Why creditors should suffer, too

That is my latest column and the core point is straightforward:

What the banking system needs is creditors who monitor risk and cut
their exposure when that risk is too high. Unlike regulators, creditors
and counterparties know the details of a deal and have their own money
on the line.

But in both the bailouts and in the new proposals, the government is
effectively neutralizing creditors as a force for financial safety.
This suggests a scary possibility — that the next regulatory regime
could end up even worse than the last.

Do read the column for a discussion of how we might make creditors suffer.  Here is why the Obama administration is having such a tough time with the issue:

Right now, people cannot understand why A.I.G. received bailout
money, so they feel deceived. A single insurance company, even a very
large one, just does not seem that essential to the American economy,
which makes the company all the more a scapegoat. Much went awry at
A.I.G., but in the context of a bailout, the company should be thought
of as the conduit for helping an entire market that went bust.

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

Why not? It would be bad precedent, and mind-bogglingly expensive, to
promise to pick up all future obligations to major creditors. At the
same time, any remarks that threaten to leave creditors hanging could
panic the markets. So silence reigns, the Fed and Mr. Geithner receive
bad publicity over the bailouts, and we are all laying the groundwork
for a future financial crisis.

James Kwak offers comment.  Here is Arnold Kling.  Mark Thoma has very good comments on time consistency problems.


Your best suggestions was your first: let the creditors make their claims in bankruptcy court. You claim that this solution is politically impossible, but I have a hard time believing that designing regulations that won't be gamed is any more likely. The way I see it, the only long-term stable solution is one with the simplest rules that explicitly prohibits the injection of taxpayer money. Otherwise, productive activity and prudence will be ever undermined by political maneuvering and expropriation.

The biggest problem as the Democrats see it is that the average individual has little to no financial savvy and therefore has been forced to pretty much turn over all their financial decisions to the company's HR department. The HR department, who generally isn't that much better off, hands this pool of money to a company and tells them to manage it. The company turns control of that pool over to a manager to take care of the details. A group of managers make decisions to invest those funds directly as well as - to some degree - manage the risk associated with their investments (CDO, Credit-Default Swaps, etc...). The average individual expects that government can regulate each chain AND that each chain is capable at performing its function; but at no point does the individual really have any choice with whom to trust their money (most people will not quit a job because the HR department is mis-allocating their retirement fund). Toss in auto-enrollment into a 401(k) and you have a large group of people who are basically minds-off with respect to their retirement fund.

Simply making the creditor (the minds-off employee) pay is not likely to change the way the system is aligned. As much as the Democrats and their constituents want to make the big hedge-funds pay for their "greed" it is impossible to separate the wheat from the chaff in this situation - and so the few get saved along with the masses.

Lastly, as the Madoff situation makes quite clear, entrusting in a single person or entity to regulate "greedy" behavior is bound to fail at some point - yet those in power (e.g. SEC) want to have that kind of authority and control; and devising more effective and redundant systems is beyond the capability and desire of those elected to office. And because government regulation is "free" and private regulation (e.g. Consumer's reports) costs money public regulation forces out competition and leaves the consumer with less choice.

That we are where we are is no surprise; and, as shown by our own history, we will be here again since our government and society are not motivated enough to make the radical changes in how our country operates. We will shout about the inequities of the system but it is hollow and words only - both government and the public at large are generally well-off (and most who are not are more likely to die off quietly is some flea-ridden motel room rather than organize and acquire a better life for themselves) and feel outrage simply to feel better and will not take any action that threatens their comfortable way of life. They may make token efforts to ease the suffering of others (i.e., by giving away other peoples money) but true very few people are capable and willing to make true personal sacrifice.

In the end it is a balancing act between appearing to act "morally" and acting "naturally". In this situation acting "morally" is acting to the betterment of the masses (who generally define what is moral) while acting naturally is acting to better one's own life. A few people are able to make grandiose gestures of morality (stimulus, welfare, etc) while leaving the natural (read practical) decisions to other (e.g., layoffs, furloughs, firings). It is a power-monger's wet dream and that is why, no matter what we do now some other "immoral" event will befall our planet. We already are seeing the beginnings of this with the changes driven by global warming and depletion of our natural resources.

