Legal Commentary

Equities, Pay Caps, Liquidity: Structuring a Bailout--Posner

By Richard 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.

Full post as published by Becker-Posner Blog on October 05, 2008 (boomark / email).