Less than the Least

As Obama, Clinton, and everyone else tout their remedies for the subprime crisis, I’m reminded of the old joke about a group of blind men who encounter an elephant. The man who grabs the elephant’s leg tells the others he has encountered a tree, the one who touches the trunk is sure it’s a huge snake, and so on. In the fall, subprime worries centered on the losses that banks were suffering, and the possibility that credit markets would seize up. Now the homeowners who are facing default are on center stage.

These parts are connected in ways that often get obscured.

Fed Chairman Ben Bernanke has now called on banks to forgive portions of the principal owed by struggling subprime borrowers, which suggests that a major intervention may be coming. As between jawboning (the Republican inclination) and a bailout (the Democrats’ leaning), I’ll take jawboning any day. But the third option, amending the bankruptcy laws to allow borrowers to reduce their mortgages, is, in my view, much superior to either, as I argued in a post last week.

Rather than repeat those arguments, I’ll simply add two additional points.

Shortly after I learned of Spitzer’s resignation, I was at dinner with
several Italian lawyers. At the table next to us at a lovely restaurant
near the Trevi Fountain sat the leading director of soft core porn
movies in Italy. (Note to wife: I didn’t recognize the director, my
companions did). The Italian lawyers were puzzled that resignation was
the obvious response to a sex scandal in the U.S. The Italian public
wouldn’t be especially alarmed about this kind of revelation, they said:
they expect it from their politicians.

Bill speculated several days ago that prosecutors’ use of criminal law to pursue the executives of firms that go spectacularly bust may often serve no other purpose than to discourage firms from engaging in the kinds of risks that make a market economy go. I for one think that this is a very real danger. Executives who commit crimes should be punished, of course, but often prosecutors seem to identify the targets in high profile cases first, and then start looking for criminal provisions to prosecute them with.

There are two problems with this, in my view.

Many of Bear Stearns’ biggest shareholders are screaming about its proposed sale to JPMorgan for $2/share. This is a good sign. It is important that shareholders bear the costs of the bank’s missteps in the subprime market. But their squawking also raises at least two questions: can they derail the deal?; and would Bear Stearns be better off in bankruptcy?

Hillary Clinton has just rolled out her most extensive recipe yet for addressing the subprime crisis. The plan, which includes $30 billion to purchase troubled mortgages and for foreclosure auctions, as well as a freeze on foreclosures and interest rates, is striking in two respects: 1) although the plan is wrapped in populist appeals to struggling homeowners (of whom we have many here in Pennsylvania), it seems nearly as attractive to big banks and other lenders; and 2) there’s nary a word about reforming the bankruptcy laws, a much more sensible way to help out homeowners. I suspect these two things may be related.

As the Bush administration begins its defense of the new Treasury Department proposal to revamp U.S. financial regulation, Democrats are arguing, rightly in my view, that the more urgent concern should be to directly address the mortgage crisis. Unfortunately, Democrats increasingly are coalescing around a proposal by Congressman Frank and Senator Dodd to pump billions of dollars into the Federal Housing Administration to guarantee new mortgages that would replace troubled borrowers’ current mortgages. Proponents cite the Home Owners’ Loan Corporation, which was set up at the outset of the New Deal, as shining precedent for the Frank-Dodd plan.

The HOLC certainly sounds like a remarkable governmental success story.

Almost a year into the subprime crisis, we still haven’t seen any major reforms. The Enron and WorldCom scandals six years ago, by contrast, prompted sweeping reforms in Congress and on Wall Street. Why the difference?

I increasingly think the most important difference is the lack of a clear villain– a person and company that serve as a posterchild for everything that is wrong and needs to be fixed with American finance.

Most of the commentary on Obama's decision to tap Senator Joseph Biden as his V.P. pick has focused on the foreign policy expertise that Biden brings to the ticket. But I think the implications for some of Obama's business reform proposals are at least as important.

Obama has suggested that he will support more federal regulation of corporations. And he has signaled his support for bankruptcy reform that would allow borrowers to write down the value of their mortgages in bankruptcy. He also has sharply criticized the major bankruptcy reforms passed in 2005, which made bankruptcy more difficult for consumer debtors.

Biden has been on the other side of most of these issues.

