The moral hazard of creditors
Ambrose Evans-Pritchard published a column this morning suggesting that the U.S may adopt the so called “Nordic model” of nationalizing insolvent banks. The piece has drawn a lot of blogospheric comment. [ Scurvon, Naked Capitalism, Financial Armageddon, Curious Capitalist, Across the Curve ].
You would think that moral hazard fetishists like me would applaud. The “Nordic model” is a very tough approach. When regulators deem a bank insolvent, they nationalize it outright, wipe out the equity holders, and unceremoniously can the incumbent management. That is harsh, as it should be. Managers who steward significant enterprises to ruin should not be rewarded, and stockholders, who earn high returns as compensation for risk, should be held accountable when they err by placing their money in the hands of gamblers.
But what you are hearing from me is the sound of one hand clapping. (Finally, an answer to that riddle!) An automatic policy that wipes out equity but makes all creditors whole creates a perverse incentive. It suggests that anyone investing in a bank should structure their investment as debt to capture the implicit guarantee. But highly leveraged balance sheets are a source of the brittleness that leads to banking crises in the first place! Our policy preference should be for equity rather than debt financing, as less leveraged firms respond much more flexibly to adverse shocks. Regulation can address this to a certain degree, but unless bank finances are kept very, very simple, probably not so much. Clever minds can come up with all kinds of contingent liability arrangements that would evade regulated balance-sheet ratios while serving as debt financing, even if “special purpose entities” are banned.
Since debt can substitute for equity, killing common stockholders while making whole even junior creditors amounts to a loophole by which lazy investors can shirk their duty of market discipline. It’s not easy to learn which firms are genuinely worthy of ones trust, but that work is precisely what investors get paid for when they earn better-than-risk-free returns. Bondholders, counterparties in derivatives transactions, and other creditors are supposed to assess the credit risk of the firms with whom they entrust money, just as stockholders evaluate business risks. Letting bank creditors enjoy high-returns effectively risk-free creates an obvious arbitrage: short Treasuries and lend as much as you can to any firm that is too big to fail!
There is one and only one class of creditors to whom we have, as a matter of public policy, agreed to make whole under all circumstances. Those are small depositors, and they should bear no risk or inconvenience whatsoever should a bank run aground. All other creditors knowingly assume credit risk when lending to banks, and should be forced to bear some downside when a bank goes south. Admittedly, reducing this theory to practice is walking a knife’s edge. The goal of nationalizations and bail-outs is to keep the financial system functioning smoothly. Too harsh a policy towards creditors might provoke self-defeating runs at the first whiff of trouble.
Can this circle can be squared? Probably. Creditors who try to accelerate replayment in advance of a firm’s insolvency can have the funds clawed back under the doctrine of preferential payments. Regulators can make clear that recently withdrawn funds will be pursued aggressively, in order to treat all creditors equitably. It makes less sense to stage a run on the bank if you know that the bank will come right back and stage a run on you. Creditors will hate all this. They will fume. Creditors are supposed to hate insolvencies. That’s the point. They should have thought about the risks ahead of time, and better supervised the firms they were lending to.
That said, creditors obviously oughtn’t be wiped out entirely like shareholders. The point here is to remind the market that on the liability side of a balance sheet lies a continuum of risk, not a bright line between junk and safety. The financial world does require a superhero, but not the Fed-on-steroids of the Paulson proposal. We want the bond vigilantes back. It’s probably sufficient to wipe out the equityholders (both common and preferred, there’s no basis to discriminate if the bank is genuinely insolvent) and let creditors suffer some delay and uncertainty prior to repayment, perhaps with a small haircut inversely proportional to seniority of claims if public funds need to be deployed.
Writing this stuff makes me feel mean, nasty, cruel, low. Isn’t it enough to take a pound of flesh from stockholders? Must we go after the creditors too? But remember, the creditors are mostly getting bailed out here, by you and me, the taxpayers. A bit of inconvenience and frayed nerves in the service of an important policy goal is not so much to ask in exchange. And there are few public policy goals more important in the financial world than getting more equity and less debt on corporate balance sheets, and encouraging all classes of investors to exercise a lot more adult supervision over the firms that they fund.
Update: See Dean Baker, who offers a similar view, more plainly and clearly expressed.
