Tag: financial crisis

Wednesday Links

  • Cato senior fellow Tom Palmer filing a lawsuit to legally carry firearms in Washington D.C.
  • Podcast: How some on the right-wing are doing everything they can to defend torture. Let’s just call them “enhanced justification techniques.”

Tuesday Links

  • Paul Krugman claims a victory for Big Government, which he says “saved” the economy from an economic depression. Alan Reynolds debunks his claim and shows why bigger government  produces only bigger and longer recessions.
Topics:

The Pay Czar at Work

Mark Calabria notes how the form of salary scheme at financial institutions played no apparent role in sparking the financial crisis.  But that hasn’t stopped the federal pay czar from boasting about his power, even to regulate compensation set before he took office.

Reports the Martha’s Vineyard Times:

Speaking to a packed house in West Tisbury Sunday night, Kenneth Feinberg rejected the title of “compensation czar,” but he also said said his broad and “binding” authority over executive compensation includes not only the ability to trim 2009 compensation for some top executives but to change pay plans for second tier executives as well.

In addition, Mr. Feinberg said he has the authority to “claw back” money already paid to executives in the seven companies whose pay plans he will review.

And, he said that if companies had signed valid contractual pay agreements before February 11 this year, the legislation creating his “special master” office allowed him to ask that those contracts be renegotiated. If such a request were not honored, Mr. Feinberg explained that he could adjust pay in subsequent years to recapture overpayments that were legally beyond his reach in 2009.

This isn’t the first time that federal money has come with onerous conditions, of course.  But it provides yet another illustration of the perniciousness of today’s bail-out economy.

Did Bank CEO Compensation Cause the Financial Crisis?

Earlier this summer, the House of Representatives approved legislation intended to, as Rep. Frank, put it, “rein in compensation practices that encourage excessive risk-taking at the expense of companies, shareholders, employees, and ultimately the American taxpayer.”

While there are real and legitimate concerns over CEOs using bailout funds to reward themselves and give their employees bonuses, Washington has operated on the premise that excessive risk-taking by bank CEOs, due to mis-aligned incentives, caused, or at least contributed to, the financial crisis.  But does this assertion stand up to close examination, or are we just seeing Congress trying to re-direct the public anger over bailouts away from itself and toward corporations?

As it turns out, a recent research paper by Professors Fahlenbrach (Ecole Polytechnique Federale de Lausanne) and Rene M. Stulz (Ohio State) conclude that “There is no evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse…”

Professors Fahlenbrach and Stulz also find that “banks where CEOs had better incentives in terms of the dollar value of their stake in their bank performed significantly worse than banks where CEOs had poorer incentives.  Stock options had no adverse impact on bank performance during the crisis.”  While clearly many of the bank CEOs made bad bets that cost themselves and their shareholders, the data suggests that CEOs took these bets because they believed they would be profitable for the shareholders.

Of course what might be ex ante profitable for CEOs and bank shareholders might come at the expense of taxpayers.  The solution then is not to further align bank CEOs with the shareholders, since both appear all too happy to gamble at the public expense, but to limit the ability of government to bailout these banks when their bets don’t pay off.

For Financial Stability, Fix the Tax Code

There seems to be near universal agreement that the excessive use of debt among both corporations, particularly banks, and households contributed to the severity of the financial crisis.  However, other than the occasional refrain that banks should hold more capital, there has been little discussion over why corporations choose to be so highly leveraged in the first place.  But then such a discussion might lead us to the all too obvious answer – the federal government, via the tax code, encourages, even heavily subsidizes corporate leverage.

Cato scholar and banking analyst Bert Ely has estimated that the subsides for debt have historically resulted in an after tax cost of debt of 3 to 5 percent, compared to an after tax cost of equity of 12 to 15 percent.  With differences of this magnitude, it should not be surprising that financial companies and corporations in general become highly leveraged.

For corporations, this massive difference in cost between debt and equity financing results primary from the ability to deduct interest expenses on debt, while punishing equity due to the double-taxation of dividends along with taxing capital gains. 

If we are going to use the tax code to subsidize debt and tax equity, we shouldn’t act surprised when firms load up on the debt and reduce their use of equity – making financial crises all too frequent and severe.

Why Promiscuous Bail-Outs Never Was a Good Idea

Jeffrey A. Miron explains in Reason why a government bail-out of most everyone was neither the only option nor the best option:

When people try to pin the blame for the financial crisis on the introduction of derivatives, or the increase in securitization, or the failure of ratings agencies, it’s important to remember that the magnitude of both boom and bust was increased exponentially because of the notion in the back of everyone’s mind that if things went badly, the government would bail us out. And in fact, that is what the federal government has done. But before critiquing this series of interventions, perhaps we should ask what the alternative was. Lots of people talk as if there was no option other than bailing out financial institutions. But you always have a choice. You may not like the other choices, but you always have a choice. We could have, for example, done nothing.

By doing nothing, I mean we could have done nothing new. Existing policies were available, which means bankruptcy or, in the case of banks, Federal Deposit Insurance Corporation receivership. Some sort of orderly, temporary control of a failing institution for the purpose of either selling off the assets and liquidating them, or, preferably, zeroing out the equity holders, giving the creditors a haircut and making them the new equity holders. Similarly, a bankruptcy or receivership proceeding might sell the institution to some player in the private sector willing to own it for some price.

With that method, taxpayer funds are generally unneeded, or at least needed to a much smaller extent than with the bailout approach. In weighing bankruptcy vs. bailouts, it’s useful to look at the problem from three perspectives: in terms of income distribution, long-run efficiency, and short-term efficiency.

From the distributional perspective, the choice is a no-brainer. Bailouts took money from the taxpayers and gave it to banks that willingly, knowingly, and repeatedly took huge amounts of risk, hoping they’d get bailed out by everyone else. It clearly was an unfair transfer of funds. Under bankruptcy, on the other hand, the people who take most or even all of the loss are the equity holders and creditors of these institutions. This is appropriate, because these are the stakeholders who win on the upside when there’s money to be made. Distributionally, we clearly did the wrong thing.

It’s too late to reverse history.  But it would help if Washington politicians stopped plotting new bail-outs.  At this stage, most every American could argue that they are entitled to a bail-out because most every other American has already received one.

Too Big to Fail

One of the most pernicious public policies aggravating the financial crisis is that of “too big to fail.” The doctrine states that some banks (now financial institutions generally) are so large that their failure would incur “systemic risk” for the financial system. That sounds terrible and it is intended to. Financial services regulators and Treasury secretaries use it to frighten small children and congressmen. How can an elected official vote to incur systemic risk? He must vote to approve the bank bailout of the day. In fact, people who use the term cannot even agree among themselves as to what it means, much less what causes it and, therefore, what the appropriate response would be. I suggest the reader substitute the phrase “too politically connected to fail” whenever he sees “too big to fail.” What follows will then be rendered intelligible.