I may be over-reading the McCain-Palin op-ed in the Wall Street Journal on Fannie Mae and Freddie Mac this morning, but it seems to me to mark a sharp break from the Bush administration on the subprime crisis. Not on the bailout itself. Just about everyone seems to agree that bailout was inevitable, and that the question was simply when it was going to take place. The break, it seems to me, is in the proposals for mortgage lending going forward. The Bush administration has relied almost entirely on jawboning and voluntary measures. McCain-Palin seem to be advocating substantially more governmental intervention. They suggest that they would establish a minimum downpayment requirement for loans guaranteed by Fannie Mae or Freddie Mac, and would impose new disclosure requirements for derivative securities.

I wonder if this means we'll be hearing a little less about tax cuts in the next two months, and more about Teddy Roosevelt-style corporate and financial reform.

The government's dance with Lehman after having bailed out Bear Stearns reminded me of a game we used to play as kids. One kid would stand in front of another and fall backwards. The idea was that the kid in back would catch his falling friend. The Fed and Treasury are like the kid in back. Unfortunately, it's now completely unclear whether and when they'll catch an investment bank as it falls.

I don't mean to suggest the government should have bailed Lehman out. I don't think they should have. But they've managed to create a situation where it's almost completely uncertain whether the government will or won't step in. This is one problem.

But there's a second problem as well: the government is focusing too much on the wrong issue.

As Congress rushes to enact the Treasury's $700 billion bailout plan this week, Obama, McCain, and politicians of both parties are insisting that the bailout include restrictions on executive pay at the firms whose mortgage backed securities will be bought by the government. Some of the executives' pay packages are indeed outrageous, but trying to impose pay limits is, it seems to me, one of the worst ideas yet proposed.

Hank Paulson has argued that firms might refuse to participate in the bailout if restrictions on pay were a condition of involvement. Perhaps this is true, although I suspect that shareholder pressure would force even the most reluctant firms to join the bailout party. But restrictions are likely to have two other effects, both of them bad. First, firms who wish to attract high quality executives will attempt to evade the restrictions. If the restrictions are onerous, these evasions may well be abetted by sympathetic courts. This is exactly what has happened after Congress imposed restrictions on executive compensation in bankruptcy in 2005.

One reason the current financial crisis seems so mystifying is, I think, the absence of a simple, coherent story that explains what the crisis is about. The Enron and WorldCom scandals earlier in the decade could be distilled to a plausible story about greed and the failure of the accounting firms and other gatekeepers who are supposed to police Wall Street. With the current crisis, by contrast, three main narratives seem to be competing for attention. And each is deeply flawed.

The first, which has been offered by Senator Bernie Sanders and others, attributes the crisis to Wall Street greed, and demands that Wall Street be punished and ordinary Americans helped. Wall Street greed certainly is a major factor in the crisis, most visibly in the pushing of exotic, mortgage-related securities that now have come back to haunt many financial institutions. But the greed story has at least two problems.

I suspect I'm not the only one who feels vaguely guilty when I'm not thinking about or talking about or trying in some small, inept way to do something about the financial crisis. Everything else seems secondary. How can we go about our ordinary lives in a time like this?

Some of the most helpful answers I've heard come, as is so often the case, from C.S. Lewis. Speaking to university students at the height of World War II in an essay called "Learning in War-Time," he asked how they could continue studying "when the lives of our friends and the liberties of Europe are in the balance?" Lewis points out that, because times are never truly "normal," if we took the assumption that we should stop our ordinary activities when things are amiss to its logical conclusion, we would never engage in ordinary activities.

He then argues that the seemingly frivolous activities in which we engage are part of what makes us different from animals: people "propound mathematical theorems in beleaguered cities, conduct metaphysical arguments in condemned cells, make jokes on scaffolds, discuss the last new poem while advancing to the walls of Quebec, and comb their hair at Thermopylae. This is not panache: it is our nature."

We now have yet another switch in the Treasury's strategy for stabilizing the markets. Plan A with the $700 billion rescue plan was to use the money to buy some of the questionable mortgage-related securities that are held by the nation's troubled financial institutions. Treasury Secretary Hank Paulson now wants to take a direct stake in the banks, to buy stock rather than simply buy some of banks' assets.

The most obvious reason for the shift is that, unless the government overpays, buying a bank's questionable securities doesn't necessarily improve its balance sheet. It replaces one asset- the securities- with another one- cash. If the government buys stock, on the other hand, the cash directly increases both the bank's assets and its net worth, potentially increasing the likelihood the bank will remain solvent.

That's the good news. But there are at least two potential problems.

In their handling of the credit crisis, the Treasury Department and Federal Reserve have repeatedly been criticized for their lack of transparency. The decisions as to which financial institutions to bail out have been made behind closed doors, the complaint goes, and Treasury Secretary Henry Paulson's original plan for the $700 billion bailout was only three vaguely-worded pages long. But I wonder if this criticism isn't exactly backwards. It seems to me that the Fed and Treasury have been too transparent, and that this could be contributing to the crisis.

