Published for the August 2nd, 2010 issue of National Review:
At the end of June, the House of Representatives voted to extend the $8,000 homebuyers’ tax credit, by an extraordinary margin of 409–5. The Senate approved the measure on a voice vote. At a polarized political moment, this near unanimity was noteworthy in itself. Conservative Republicans and liberal Democrats, from cities and suburbs and small towns across the country, joined together to shower a bit more taxpayer largesse on one of America’s favorite industries: real estate. But there’s a problem with this bipartisan idyll.
Though the homebuyers’ credit was sold as a stimulus measure, we have no reason to believe that it is anything other than another wealth transfer to a large and powerful industry, one with allies conveniently situated in every congressional district. Casey Mulligan of the University of Chicago has suggested that the credit had almost no economic impact. As Harvard economist Edward Glaeser observed, it did little more than create an incentive for “mindless house swapping.” It didn’t even have a meaningful impact on the behavior of first-time homebuyers — people already planning to make purchases simply moved them forward a few months. Yet this is where we find a consensus in policymaking: We can’t agree on balancing the budget or reforming entitlements or the tax code, but we can agree to churn the housing market so that a handful of real-estate agents can make a buck on commissions while the economy crumbles.
Across the world, governments have spent vast sums on doomed industrial policies. We often hear about the occasional success of efforts in East Asia to nurture shipbuilding and automobile manufacture and electronics. But we don’t hear about the countless failures, in which cronies of the party in power receive endless subsidies and concessions, getting richer at the expense of the economy as a whole.
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As published for Economics 21 on May 5th, 2010:
In the debate over reform of America’s financial regulation, perhaps the most important sticking point has been how to handle failing non-bank institutions such as insurance companies, hedge funds, and bank holding companies (the corporate parents of banks). Many Republicans argue that the proposed “resolution authority” for “systemically significant” firms would institutionalize bailouts. Other left-of-center experts contend that neither the House nor the Senate measure would have prevented the recent crisis, or stand much of a chance of heading off a future emergency. This has not stopped the President from calling some of these assertions “cynical and deceptive” – and boasting that the bill sponsored by Senate Banking Chairman Chris Dodd would end bailouts forever, not perpetuate them.
Such diametrically opposed interpretations of the same provision are standard fare when governments establish ambiguous, extrajudicial procedures to resolve failing businesses. A better idea would be to focus on changes to the bankruptcy code so these matters can be left to judges and courts of law.
First, this paper will quickly review the Lehman Brothers bankruptcy and why it should not be cited as the “reason” why the bankruptcy process is ill-suited for resolving a large financial institution. This section also touches on why AIG did not follow Lehman into bankruptcy.
Second, to gain a better understanding of why it’s problematic to create a new and separate resolution process outside of the bankruptcy code, this paper will review some of the other cases where extrajudicial resolution have been proposed (and used). In particular, this section of the commentary will focus on the GSEs and how the FDIC currently facilitates the sale of failed banks.
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As published for Economics 21 on April 13th, 2010:
Some Democrats and their allies in the media are determined to pin the blame for financial reform’s failure on Republicans who, according to Paul Krugman, “will always find reasons to say no to any actual proposal to rein in runaway bankers.” Republicans recognize that financial reform is very popular among voters and that a partisan filibuster to block reform would play directly to the playbook of left-leaning bloggers. As a result, Republicans have a choice of either accepting reform as currently conceived or of convincingly articulating why their alternative is actually tougher on the large financial firms that the public blames for the crisis. This second strategy requires that Republicans: (1) explain why the Democrats’ resolution proposal not only fails to solve the “too big to fail” problem, but could actually make matters worse; and (2) devise an alternative that more effectively deals with the core policy issue emerging from the financial crisis.
The Democrats’ “resolution authority” proposal needs to be thought of in two discrete time periods: the “crisis” period, when the firm is on the verge of collapse, and the “ordinary” period when the firm is able to access external funding and otherwise function normally. During the “crisis” period, resolution authority is quite useful as it provides the government with greater legal authority to assume control of a firm on the brink of failure. As the Treasury has argued, current law forces the Administration and Federal Reserve to choose between two unpalatable options: (1) government capital injections and financial guarantees (as occurred with AIG), or (2) a bankruptcy filing (as occurred with Lehman Brothers). In the first case, the government uses taxpayer resources to keep an insolvent firm afloat without the ability to alter contracts or otherwise wind-down the institution. In the second, the government takes a hands-off approach and allows an uncontrolled bankruptcy to occur with no ability to monitor or control the potentially significant collateral damage.
The problem is that this crisis period is very short in duration relative to the “ordinary” period when the firm is not on the verge of collapse. During the ordinary period, the resolution authority and the accompanying “resolution fund” are likely to distort prices and capital allocation decisions. The result is subsidies for larger institutions that could make it harder for small banks to attract debt finance and a less stable financial system.