- 4-Apr-2008, 1:20 a.m. EDT: Added update re the Dean Baker post.
I know this will come off as a stupid question, but there seems to be so many problems with utilizing this model.
1) The article you linked to indicated that two banks in Norway were seized by Force Majeure, but government confiscation of the entity prior to bankruptcy is slightly dangerous.
How will this work with the 5th amendment? Where just compensation is needed to be paid for all taken property, to give 0 and wipe out equity positions in a firm that is still functioning and not insolventant, or is judged so by inapt regulators seems unconstitutional.
Next, i do not see how this model can work when banks are charted by both state and federal regulators. This is more than a pre-emption of state law, but a striping away of their rights to regulate entities within their sphere of influence. If the federal government has failed since the 1960’s to get a universal federal foreclosure procedural law to pass congress, how would they go about this?
What of the FDIC? WOuld this call for a dismantling of this agency? Are they not in place to put insolvent banks into receivership in order to stop any failure, and protect the publics deposits? This of course brings to mind the question on how this would be any better than that what we have already? Are we also inadvertly creating Bankruptcy proof entities? If so, how can this not also lead to a moral hazard? FOr once it is nationalized than the accountability of the management could emulate those that are in place of Fannie Mae or for that Matter HUD?
I know the stress of the article is pushing insolvent banks, but when there is such a small time frame from which a firm is weakened but able to restructure and that of a failed bank, this will always lead to dangerous precedents. Last, to what end would this even serve? Do we actually want to have a nationalized industry in this country? Other than Tennessee valley Authority, and i guess you can consider Amtrak(but this is more quasi), there is no nationalized industries in this country. If the government did exclusively own a Business and operated it, than acting as a market participant would they not be waivering their sovereign immunity? The Justice department has extended this argument to other countries acting in the same position…. The blurring of the lines is too much to unravel, would the actions of this new firm be those coming from the power of the Federal government, or that of a business, and if there actions impact others in a adverse way, and the parties are non-resident business, to what extent would this be a violation of treaties such as NAFTA or WTO treaties?
But like i said, i know it is somewhat of a dumb quesiton.
April 1st, 2008 at 4:09 am PDT
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Steven,
The thing is, what the Fed has already done was completely outside of the rules. What we are talking about is solutions that fall outside of the traditional responses, so yeah, you can’t expect them to confirm with every other law out there. There is some talk that Bernanke’s actions in the Bear Stearns bailout were actually illegal (not to mention Jamie Dimon sitting on both sides of the deal table). Desperate times call for desperate measures. Nordic nationalization is the least-bad option. The details can be worked out later.
April 1st, 2008 at 8:41 am PDT
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how ceditors and counterparties get treated in a failure event has a large influence on behavior. if these two groups are subject to harcuts, then they are more likely to impose discipline. it is a given that equity holders should be wiped out if any taxpayer money is used. the equity holders are simply in a long call option position and when the firm becomes distressed, they are willing to go along with any strategy (no matter how remote) to prevent failure. the sophisticated term for this behavior is “moral hazard” — if its heads, the equity holders win; if its tails, then the taxpayers pick-up the tab. this is why the equity class cannot be expected to impose discipline like creditors or counterparties.
this is the problem with bear stearns deal — bondholders and creditors were made whole and the equity holders still walked away with some money while the taxpayers are on the hook.
under basel 2, the credit rating agencies and bank internal models have failed on a grand scale. now, market discipline is not enforced. exactly how many pillars are left holding up basel 2?
April 1st, 2008 at 9:47 am PDT
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Brilliant. You got it. Michael Milken taught us debt can replace equity. Hence, to capture the implicit debtors guarantee, encumber the balance sheet with debt. Voila, the Fama-Miller arbitrage concept falls away as the value of the guarantee increases. My answer: do nothing and let the bankruptcy courts sort it out.
April 2nd, 2008 at 3:01 am PDT
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The financial stability of society is too important to let ANYONE ‘play’ with it.
Now that capitalism has hit the wall’, (failed) it’s time to put a stop to this nonsense!
I’m amazed that the taxpayers are ‘cool’ with how the Fed is making the investor class ‘whole’ at their expense…which is to say I’m pretty sure most folks are worried sick over how this whole mess is going to play out.