Take the bailout of Bear Stearns in March and the decision not to bail out Lehman Brothers six months later.

The most surprising development in the Big 3's campaign for a bailout has been the amount of resistence it's met. Surprising to me, at least. After all the money that's been committed to the financial bailout, I assumed the carmakers would get a sympathetic welcome in Washington. It's encouraging, in my view, that this hasn't happened. The best case for a bailout is a situation where the company simply has a cash flow problem and will be fine if it is given temporary funding. GM's problem isn't cash flow; it's solvency- too much debt and not enough asset value. That's precisely the kind of problem chapter 11 is designed to address.

One of the most intriguing questions is where GM will file for bankruptcy if that's where it ends up. Large companies generally have a variety of filing options. In recent years, most have filed in New York or Delaware, because these are the bankruptcy courts with the most sophisticated judges- judges who handle a lot of big cases. I suspect GM wouldn't follow this pattern. Both the CEO, Rick Wagoner, and the employees may think they'll get a judge more sympathetic to their plight in Detroit. If they file in New York or Delaware, on the other hand, they'll seem to be turning their fortunes over to Wall Street (New York) or corporate America (Delaware). Assuming the bailout falls through, look for Wagoner to portray himself as a champion of employees' interests, and to file the case in Detroit.

            The most frequent worry I’ve heard about the new administration is that President Obama will get swept up in the messianism surrounding his historic presidency, and he will take advantage of it to pass a vast legislative agenda that is already mapped out in his mind. This seems to me exactly backwards:  President Obama seems to be the one person who hasn’t gotten swept up in the messianism, and while he obviously has a few pet issues, he doesn’t seem to have a grand scheme in mind.  

Like just about every university, we recently had a forum to talk about the financial crisis-- its apparent causes and possible implications.  The panel was moderated by the university president, Amy Gutmann, and I was one of five panelists.  For those who are interested, here is a link.  (For anyone who perseveres and actually watches, you'll notice that I'm at my best in the first ten minutes-- when I'm simply listening to the others, who know what they're talking about).

 Almost the only tool the government hasn’t seriously tried in its battle against the economic crisis is bankruptcy. Rather than bailout out Bear Stearns, AIG or GM, it would have made more sense to address their financial distress in bankruptcy. The most sensible strategy for addressing the foreclosure crisis is a proposed amendment to the bankruptcy laws that would let a homeowner write down her mortgage to the value of the house if the house is worth less than she owes.

In each case, an irrational fear of bankruptcy seems to be coloring people’s perceptions. 

A student emailed me this marvelous commentary by Stanley Fish, which I hadn’t seen. I’ll only add two brief thoughts, since Fish speaks for himself as always: 1) the two Christian discourses Fish discusses don’t strike me as necessarily at odds with one another—any more than faith and works are; and 2) the forgiveness offered by Christ, and the economic imagery so often used to describe it, was of course vividly foreshadowed in the Old Testament by the Jubilee (Leviticus 25), which had both practical and spiritual significance. 

Readers of this blog are no doubt tired of hearing me argue that bankruptcy would often be a better solution to the financial distress of large financial firms like AIG or Bear Stearns than the bailouts the government has used throughout the current crisis.  But for those who haven't yet had enough, or are interested in a more scholarly treatment, here is a link to a paper by Ken Ayotte and me about the bankruptcy vs. bailout choice.

Treasury Secretary Geithner finally sketched out the administration's blueprint for new financial regulation yesterday.  Many of the proposals, such as a new registration requirement for hedge funds, strike me as sensible.  But I think the proposal to give federal regulators the power to take over troubled investment banks and hedge funds is a serious mistake.  A colleague and I criticise the proposal in this op-ed piece.

Debtors’ prisons seem to be back in the news. Last week’s New Yorker included an interesting article about debtors’ prisons in late eighteenth and early nineteenth century America (a link to the abstract is here). Decreasingly few states allowed imprisonment for debt by the mid nineteenth century, but debtors’ prisons weren’t abolished altogether until the Thirteenth Amendment was passed after the Civil War. Some commentators have argued that the 2005 amendments to the bankruptcy laws, which increased the costs and hassles of filing for bankruptcy, violate the Thirteenth Amendment. This is rather far fetched, but a recent practice in Florida seems a much closer call. A New York Times story reported that Florida courts have been throwing criminal defendants in jail if they fail to pay their court fees. Although this may not be imprisonment for debt, it seems awfully close.

