Divide the world into the consolidated financial sector and taxpayers. Under PPIP, each dollar a “public-private investment fund” overbids provokes a net transfer to the consolidated financial sector from taxpayers. The size of transfer to the financial sector increases with the degree to which bids are overpriced, and is maximized if the true asset value is very small relative to the price actually bid. If an asset is worth $6 dollars, and financial sector actors purchase a contract for $7 while the Treasury invests alongside, the consolidated finacial sector gains a dollar. But if financial sector actors pay $70 for the same asset, the financial sector would receive a net transfer from taxpayers of up to $118. (For more detailed arithmetic, see below.) The more financial sector actors are willing to overbid, the greater the net transfer from taxpayers to the financial sector. In theory the scale of the transfers is limited only by the quantity of asset purchases the government is willing to guarantee.

There are problems with this story. In real life there is not a consolidated financial sector, but a lot of different players who are usually in the business of competing with one another. PPIP includes rules and tools by which the government could prevent the use of taxpayer money to fund overpriced bids, and ensure that the parties who take small losses are distinct from the parties who make large gains, eliminating incentives to overbid. An important question is whether the government genuinely wishes to prevent backdoor transfers to the financial sector, or views such transfers as a desirable means of helping core financial institutions. (See Joe Weisenthal and Noam Scheiber)

It is worth noting that overcoming coordination problems so that diverse parties can collaborate on profitable ventures is precisely what the financial sector is supposed to be good at doing. Ideally, we would like the profitable ventures to be welfare-improving projects in the real economy, but there is little question that financial sector actors will gladly apply the same skillset to extracting transfers and rents when the opportunity presents itself. Attempts to regulate away intentional overbidding by cooperating parties will have to outwit some very clever professional deal makers.

A few more caveats — financial sector actors do pay taxes, so they are not distinct from the taxpayers from whom transfers are made. Qualitatively, this overlap would’t change the story very much. (Quantitatively, it’s interesting, you’d have to think hard about the realizability of “deferred tax assets” from losses the financial sector would absorb without the transfers.) The numbers I’m using are for the PPIP whole loan program. The degree of nonrecourse leverage that will be provided by the Fed towards the securities purchase program is as far as I know unspecified.

Some links:

There are way too many good links on this issue, but rortybomb’s take is my all-time fave.

Restricting to the last 24 hours or so, see also Scurvon, Carney, Sachs, Nemo, Krugman, Free Exchange, Felix Salmon, Economics of Contempt, and Cowen. See also articles in the Financial Times (ht Conor Clarke, Calculated Risk) and the New York Post (ht Yves Smith). As far as I know, Karl Denninger is the first person to have pointed out the potential for gaming. My first take on this issue is here. Mish has a very similar take (here, here, and here). I’m sure I’ve left many great posts out of this linksplatter. My apologies to the unsung pundits.

Arithmetic:

Case 1: A private fund buys an asset for $7, but pays only $1, as the rest is borrowed from the bank via an FDIC guaranteed loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6. The private fund loses its dollar, but this becomes a gain to the selling bank, causing neither a loss or gain to the consolidated financial sector. However, the Treasury also loses a dollar, which becomes a gain to the selling bank, and amounts to a transfer of $1 from taxpayers to the consolidated financial sector.

Case 2: A private fund buys the same asset for $70, of which it pays $10 cash and borrows the rest on an FDIC guaranteed nonrecourse loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6, so each purchase amounts to a transfer of value to the bank of $64 dollars. When the value becomes known, the FDIC (indirectly) accepts the $6 asset in exchange for $60 of loan extinguishment, bearing $54 of the private investor’s $64 loss. The net effect of the private investment is a transfer of $54 from taxpayers to the consolidated financial sector. Taxpayers bear the full loss of $64 on the Treasury’s investment. So the total transfer fronm the public to the private sector is $118.

Not unusually, I was a bit incoherent in my previous post on bank size. On the one hand, I wrote…

…a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.

