It is undoubtedly true that the explosion in sub-prime mortgages occurred after the 1999 deregulation of the banking system spearheaded by Phil Gramm. Nevertheless, many libertarians still seek ways to blame government interference with the free market for the economy’s present woes. It seems to me that the economic system that the libertarians think of as the free market is in fact a product of government interference.
In a market free of government interference, I would think that a man would only be free to make promises that bind himself and others who expressly authorize the man to make promises on their behalf.1 This would limit the acceptable forms of conducting business to the sole proprietorship and the partnership. However, in our society a man is permitted to make promises that bind an entity known as a corporation. The corporation is a fictional person authorized by government regulation so that investors can share in the profits of business ventures without risking the liability of being a partner. Absent the corporation, the only option available to people who wanted a return from a business without the obligation of overseeing its activities would be to loan the business money.
The corporation is a useful tool because it can lead to the more efficient use of capital. Suppose for example, that a man had an idea for a new restaurant. Restaurants are notoriously risky ventures with a high failure rate. On the other hand, a successful concept can be extremely profitable. The man might find it very hard to borrow the money to open the restaurant because the lender would consider his chances of getting paid back pretty poor and might charge a prohibitive rate of interest. On the other hand, an investor might be willing to buy stock in the restaurant because the profits upon success will be great enough to justify the risk of failure. The existence of the corporation can allow beneficial economic activity.
The problem with the corporation is a product of the very quality that is its reason for existence. The shareholder who stands to benefit from the success of the business is not on the hook for more than his investment if things go wrong. That provides an incentive for the corporation to ignore catastrophic risks if their probability is very small. Suppose that a business executive is presented with an opportunity that has a nineteen out of twenty chance (.95) of producing a 25% profit and a one in twenty chance (.05) of producing a loss of 2000%. If the executive is running a partnership, the expected return for his investors is the sum of the return on success times its probability plus the return on failure times its probability ([25% x .95] + [-2000% x .05]), or negative 76%. On the other hand, if the man is running a corporation, a shareholder’s loss is limited to the amount he invested so the expected return for a shareholder on the same venture ([25% x .95] + [-100% x .05]), or positive 19%. When an investor’s loss is limited, an otherwise foolhardy investment can suddenly look quite reasonable. The excess losses will fall upon third parties such as customers who do not get the orders they paid for, employees who do not get their salary, suppliers who go unpaid, or people who get injured by the corporation. If the third parties are unable to bear the loss, it may wind up being borne by society as a whole.
This is more or less what happened with AIG this week. The insurance giant entered into contracts to insure the debt of other businesses. The odds may have been good that these contracts would produce a generous return for AIG’s shareholders, however, there was a small chance that AIG would not be able to make good on its contracts in which case the losses would be astronomical. Unfortunately the worst case occurred and the federal government was forced to bail out the company this week.
Fifty years ago, most of the major investment banks on Wall Street like Morgan Stanley, Lehman Brothers, Bear Stearns and Goldman Sachs were organized as partnerships. In those days, their income came primarily from fees and commissions earned through transactions. They would help issuers bring securities to market by placing the securities with investors. However, they were limited in the extent to which they could buy the securities for themselves because they depended on the personal wealth of their partners and the willingness of those partners to take risks. It is said that they were in the transportation business rather than the storage business.
Over time, however, the investment banks started incorporating and going public. By floating stock, they got access to investors whose risk tolerance was different than the partners whose personal assets were on the line. As this happened, they started taking more risk. Trading for themselves became a bigger portion of their business. Like AIG, they wound up with positions that had a good chance of producing generous returns and a small chance of producing catastrophic losses. (Interestingly, the healthiest surviving investment bank is Goldman Sachs, which I believe was the last one to go public. Perhaps it best remembers how to manage risk like a partnership.)
Corporations have been around so long that it is easy to think of them as the essence of free market capitalism, but, in fact, they are legal constructs created by the government in order to separate the enjoyment of profits from the risk of losses. Corporations are incredibly useful tools for allocating capital efficiently and promoting general prosperity. Unfortunately, when the government abdicates responsibility for regulating the entities that it created in the first place, the risks end up being dumped on society as a whole and fewer and fewer people enjoy the rewards.
1 The Barefoot Bum informs me that promises as we know them would not exist in a market that was truly free of government interference because a promise can only be binding by virtue of government enforcement. "In a truly free market, promises cannot actually bind: you are rationally justified in trusting a "promise" only insofar as keeping the promise is in the long-term self-interest of the person making it." I confess that I am not equipped to argue the issue at that level of libertarian purity.