T.S. Eliot famously wrote that “The last temptation is the greatest treason: to do the right deed for the wrong reason.” 

Several days ago, I wrote a short post noting some of my concerns about the extent to which the government seems to be commandeering the bankruptcy process in Chrysler as a means of effectuating its auto policy.  This commentary develops the critique in a bit more detail, and puts it in historical perspective. 

This op-ed by equity fund manager Scott Sperling in today’s Wall Street Journal makes an interesting case that the Obama administration’s handling of Chrysler and GM is actually evidence of capitalism at work. In my view, he’s right that the restructuring of these companies has some similarities to how things would play out if the government weren’t cramming down its own preferred plans. Both companies would have filed for Chapter 11, and would have been restructured. But the op-ed strikes me as very misleading in its suggestion that restructuring of Chrysler in particular can be squared with the bankruptcy laws. In talking about Chrysler, Sperling seems to suggest that it’s fine to give employees, retirees or anyone else (including current stockholders, presumably) a large stake in the new company, so long as they aren’t allowed to keep everything they have now. That is, he seems to forget the rules of priority, which say that the senior lenders are required to be paid first. When he turns to General Motors, on the other hand, he suddenly remembers the priority rules. The recalcitrant bondholders really aren’t entitled to anything (or much of anything), he argues, because the government, as senior lender, is entitled to be paid first.

            I was a minor player in a very interesting conference on systemic risk yesterday at the American Enterprise Institute in Washington DC yesterday. In the keynote address, Alan Greenspan suggested that he sees only three plausible responses to the emergence of financial institutions that are “too big to fail,” and thus will be bailed out if they fail. The first is to impose higher capital requirements on bigger institutions—in effect, to require them to have more equity and less debt on their balance sheets, so that they are less likely to fail. The second is for people to start new more new banks. Since new banks won’t have the baggage of the banks that are still holding lots of “toxic” assets, they presumably would be well positioned to compete with the big current banks. Third, he suggested that lawmakers might require that investment banks be structured as partnerships rather than corporations, as they were until recently. Because the partners of a partnership are personally responsible for its debts if it fails, the folks running future banks like Bear Stearns and Lehman Brothers might take a lot fewer risks. 

            The enormous recent bankruptcies have provided a lot of reasons for a bankruptcy scholar to leave the library and venture out into the real world for a change. I’ve spent more time in New York and Washington in the past month than I ever would have imagined. In addition to conferences and conversations with congressional staff, I had the privilege of testifying at a House Judiciary Committee hearing on the auto bankruptcies two weeks ago, and I went to the bankruptcy court in New York last week to watch the first several hours of the hearing on the proposed sale of Chrysler’s assets to New Chrysler. (The bankruptcy court, by the way, is a lovely building—the old Custom House—at the very bottom of Broadway, at the southern tip of Manhattan, and well worth a visit).

This is more David’s department than mine, so if this observation is all wet, I’m happy to take correction. But in recent weeks, I’ve been thinking about the fate of the railroads in the late nineteenth and early twentieth centuries. Like the auto companies today, the railroads of the late nineteenth century received huge subsidies, often in the form of free land adjoining new track. Like GM and Chrysler, most of those subsidized railroads went belly up – not despite the government subsidies, but partly because of them. 

The $64,000 questions in my little world today are 1) what to make of Justice Ginsburg’s order temporarily halting the Chrysler sale; and 2) what it means for the General Motors bankruptcy. 

The Supreme Court has now lifted its stay on the Chrysler sale, which makes the first part of the last post moot.  On to GM.

The most surprising of Obama administration’s new financial reform proposals would establish a new Consumer Financial Protection Agency to look after consumers’ interests in financial services contracts such as credit cards and mortgages. It’s been discussed in Washington for many months, but it was not part of the earlier version of the reforms announced by Treasury Secretary Geithner in the spring. This new agency would have the power to write rules for credit card contracts and other transactions, examine financial institutions, and require firms to offer a “plain vanilla” mortgage product as a yardstick for comparing their more exotic mortages. 

The Obama adminstation's new financial reform proposals, like the version proposed several months ago, would give regulators the power to step in and take control of large nonbank financial institutions, as the FDIC already does with commercial banks.  As folks who have stumbled on this blog in the past  will know (and are no doubt tired of hearing about), I think this is a serious mistake.  This magazine article describes the concerns in a bit more detail, and offers what I think would be a better approach.  I'd be very interested in reactions.