The crisis, in itself, is proof enough that ‘fooling’ with the ‘lifeblood’ of society should be strictly ‘off limits’.
April 2nd, 2008 at 4:43 am PDT
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Perhaps I am being obtuse, but I don’t see how the nordic model of nationalization relates to how a bank is capitalized. It seems to me that bank regulators already enforce equity capital requirements. And regardless of how a bank goes bust, investors would prefer, all things equal, to be in senior rather than junior securites. So am I missing the obvious?
April 2nd, 2008 at 3:39 pm PDT
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Chris — As I understand it (but I might be wrong!), the “Nordic model” involved nationalizing banks when they reach a minimum capitalization threshold, wiping out equityholders, but making whole all creditors. Sure, all else equal, you’d rather hold senior than subordinated debt. But if you know all classes of creditor will automatically be made whole, that distinction turns academic. All things equal, I prefer red napkins to blue napkins, but if I can earn 200 basis points extra a year for using blue napkins, I’ll deal. If creditors expect that junior claims will be treated just as well as the most senior claims, and paid-in-full regardless of the bank’s finances, why shouldn’t they reach for yield as an unsecured creditor without the all the hassle of analyzing the business?
April 2nd, 2008 at 7:26 pm PDT
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You, like so many use the term “taxpayer”. I have not found anyone who is happy about having money extracted from them for government programs that they did not vote for.
I prefer to use the term “taxvictim”.
April 3rd, 2008 at 11:26 am PDT
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While as described the Nordic model allows the arbitrage detailed, it would be reasonably straightforward to accordingly take an unspecified but seemingly just pound of flesh according to creditors relative place in the capital structure – not so generous nor stated as to encourage the dreaded (and real!) moral hazard of a free lunch though not so great as to torpedo the hull of the systemic vessel. It is surely better to stabilize the patient quarantine the toxic bits, and deal it back out to recover one’s guarantees and collect what one can for towards efforts.
Yes depositors up to a reasonably large level should be made whole to prevent runs, along with perhaps the most senior of paper (or more interestingly, a portion thereof by lottery, to introduce further uncertainty with which to deter free-riding and create additional pressure to price credit-risk appropriately and NOT shoot-the-moon), and to prevent the dislocations from withdrawal of lines steeper losses might infer. Those risk-bearers reaching for yield however – in particular those speculators leveraging to do so – must be periodically spanked and disciplined.
From an economic point of view, I cannot believe that the bankruptcy courts with all their piggy lawyers and accountants conflicted as they are, absurdly feeding at the trough (ones that make DoD procurement process look honest), will provide the “best” outcome here. One can sanely argue that financial institutions are indeed somewhat special in their systemic role and, as such, their goring and dismemberment should not be left to senior creditors to railroad a workout in THEIR sole interests given the true multitude of constituencies with tinges of public interest. I reckon informed arbitrators with good technical grasps and not in the pockets of the creditors in past, present or future – could arguably apply a consistent set of rules (be it a matrix, a usual &customary scale) that averts implosion (with all associated systemic cascades), paying more than a lip-service to fairness in the process. Such a form of “just certainty” might, maybe just, achieve many of the desired goals of stability workout and consolidation and quick disposal while limiting the free-riding to those wanting to brave the administrative hassle of dealing out upper-boundary deposits across all potential institutions .
April 3rd, 2008 at 4:42 pm PDT
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Yes, this take-over may be happening. But we need to be sure it happens correctly. It is the fed itself that caused the problems by supporting, even promiting derivatives and other exotic investments. The investment banks, conduits, etc. screamed for more paper, and took anything the mortgage industry could give them. Liar’s loans were not a secret. Everyone knew what was going on.
The Fed needs to be fully renationalized (run from and by Congress). Regardless of whose fault the problem is, the taxpayer is going to foot the bill to fix it. So we may as well go back the the constitutional formula and give the taxpayer (through representation) oversight of the process while it happens, not only after it crashes and he/she must open the wallet.
See a proposal at http://www.TakeBackTheFed.com.
April 3rd, 2008 at 7:14 pm PDT
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So the Nordic model eliminates the creditor’s normal short put option exposure.
April 5th, 2008 at 1:37 am PDT
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