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Wait, what?
ReplyDeleteHow can -- if we're assuming that individuals are free to make promises (contracts) -- those same individual not be free to make a contract? That's what investment boils down to : I'll give you X USD in exchange for Y profits is not the full concept of corporate investment, but it's a pretty workable one.
You see this sort of thing done fairly commonly even outside of the typical concepts of investors and stock, especially in post-bubble tech start-ups -- it's not unusual to get support from other companies in return for the promise of future purchases, or to have employees working for less pay now on the understood promise of future rewards.
Without the legal fiction of a corporation, you'd be without a corporation's protection from damage to the company owner's personal assets in the case of severe damage to the corporation, or the protection of several hundred laws and regulations intended to provide the corporations with encouragements... but those effects are significantly less immediately observable to a potential investor.
I'm not an advanced economics major, and I'll acknowledge that more smart regulation would have almost certainly prevented the massive levels of fraud underlying a lot of subprime loans (and, in the case of AIG and Fred/Fann, a lot of internal valuations). I'm not sure what keeping Glass-Steagall or similar old-style regulation would have done to confront the changing technologies and laws encouraging the specific activity here, potentially only resulting in a lot of little dead companies which collectively could not be allowed under.
On the other hand, I'm not sure all the incentive breaks down to just that of your math. Humans have a huge neurological bias toward avoiding risks with a small perceived odds of occurring but large loss in those situations. In many cases, the risks were not merely clear, but almost a given. It's not clear how many of those risks would have been taken without many of the artificial incentives placed by both federal and local activities.
It's rather easy to point out the lack of Great Depression since Glass-Steagall went through, but it's not clear if it prevented one (especially given other major economic powers that never erected a barrier between commercial and investment banking), and regulation did happen to mandate redlining (under early FHA insurance rules) and encourage lending to politically interesting but economically risky groups (under more recent laws).
Humans have a huge neurological bias toward avoiding risks with a small perceived odds of occurring but large loss in those situations. In many cases, the risks were not merely clear, but almost a given.
ReplyDeleteI agree Josh, but in the case of a corporate investment, the odds of a large loss are eliminated. The loss can never exceed the amount invested. For example, if the investment were a highly profitable nuclear power plant (and I recognize that this is purely hypothetical), the possibility of a Chernobyl level meltdown would not deter a shareholder because the probability is small and the risk to the share holder is limited to his investment. Someone else will have to clean up the mess. If the only form of investment were a partnership, the investor would be all over the manager who took the risk of a huge loss.
It's not clear how many of those risks would have been taken without many of the artificial incentives placed by both federal and local activities.
Here is my problem with blaming this on artificial incentives. If a government regulation requires a bank to make a certain class of loans that are unprofitable, that bank will make the absolute minimum number of loans necessary to fulfill the requirement. They will not go nuts making that class of loans unless they truly believe that there are profits to be earned from them. I don’t deny that government regulation affects the free market. I just can’t buy the idea that government regulation is sufficient to explain a problem of this scope.
I agree Josh, but in the case of a corporate investment, the odds of a large loss are eliminated. The loss can never exceed the amount invested.
ReplyDeleteThat's true, but I think you're underestimating the size of that particular neurological bias. Even in the face of highly likely successes and comparatively smaller and lower-risk losses, it still pops up pretty often.
If a government regulation requires a bank to make a certain class of loans that are unprofitable, that bank will make the absolute minimum number of loans necessary to fulfill the requirement. They will not go nuts making that class of loans unless they truly believe that there are profits to be earned from them.
That's only the case if there is an absolute minimum number involved in the requirements; in the cases of loans and many of the federal legislation over the last couple decades, there was only an abstract goal, or goals made up as X% of all loans, or goals with relatively uncapped rewards.
If the Feds say I have to build 5 solar plants of N size at massive losses to keep my company in X status, and I want X status, I'll almost certainly stop at 5.
If, however, I'm told that I will be looked at favorably if I build more solar plants than before, or more than other power plant builders, I'm probably not going to stop at 5 if I can divert capital for more than that, especially if I do not know what the magic number is and may be basing most of a business strategy around achieving those incentives. Likewise, if I'm told that I can only build a coal plant for every N solar plants, or that I'll get incentives per plant built that overweighs the natural disincentive to build solar plants, I'm not going to stop as long as I have the capital.