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As published for Economics 21 on March 24th, 2010:
After months of emphasizing the need to coordinate a global regulatory response to the global financial crisis, the Administration has done an about-face. Instead of working in concert with international partners, the Administration now wants to enact reform unilaterally so as to “set the global agenda.” The supposed first-mover advantage would allow the U.S. to shape “a level playing field on terms that play to our strengths.” In reality, regulatory reform at the national level is unlikely to work because of the size and breadth of the institutions. And rather than stimulate international cooperation, unilateral action is likely to result in regulatory competition that ultimately disadvantages U.S. firms.
In the wake of the financial crisis, most policymakers spoke of the maddening “fragmentation” of the existing regulatory system. Secretary Geither blamed lax regulation on fragmented oversight that “invites corrosive competition in regulatory laxity.” President Obama lamented how fragmentation allowed “some companies to shop for the regulator of their choice.” New York Federal Reserve Bank (FRBNY) President Bill Dudley explained that “the financial system is simply too complex for siloed regulators to see the entire field of play.”
However, as each of these speakers made clear, the crisis-generating regulatory fragmentation was not limited to the multiplicity of agencies inside the U.S. In fact, President Obama pointed to the challenges posed by the regulatory “gaps that exist not just within but between nations.” Secretary Geithner called for nations to “coordinate regulation” so as to “prevent geographic regulatory arbitrage” caused by unprecedented capital mobility. NYFRB President Dudley probably thought he was stating the obvious when he explained that reform required “intensive work internationally to address a range of legal issues.”
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As published for Economics 21 on March 2nd, 2010:
A recent article in Barron’s highlighted the outsized returns generated by “activist investors” in 2009. The “shareholder activist” is an investor or investment manager who buys shares in a corporation with the intent of directly influencing management. While the “causes” pursued by activists differ widely, the dominant form of activism in 2009 related to corporate governance – existential questions about how to run a business. According to the research firm 13D Monitor – 13D is the SEC filing that must be made when an investor’s ownership interest exceeds a 5% threshold – corporate governance activism yielded outsized returns. The share prices of large firms with these “shareholder activists” increased by 84.3% in 2009 relative to 16.1% overall increase for the S&P 500.
How Do Activist Investors Generate Such Large Returns?
For decades academics have chronicled the “agency cost” imposed by the separation of a business’ ownership and control. Contrast the diffuse ownership of the corporation with a sole proprietor’s local pizzeria. Unlike the manager of the corporation, the owner-manager of pizza parlor owns all of the resources that he controls and bears the cost of every decision he makes. If he increases his leisure time, he pays for it through lost sales or wages paid to someone making pizzas in his stead. Each indulgence to make the workplace more appealing is financed directly out of his own pocket.
However, if after a period of years he sells 50% of the pizzeria to a local investor, his trade-offs change. Now, closing the pizzeria an hour earlier at night or buying an expensive new wood-burning oven costs only half as much as it once did in terms of foregone personal wealth. As the proprietor’s ownership stake in the firm declines, the moral hazard grows because he still internalizes 100% of the benefits of the leisure or new investment but pays a shrinking fraction of its cost.
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As published for Economics 21 on February 1st, 2010:
Much of the debate about reforming financial regulation revolves around a single question: are certain financial institutions “too big to fail”? The historic turmoil that gripped the markets following the bankruptcy filing of Lehman Brothers – and the extraordinary expense incurred to avoid similar defaults at Fannie Mae, Freddie Mac, and AIG – makes it clear that there is something to the notion that certain institutions are too big or interconnected to be allowed to “fail.”
A true understanding of the “too big to fail” phenomenon requires a more precise definition of failure. What does it mean to fail? The simplest answer is that a firm “fails” when it ceases to exist. Yet equating failure with the “death” of a firm obscures more than it clarifies.
Contrast the cases of (1) Lehman Brothers, which “failed” and then saw many of its U.S. assets purchased by Barclays Capital with (2) AIG, which continues as a franchise thanks to a government rescue, to (3) Bear Stearns, which was merged with JP Morgan Chase thanks to a collateralized loan from the Fed of nearly $30 billion. The senior management of all three firms lost their jobs and the common stock lost nearly 100% of its value in each case. However, the creditors of Bear Stearns and AIG received 100 cents on every dollar of debt obligations they held, while holders of Lehman Brothers’ senior bonds received just $8.625 per $100 of face value, a 91% loss. Counterparties on AIG’s tens of billions of dollars worth of credit derivatives actually saw their positions improved, while Lehman Brothers’ derivatives counterparties suffered losses on any under-collateralized exposures. Bear Stearns’ derivatives obligations, prime brokerage, and custodial accounts were transferred to JPMorgan Chase, holding counterparties harmless.
In all three cases, the management of the firms “failed,” the common stock – which comprised much of the wealth of employees that held it through retirement accounts and compensation – failed, but the franchise, creditors, and counterparties failed in some cases but not in others. The only one of the three failures that threatened systemic financial stability was the failure of Lehman Brothers. And the only unique feature of this failure was the losses suffered by creditors and counterparties.
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