Years ago, I read (I think in the Economist) a proposal to require banks (for which, one could read financial institutions generally) to obtain a good part of their capital from issuing debt obligations that were expressly junior to depositors (and thus, presumably, trade creditors and other debt holders). The idea was to focus a lot of the default risk into a concentrated group of instruments, so that the holders of those instruments would have every reason to closely monitor the health of the institution. A dramatic fall in the value of those instruments would also tip off regulators and the market to take a closer look. It would be something like removing the oligopoly on ratings for those institutions who issued these kinds of obligations. It would also be politically easier to make these kinds of debt-holders convert to common stock when equity gets wiped out because that's exactly the risk they wanted to be paid for taking. Presumably, institutions required to issue this kind of debt would look for ways to maintain the value of the debt to make future issuances cheaper; I could come up with examples (e.g., audits by an auditor controlled by a creditors' committee), but the point is that the debtors would have a strong reason to innovate around disclosure, rather than resisting it. I think the proposal was to require this kind of debt in lieu of other regulations, but I can't remember the details because it must have been over a decade ago.

What think you? Has this been talked down while I wasn't paying attention?


Good points Tyler. I'm glad more and more economists are acknowledging that people really are being bailed out. There was a train of thought going around from free market economists (I'm not saying people here at MR, I really don't remember who it was) along the lines of, "What 'bailouts' are these whiny liberals talking about?! The shareholders are all wiped out!"

Didn't creditors lose lots of money even when the government intervened as recently as the 1990s?

What changed with the election of Bush that made creditors decide that the government would bail them out so they didn't need to worry about risk?

And even during the Bush administration, the ENRON failure resulted in lawsuits against everyone involved, investment bankers, credit rating agencies, and so on.

By what means did hundreds of corporations and hundreds of thousands if not tens of millions of people determine they should act in concert to buy risky bonds because by acting together, the government would bail them out?

In fact, I can't think of a time when the kind of bailouts and protection of creditors has occurred in US history such that anyone could trust that the government would bail them out of the current credit crisis.

What we need is boring banking.

Remember the old depression era saying that the most dangerous thing in the world is a smart banker.

also -- i think part of the problem here is that the treasury has no subtle tool here.

the treasury / fdic see a citigroup bankruptcy as a disaster for the US and world financial systems and so everyone knows they are not going to allow this. this means they have limited leverage on creditors, because they have no legal way to _force_ creditors to do anything short of a trip to the bankruptcy courts.

there have been two major failures where creditors took big losses, WAMU and Lehman. in wamu's case the FDIC took over a bank that may have been solvent (i hear differing opinions here). subordinated debt holders got zero (no equity either). this was seen as quite arbitrary, causing potential bank creditors to sit out. in Lehman's case the market had been expecting a high recovery (80+%) on senior unsecured debt but got 7% or 8%, again discouraging potential creditors from lending to banks. (i am not sure why recovery was so low -- was it the fact that derivative collateral got priority over senior debt?)

i think the treasury and obama are quite desperate for funds for recapitalizing the large banks and would be very happy to get these from bond holders or from new private investors, but they haven't figured out how to get creditors to agree to it and they aren't willing to go through with bankruptcy or fdic seizure yet. that may change.

I agree with babar's comments and suggest that people read the angry bear link he provided.

After Lehman, the idea of letting these firms (C, BAC) go into BK seems very unwise. After AIG, the idea of nationalizing doesn't make much sense either. LEH got pennies in BK for pretty decent assets simply because they were liquidated under extreme market conditions. AIG's once healthy insurance subs are losing their franchise value as people leave. There is no such thing as a quick, surgical bankruptcy or intervention. A far as the idea that AIG shouldn't have paid off on the CDO's -- the counterparties already had the cash via collateral calls, which put AIG in trouble in the first place.

People are also not considering the total costs of the various Treasury actions and inaction. Remember that the taxpayer gets 20% of GNP and 1/3 of corporate profits, so IF the moves help the economy, there is upside that isn't identical to that of a private investor.

Well said Tyler. We need to get you on TV. You would bring much sanity to broadcasted debates. I suggest you start doing something quirky. Maybe wear sunglasses constantly or loudly proclaim that you have created your own school of economics.

