevin Drum gets a bit sardonic about this:

So it looks like the answer here is simple: even though the purpose of this tax would pretty clearly be punitive with extreme prejudice, we need to carefully pretend that it’s not. And we need to make sure the legislative history shows that it’s not (it should be “manifestly regulatory and fiscal” Tribe says). Then everything is kosher! We can tax their socks off!

While a lot of us might want to be “punitive with extreme prejudice”, this is too cynical a view. The requirements of the Constitution seem perfectly consistent with imposing a clawback that permanently alters the incentives of the people who run systemically important banks. A good law would be both retrospective and prospective. It would help defray the costs of the current crisis while firmly establishing the principle that the individuals who run critical financial institutions can be decompensated if they let those institutions melt down on their watch. The analogy to Superfund is quite close, I think. If we do this, we oughtn’t conceptualize what we’re doing as finding a loophole we can use to shaft the f@kers. We should craft a good law that lets us to recoup some of the cost of cleaning up existing messes, and that defines a framework for sharing the cost any future messes with the people most responsible for them.

Rep. Carolyn Maloney is circulating a bill that would try to claw back bonuses taken by employees of firms that had to be bought by Uncle Sam. I’d quibble with the terms of her proposal, and, although I’ve suggested something like it myself, I’m not sure this is a road we want to start down.

I am sure, though, that this idea — levying a special tax on people who were paid very large sums of money in recent years by firms that have been expensively rescued by the Treasury — deserves to be a part of the mainstream debate. Let it be thoroughly vetted, then enacted or rejected after careful consideration.

Conor Clarke suggests that such a bill would be unconstitutional on its face. I think he’s wrong about that. He cites the following line from the US Constitution:

No Bill of Attainder or ex post facto Law shall be passed.

I am not a lawyer, but I don’t think this prohibition would much apply, as long as the tax is civil and remedial in nature, rather than criminal and punitive. Consider the so-called “Superfund” law, which made polluters liable for cleaning up environmental messes, even though that liability may not have been written into law at the time when the polluting was done. The current banking crisis strikes me as quite analogous to the Superfund situation: A large class of private actors have caused harms that must be remedied. While the state has no choice but to pick up some of the tab, it also identifies the responsible party and holds them partially liable for the mess they have made. We even use the same words: It’s all about “toxic waste”.

Thanks to Google books, I can quote Daniel E. Troy, of all people, the former chief counsel of George W. Bush’s FDA. (There’s something fitting and ironic about that. Look him up.) In Troy’s book Retroactive Legislation (1998), he writes

Carefully assessed, the argument that CERCLA [Superfund] is unconstitutional is in tension, at least, with the Supreme Court’s current interpretation of the ex post facto and bill of attainder clauses. It may also be at odds with the original understanding of those clauses.

A Bill of Attainder? The contention that CERCLA violates the bill of attainder clause may be dispensed with easily. Under the Supreme Court’s current case law, the class “responsible parties” is almost certainly not sufficiently small to warrant treatment as a bill of attainder. The Court, which has not struck down a law under the bill of attainder clause in thirty years, is not likely to consider CERCLA a “legislative punsihment . . . of specifically designated persons or groups.” Moreover, as we have seen, the bill of attainder clause was originally understood to prohibit laws that affected life and liberty only.

An Ex Post Facto Law? Because the ex post facto clauses do not apply to civil laws, Superfund therefore would have to be characterized as punitive in nature to be classified as an ex post facto law. The current Court, though, has suggested that unless a law is exclusively punitive, it will not come within the scope of the ex post facto clauses. Although CERCLA certainly has a punitive element, it is hard to contend, under the relevant Supreme Court test, that it “may not be fairly characterized as remedial, but only as a deterrent or retribution.” [emphasis original]

Speaking personally, I might prefer that Clarke’s naive interpretation of the Constitution were binding. Again, I don’t like the taxback approach, it puts us on a slippery slope to a lot of things I’d find disagreeable. But then I also dislike it when idealistic protections apply to the wealthy and well-connected while ordinary people have their vehicles forfeited ‘cuz the cop said he smelled pot. And the scale of the injustice to be remedied here viz the financial system is immense. I think we should carefully consider all our options, and hire very good lawyers. We certainly oughtn’t take the CEO of AIG’s word for it that nothing can be done.

I would point out that effectively ex post changes to civil law are quite common. Greg Mankiw is teasing Larry Summers today for supporting ex post changes in contracts with respect to so-called mortgage cramdowns. But the 2005 bankruptcy law also amounted to an ex post change in the terms of nearly all debt contracts, as did the original prohibition of cramdowns on a principal residence, which had fallen within the ordinary powers of a bankruptcy judge until the late 1970s.

The law may be the law, but it is also a battlefield upon which people play to win and hypocrisy is everywhere. I’d like to be idealistic, but if that means a kind of “unilateral disarmament” under which the least idealistic run roughshod, we’d better try a different strategy.

Update: Marc Ambinder (ht Clusterstock) reports on a tax clawback proposal by Rep. Gary Peters.

A suggestion for Congress: Tax clawback proposals should be written to apply to a rational and preferably large class of people — singling out AIG bonus recipients won’t fly. I’d suggest setting specific support criteria for firms (e.g. firms to which at least $2B of Treasury funds were provided or $10B of assets guaranteed, with support not returned or relinquished prior to September 20, 2009), income floors for individuals (e.g. applies only to income over $1M in any year between 2004 and 2009), a high but not outrageous tax rate (maybe 50% of earnings above $1M, not 100%), and a generous repayment schedule (payment of taxes under the act due can be spread over a five-year period). All in all, a proposal should be a reasonable means of identifying agents who benefited extensively from activities that induced a government bailout and asking them to contribute alongside taxpayers to a remediation effort.

