October 5, 2008
Equities, Pay Caps, Liquidity: Structuring a Bailout
Equities, Pay Caps, Liquidity: Structuring a Bailout--Posner
I want to comment on Becker's post, of course, but I will also take the opportunity to respond to one of the themes in the very interesting comments that readers of our blog made on my post of last week.
I agree completely with Becker that the government should not in general have an ownership interest in private companies. The "in general" qualification is intended in part to approve of allowing the government to acquire such an interest temporarily, as part of the current bailout (for reasons I explain below); and in part to leave open the question whether the Social Security Administration should be permitted to invest some of its funds in the stock market; if the investment were spread over the entire market, so that SSA had only a very small stake in any given firm, the influence of government on firm management would be small. I would worry, however, that it would grow and turn out to be an entering wedge for socialism, but that is a story for another day.
I also agree that caps on the salaries of the executives of banks that participate in the bailout are dumb. Not only are such caps bound to be evaded, but if they were not evaded they would have the curious effect of subsidizing mediocrity. Capping the salaries of the executives in one industry will drive out (and deter from entering) some of the ablest executives, creating a space that will be filled by mediocrities. The allocation of talent across industries will be distorted and the recovery of the financial sector retarded.
Where I differ from Becker is with respect to the question whether the government should demand common stock in the banks it buys assets from. I think it should (as it is authorized to do by the bailout law just enacted).
The reason goes to the heart of the justification for the bailout. The banks are holding assets of dubious value. This makes them reluctant to lend money, because as I explained in my last post what banks do is borrow (for example, from depositors) and then lend the borrowed money, and they need a capital cushion against the possibility that the people they lend to will default. The smaller the cushion, the more conservative a bank's lending policy must be.
If the government in executing the bailout buys the bank's bad assets at prices equal to their true, low value, the bailout will have no effect (with a qualification, concerning liquidity, noted below). A bank will be exchanging an asset worth say $1 million for $1 million; its capital will be no greater, and so neither will its willingness to lend be any greater. The bailout will work only if the government overpays. Suppose it pays $2 million for an asset worth only $1 million. Then it has added $1 million to the bank's capital. That capital is owned by the bank's shareholders. The government's purchase of the asset will therefore have enriched the shareholders.
Moral-hazard issues to one side, why should the taxpayer be enriching shareholders? The alternative is for the government to say to the bank in my example: we will pay $2 million for your lousy asset but in exchange we want you to issue us $900,000 worth of stock. (Not $1 million worth of stock, for then the bank might have no incentive to make the sale--or might, as the capital infusion could help it to stave off bankruptcy.)
I anticipate the following objections: (1) The banks will not participate. But why not? They would not only be making money on the deal; as I just mentioned, by strengthening their capital base they would also be reducing the likelihood of bankruptcy. (2) Government should not have an ownership interest in private companies. I agree, but this would be a temporary interest; the government would sell its interest as soon as it could find a private purchaser. (That was what happened in Sweden after it bailed out its banks from a crash similar to ours in thr 1990s. See Joellen Perry, "Swedish Solution: A Bank-Crisis Plan That Worked," Wall St. J., Apr. 7, 2008, p. A2.) (3) The taxpayer can recoup completely without the government's taking an ownership interest because the problem is not that the "bad" assets are so bad, as that they are illiquid; the bailout will restore liquidity without adding to bank capital.
The third point is the most important, and let me pause on it. The idea behind it is that the value of the "bad" assets that the banks hold is unnaturally depressed by the panic that has seized the financial industry. The bailout will dispel the panic and so restore the "bad" assets to their true, "good" value. The government will need only to hold the assets until their maturity and it will be able to sell them then at a price equal to or even higher than the "excess" price that it will have paid for them during the bailout.