Government should have the tax on creditors, like taxing on executive bonus, who get the benefits of AIG reckless actions. AIG bailout is intentionally the way to turn the loss of private investors into the loss of public that is unacceptable.

Now the loss of US government is increasing everyday and that will cause the higher cost of living of people from the higher government debts and higher tax on taxpayers, not higher tax on private investors. Therefore, I do not understand why taxpayers should pay higher tax to support loss of private investors.

One thing we have seen is the lower welfare of country. Now government will create higher budget deficit and will create higher uncertainty of deficit from unknown loss of bailout. FED has also intervened market by printing money and definitely will create loss from intervention and uncertainty of amount of money expansion in the future.

From the uncertainty of loss of intervention and size of government deficit and size of money printing, the medium-to-long term bond yield is at the highest risk of losses from government new supply from higher deficit and the higher risk of hyperinflation of money printing. If government debt is uncontrolled and FED has to monetize debts more aggressively, the 3% 10-year bond yield is not reflecting the future hyperinflation and new supply of debts. We could not see the sharp increase in inflation in this or next year but we have the higher uncertainty and higher risk of hyperinflation and new bond supply. The medium-to-long term bond yield should move upto 5-10% and is volatile to reflect the uncertainty.

The higher bond yield and uncertainty will create the uncertainty of economic policy and definitely deter the private investment and consumption from the higher risk premium compensation. That will create the long deterioration of growth. We could end up only the stagflation (there is some growth but low) or the depression with hyperinflation (no growth but price will increase sharply because in the long run there is no relationship of price and economic growth)

I found it interesting that this is how Tyler is being introduced these days:

Kwak: "Tyler Cowen, co-author of a prominent independent economics blog,..."

Didn't Tyler say that the moral hazard arguments are overdone? I agreed. I don't think these people thought these investments were (as) risky (as they turned out to be, anyway). They believed the risk spreads as efficient market gospel. They forgot about downturns. They created a self-fulfilling catastrophe based on the assumption that housing was diversified and resistant to downturns, therefore a global securitization of real-estate made sense.

We need higher risk premiums and smarter investors who actually do work instead of free riding on the efficient market idea, and sometimes it takes a generational catastrophe to remind us of that. In fact, it seems like we need a reminder once every generation.

We also need more financial instruments. If people need reasonable returns with no risk, why are their only choices government bonds or complicated instruments backed by insurance from the likes of A.I.G.?

The interesting thing about government and banking innovation is how a product is proliferated across the entire market before we know the products are faulty. A whole economy was wrong about products that took years to develop, even from a non-ideological place, I don't understand how anyone can think a gov't of non-experts can fix the problem by design in a short time-frame. Progress usually comes from trial and error, if the errors don't kill you.

If individuals actually held the securities, they would be better off than holding the stock of banks that hold the securities. 22 cents on the dollar is better than 90% declines or zero. But, why, in finance, are people impatient to let the product get out and see how it does, like we do with new electronics, new car models, etc.? Well, I think it is because in finance you are always worried that the other guy is getting ahead, and with a credit-fueled boom, and the assumption that numbers are commodities and right in the eyes of the market, he is getting ahead, until he's not.

What about a simple "regulation" which wouldn't even really be an increase in regulation at all, because bankruptcies are already run by the government. How 'bout when a financial entity becomes systemically risk, the government requires them to keep a speed bankruptcy plan updated periodically in return for service of bankruptcy PROTECTION. Part of the problem is the agonizingly slow and arbitrary political process that bankruptcy has become. Fix it.

Further to babar at Apr 5, 2009 4:05:10 PM, the chairman of BB&T gave a recorded speech on the causes of the crisis. He claims that one of the more immediate aggravating causes (i.e. not fundamental causes) was that the FDIC fully protected uninsured depositors while wiping out creditors who should, in bankruptcy, have been treated on par with those uninsured depositors. He claimed that the result was that credit to banks immediately seized up. If that's the case, it might help explain why banks are piling up additional reserves (i.e. not just because they might have losses; they might need cash and not be able to get any, except from the government).


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