Update 2: The excellent and widely read Kevin Drum writes about an ex post tax on bonuses, and seems broadly supportive. This idea may yet get a mainstream, public vetting. Drum quotes a Washington Post story

In the House, Reps. Steve Israel (N.Y.) and Tim Ryan (Ohio) introduced the “Bailout Bonus Tax Bracket Act” to create a 100 percent tax on bonuses over $100,000 that are distributed to employees of financial firms receiving federal bailout funds.

This is the most sensible variant so far pursued, but I think going for 100% is too aggressive if the good Representatives are not just grandstanding. Senators Harry Reid and Max Baucus would tax 98% of AIG bonuses only, which I think is not a good idea. (It’s narrow and punitive, so it might not pass constitutional muster, and it scapegoats AIG employees only rather than getting the gatekeepers of systemically important financial institutions broadly, the group that should really be held responsible.)

Update 3: Conor Clarke responds, and gets an opinion from Harvard law prof Laurence Tribe to boot. I think it’s safe to say that this idea is under consideration in mainstream policy circles. Megan McArdle expresses some concerns. Felix Salmon turns populist.

I like reading James Surowiecki, because he’s smart, and because I tend to read exactly the same facts he reads and draw precisely the opposite conclusions.

In two recent Surowiecki posts (here and here), Surowiecki points out that during the banking crises of the early eighties and early nineties, banks were arguably as insolvent as our banks are today, but hey, with a little time and without any radical changes, everything turned out great.

The means by which banks recover their rude health, if you give them time, deserves a critical review. I mean to pen some nasty polemic about that, but for the impatient, Yves Smith tells much of the story (with all too little nastiness). See also here, and think about how much poorer people who run credit card balances have paid over the years on loans tied to the “prime rate”.

The fundamental difference between my perspective and Surowiecki’s is that I don’t think those previous recoveries were real. My view is that the crisis that we’re in now is precisely the same crisis we’ve been in since at least the S&L crisis. We’ve had a cancer, with some superficial remissions, but fundamentally, for the entire period from the 1980s to 2008, our financial system in general and our banks in particular have been broken. They have profited from allocating capital poorly, from funneling both domestic loans and an international deficit into poor investments (current consumption, luxury housing) rather than any objective that might justify arduous promises to repay. We all got a reprieve during the 1990s, because internet enthusiasm persuaded many investors to fund our consumption via equity investment, which we could wash away relatively painlessly in a stock market crash. Debt investors don’t go so quietly. Thanks to the cleverness of our banking system, we have a very great many lenders, both domestic and foreign, who’ve invested in trash but who demand to be made whole at threat of social and political upheaval. That is the failure of our banks. That they are insolvent provides us with an occasion to hold them accountable, and to reshape them, without corroding the rule of law or respect for private property.

(Incidentally, I don’t think that the problem is overconsumption or that austerity is the solution. I think we can afford to throw a perfectly good party, but it has been easier to put everything on the credit card than to come up with smart ways to pay for the economy we want in real time.)

Surowiecki seems to believe that if we could resolve the current crisis in pretty much the way we resolved the previous crises, that’d be okay. For me that’s the second-worst-case scenario, after a major social collapse. Because I know that a superficially reformed financial system, both in terms of banking and international architecture, will continue to do great harm, permitting imbalances and injustices that will bring a serious collapse or a dangerous war if they are not addressed. We are fortunate, very fortunate, that things have pretty much held together so far, and for that people whom I usually criticize, Messrs Bernanke, Paulson, and Geithner, deserve some credit. But if they manage to “save the world” like that famous committee did during the LTCM crisis, with a lot of empty talk but no real changes once the crisis had passed, we will be here again, and we won’t get lucky forever. This is a very serious business.

There are profound economic problems in the United States and elsewhere that our financial system has proved adept at papering over rather than solving. Those of us who’ve played Cassandra over the years have been regularly ridiculed as just not getting it, as economic illiterates and trade atavists. Unfortunately, as Dean Baker frequently points out, the people who could never see the problems are the only ones invited to the table when the world cries out for solutions. The solutions on that table are those Surowiecki tentatively endorses, weather the storm, take some time to repair, the temple is structurally sound. But the temple is not sound. We either build a decent financial system, or suffer real consequences, in unnecessary toil and lost treasure, in war and conflict over false promises set down in golden ink.

The banking mess and the high unemployment rate are not the crisis, they are symptoms. This is not “dynamo trouble”, it is a progressive disease, and what is failing is the morphine. Those of us who believe that financial capitalism is a good idea, that it could be the solution, not the problem, do their cause no favors by resisting radical changes to a corrupt and dysfunctional facsimile of the thing. We need to approach financial capitalism as engineers, and to largely rearchitect a crumbling design. If we don’t, we may be so unfortunate as to suffer yet another superficial remission. But error accumulates, and error on the scale now perpetrated by national and international financial institutions is unlikely to be without consequence.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This is a simple point.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In a different post, Drum points out that

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

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

Drum is right when he argues

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

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

If Drum is right that…

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

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

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