The objection to this analysis is that if the situation is as depicted, there should be more private buying of bad bank assets than we are observing. Buffett should be investing not only in Goldman Sachs but also in hundreds of other financial institutions. There is plenty of global capital and why isn't more of it going to the purchase of bank assets whose true value is greater than their current market value? The bailout makes most sense if hundreds or even thousands of banks (there are more than 8,000 banks in the United States) really are broke or nearly broke, so that credit will dry up unless there is a massive infusion of capital into the banking industry. The fact that the required infusion is coming from the U.S. government suggests that the global capital markets are not confident that they could recoup investments in buying bank assets.
But this objection is not conclusive. It is possible that the banks' problem is not, or at least not only, undercapitalization because of the decline in the value of their assets, but lack of liquidity, which is different. Suppose you have a very valuable asset but all of a sudden the government decrees that money is no longer legal tender--that all transactions henceforth must be in bamboo shoots. Now, though your asset was valuable before the decree and will again be valuable when the decree is lifted, at the moment there is no market for it. If you do not know when the decree will be lifted, you will be very reluctant to make loans, because you will not know whether, if a loan goes sour, you can sell or borrow against your assets in order to cushion the loss and avoid bankruptcy.
If that is the problem, the bailout may restore liquidity and thereby enable banks to sell or borrow against assets on the basis of their true value, and eventually the government will recoup the cost of the bailout, because it will own those assets and can sell them, when markets return to normal, for at least what it paid for them. But probably the banks' problem is a combination of undercapitalization and illiquidity. Their assets include assets whose value is tied to mortgages, and the value of mortgages has declined because of increased risk of default as a result of the bursting of the housing bubble. Insofar as the bailout helps banks to overcome undercapitalization as well as illiquidity, it will be enriching the banks' owners--unless it demands common stock in partial compensation for its buying the banks' questionable assets for more than they are worth.
The theme in the readers' comments to which I would like to respond, and it is also a theme in the Wall Street Journal's editorial comments on the financial crisis, is that government policy, rather than the free market, is responsible for the crisis--government policy in the form of encouragements spurred in part by Congress to home ownership through the government-chartered though private Fannie Mae and Freddie Mac home-mortgage companies, low interest rates imposed by the Federal Reserve Board, and lax supervision by the Securities and Exchange Commission and other regulators. I wish it were true. And what is true is that the government, including Congress, the Federal Reserve Board, and the SEC, were complicit in contributing to or creating some of the preconditions for the crisis--cheap credit and lax regulation. But there is a difference between creating and merely exacerbating a crisis. Moreover, it is a paradox to exonerate the market on the ground that the government did not do enough to regulate it!
I believe that the basic causes of the crisis were six factors internal to the market system. The first was abundant and therefore cheap global capital--the result of private economic activity--and, consequently, low interest rates, which encouraged borrowing. The second factor was a housing bubble caused in part by those low interest rates and in part by aggressive marketing of mortgages. The third was new financial instruments that businessmen believed reduced borrowing risks and so increased optimal leverage. The fourth was the difficulty of "selling" a conservative business strategy to shareholders in a bubble environment. Borrowing more and more at low interest rates while home or other asset values are rising enables financial institutions to make higher profits, and a firm that refuses to jump on the bandwagon will as a result experience lower profits and will have difficulty convincing shareholders that they really are better off because the higher profits of the competing firms are unsustainable.
The fifth factor was sheer uncertainty--was it a bubble? If so, when would it end? Would the new financial instruments assure a safe landing if it was a bubble and it burst? And the sixth factor was that the downside risk to highly leveraged financial institutions was truncated by generous severance provisions for their executives, authorized by boards of directors that were not effective monitors of executive decisions.
Cycles of boom and bust are intrinsic to capitalism. Government can make them more serious, and sometimes less serious, but if you take away government you will still have periodic economic crises.