That's essentially one of the major situations behind all the fraudulent sub-prime loans. From what math I can do, they didn't look to be that profitable, especially given even the pre-2005 rate of default. They weren't money-losers -- worst case, the banks were getting land worth a sizable portion of its previous value -- but the alternatives seemed much more lucrative and involved lower overhead, even on by-the-book subprime loans. The ones with fraudulent income values were... well, probably not worth the paper they were written on. However, if you need an unknown amount of paper signed by minorities or the poor to pass FDIC and OOC approval for an acquisition worth many times what even large amounts of bad subprime loans were estimated to cost you, it still made sense to purchase them.
This shouldn't be surprising: if these options were naturally lucrative, there wouldn't have been any clamor to create governmental incentives to present them (specifically, at least).
I just can’t buy the idea that government regulation is sufficient to explain a problem of this scope.
Look up some of the messes around the turn of the last century sometime. Depression Era stuff is still oft-argued, but you won't see many people defending the pre-1873 regulations.
Anything with the potential to do a lot of good, has the potential to do much more harm. Damages are easy, after all.
Even if the required number of unprofitable loans is indeterminate, a bank is going to try to do some risk reward calculation, i.e., what the potential benefit of any particular number of such loans is verses the potential cost, and it will not just keep making them indiscriminately. It will stop making them when it does not think the potential profits justify risk.
ReplyDeleteDon’t forget that a lot of financial institutions got into trouble here with little or no prodding from the government. Half of all the sub-prime loans were made by mortgage companies like Countrywide that were not subject to the laws that encouraged our required sub-prime lending. Bear Stearns set up hedge funds to buy collateralized debt obligations (CDO’). Banks set up off balance sheet entities called SIV’s to buy CDO’s with money borrowed in the commercial paper market. I don’t deny that government regulation creates incentives, but an awful lot of people jumped on because they thought that these loans were naturally lucrative.
They thought these things were naturally lucrative for some foolish reasons: They thought that the CDO’s reduced the systemic risks of sub-prime lending through diversification when in fact it just spread the risks around so that the whole world financial system was polluted by it. They thought that housing prices would only ever decline on a regional basis. They could not conceive of price declines on a nationwide or worldwide basis.
It will stop making them when it does not think the potential profits justify risk.
ReplyDeleteYes, but in many cases the potential artificial profits were overwhelming, even with the risks. Some of the resulting mergers resulted in more than the initial value of one company in extra worth being generated. Even with the neurological bias against the risks involved, the rewards were huge.
To use your last metaphor, we're not talking about a government mandate to build one Chernobyl-style (to be precise, RBMK-1000) plant, and building more won't have similar rewards. It's more like having to build a Chernobyl-style plant for every five that actually generate profits.
You say that as if the CRA was the only reason for this sort of thing, and only the merger-related controls of the CRA.
You bring up the example of Countrywide, as if it were completely divorced from CRA and CRA-related loans. Surprisingly, they had a device set up entirely for CRA loans and CRA credits (Google cache). That's not because they were directly covered by the CRA (I'm not sure if they were/are planning to aim for financial holding company status, which requires compliance with CRA goals), but because there was a lot of entirely artificial value tied to those things.
Clearly Countrywide was marketing its mortgage backed securities to other banks that were covered by the CRA, but just as clearly the hedge funds that bought them and the foreign banks that bought them were not subject to the CRA.
ReplyDeleteAre you aware of any sources that detail the CRA requirements that were imposed on merging banks? I would be interested in seeing specific numbers for a specific transaction.
That's precisely what I mean. Just because the statute did not directly cover a matter, does not mean that it is hands off. The first rule of economics is that nothing has a single cause, but the second rule is that nothing has a single effect.
ReplyDeleteRemember, we're talking about loans that a) were not especially fluid on increases (lenders can not easily search for new customers), b) were necessary for interactions as valuable as some entire corporations, and c) provided secondary benefits (fewer protests for example).
From what I can tell, there were no listed requirements. The statute itself only requires that "all of the subsidiary insured depository institutions of the bank holding company had achieved a rating of “satisfactory record of meeting community credit needs”". The FFIEC's postings are just as vague, arguably unconstitutionally so.
I believe at least a sizable portion of Countrywide's CRA values were sold to CRA-covered banks. They'd merely be advertised as loans, usually with the marker option-ARM, as the term has very little meaning to foreign banks.
Josh,
ReplyDeleteI understand that nothing has a single cause or single effect. However, you seem to be arguing that a significant cause of this crisis was banks knowingly making unprofitable loans and knowingly purchasing unprofitable loans from other lenders on a massive scale (despite a huge neurological bias against taking such risks) on what seems like little more than pure speculation that some undetermined regulatory benefit would accrue.
It seems much more likely to me that the banks truly believed that they could manage the risks on these loans such that they would be profitable.