Government Equity in Private Companies: A Bad Idea-Becker
The Federal government of the United States has seldom taken an equity interest in private companies, although this has been proposed sometimes, especially as a way to get higher returns on social security assets. However, the new financial bailout bill provides not only for the government to buy assets from banks, but that it also take an equity stake in the banks being helped. The purpose is to protect the government from paying too much for the many difficult to value assets that are acquired. The thinking is that if they overpay for some assets, they can make that back through a rise in the value of the stock or other equity interest that they would have.
However, the main purpose of the buyout is to increase the liquidity of the banking system and thereby reduce the banking system's retreat from riskier investments. Yet the government's actions regarding an equity interest seem to be based on a fear that it will be outsmarted in the prices it pays for assets that are very difficult to value because they have no market. Whether the government will lose after the fact is not clear since it can afford to hold the assets to maturity. Moreover, taking an equity interest is also unnecessary in order to protect taxpayers from overpaying. Modern auction theory offers various ways to induce sellers (or buyers) of assets and other objects to "tell the truth"; that is, to bid their best estimate of an asset's worth. In using auction to buy bank assets it would be helpful if the government did not automatically take all assets offered by banks, so that banks have to compete against each other. Competition can also be increased by spreading the auctions out over time (I am indebted to my colleague Phil Reny for useful comments on optimal auction design). To be sure, the seller's estimates of the worth of their assets may turn out to be wrong, so the government would bear some risk. However, with an optimal auction mechanism design, the government need not fear grossly overpaying ex ante for the assets they acquire.
Even if the government were to lose money on this buyout, it is a bad precedent for it to take an equity interest in private companies. Inevitably, this leads to government involvement in business decisions and corporate governance. Experience shows that political rather than economic criteria tend to dominate in the pressures exerted by government shareholders on corporate decisions. This is already reflected in the bailout bill since it limits compensation for executives, including "golden parachutes" for executives of the companies helped. One can hardly have a high opinion of the executives who led such venerable institutions as Merrill Lynch and Lehman Brothers, and many other banks, into investment portfolios with such poor capacity to withstand a financial disturbance. Still, many of these executives have lost most of their very considerable fortunes since they usually owned or had options on many shares of their companies, and these shares have plummeted in price. It is appropriate that top executives suffer major losses when their companies collapse.
There is no good reason, however, for the government to interfere and impose limits on salaries and severance pay. Controls over wages and salaries have never worked well, and only encourage myriad ways to get around them, including generous housing allowances, vacation homes, easy access to private planes, large pensions, and other fringe benefits. There develops a war between the government's closing of loopholes, and the ingenuity of accountants and lawyers in finding new ones.
Governmental ownership of shares, with or without voting rights, opens up possibilities for much greater mischief than controlling executive salaries. For example, a bank or other company may want to reduce its employment in order to regain greater profitability. The government owners of these shares will be under pressure from congressman and senators who represent districts where employment would be affected to try to rescind or modify these cuts. Even without government ownership, congressmen protest corporate efforts to shift various activities overseas because labor and other resources are cheaper there. Such objections will be magnified when governments have direct equity stakes.
There are many illustrations of the bad influence on corporate governance exerted by the governments of France, Italy, Russia, and many other countries that own shares in private companies. One current appalling example is the situation of Alitalia Airlines, where the government owns almost half the stock. This has been a very inefficiently run airline that is hostage among others to powerful unions. Strikes have been common, flights frequently takeoff and arrive quite late, and baggage losses are high- experienced travelers try hard to avoid using Alitalia. Since Alitalia's command of routes into and out of Italy has market value, stronger European Airlines, such as Air France and Lufthansa, have wanted to take this airline over. However, the Italian government has resisted these efforts and continues to finance the sizeable monthly deficits of the airline. It fears the power of the unions who realize that many airline jobs at Alitalia will be lost if a more efficient airline takes charge.
This and other examples of harmful government interference in the running of companies where they have an equity interest provides a very good lesson for the United States. Avoid taking any equity interest in private companies when buying assets of banks under the bailout bill, or when investing other government revenues.