On the other hand…

…limiting size defined by total asset base plus an expansive notional value of all derivative and off-balance sheet exposures limits both interconnectedness and leverage.

If limiting size constrains leverage and interconnectedness, how could a microbank get to be so interconnected and level as to bring on armageddon?

The key, of course, is in the definition of size. Entities that are small in terms of number of people involved and level of capitalization certainly can blow things up, by loading up on traditional leverage (debt) and untraditional leverage (derivative exposures, off-balance-sheet contingent liabilities). AIG might have been a big firm, but the unit that blew up the world amounted to a handful of people in a well-appointed London garage. The “bigness” of AIG mattered only insofar as it permitted that tiny operation to lever up, by taking on trillions of dollars in notional CDS exposure.

But if size is defined properly to mean the total scale of assets to which a firm is exposed, including balance sheet assets plus the notional value of any derivatives plus any off-balance-sheet commitments, then size is basically everything. Suppose there was a bank levered 10000:1. Sounds pretty bad, huh? But suppose the bank has precisely one penny of equity against a hundred dollars of assets. That might suck for the fool who lent the hundred bucks, but the rest of us can sleep easily. Leverage alone can’t cause crises: it’s only when an entity is levered up to some systemically troubling size that bad things happen.

That doesn’t mean we could regulate bank size and then ignore leverage: If all banks had $100 on assets against a penny of equity, we’d end up with a lot of bank failures, creditor bailouts, and sleepless nights. What size limitations do is prevent mistakes or misdeeds at any one or few firms from becoming all of our problem. Smallness also reduces the likelihood of misdeeds, since dumb gambles have a bigger payoff for managers at big banks than at modest thrifts. Some banks will always slip through regulatory cracks. If they are small and few, that’s not a problem. If they are big or many, we’re screwed.

Size limits, like leverage and risk constraints, will inevitably be gamed. There will always be fuzziness surrounding what sort of contingent liabilities should fall under a size calculation, and bank lobbyists will work assiduously to create loopholes. Adding hard limits on size and trying to police them won’t be a panacea. But faking small might be harder than faking well-capitalized. Plus, forcing banks to appear small may help to keep banks actually small, since counterparties get nervous about offering sneaky, uncollateralized leverage to banks that look like they are small enough to fail.

In the end, banks-as-we-know-them are flawed by design. They serve an important purpose, but do so in a manner that is predictably prone to failure. If your roof has a leak and water drips in, one way to handle the problem is with a bucket. That approach can be effective, but it demands constant supervision. There is always the danger of some lapse of attention, then whoops!, the bucket overflows and your floor is ruined. Resolving to watch the bucket very carefully by, say, titling yourself the integrated bucket super-regulator might help, a bit. But even super-regulators need the occasional bathroom break, and buckets are notorious for tempting super-regulators with songs of free water flows and offering cushy jobs if they look the other way. Imposing size and leverage constraints on banks is like replacing a small bucket with a big washtub: You’ll still have problems if you don’t watch the thing, but the occasional lapses in supervision are less likely to conjure the Great Flood. Of course, the best way to manage a leak in the living room would be to stop messing around with buckets and patch the roof instead. To do that, in my opinion, we’d have to separate the credit and investments function of banks from the payment and deposits function, and draw an enforceable bright line between guaranteed claims and risk investment.

But if we’re too scared to climb that ladder, I suggest we get the biggest washtub, — I mean, the tightest size restrictions — that we can possibly manage. Promising to stare very sternly indeed at the same old bucket just won’t cut it.

p.s. if you haven’t seen it, I really like James Kwak’s Frog and Toad post on the difference between supervisory and structural approaches to regulation.

Kevin Drum has nicely posed the question of whether it really is important to break up big banks. After all, he argues, even small-ish banks have proven to be too leveraged and interconnected to be permitted to really fail. He argues that maybe it’s the banking industry, rather than individual banks, whose size and reach we need to constrain.

John Hempton has been arguing for the Australo-Canadian model of an oligarchic, heavily regulated, generously profitable banking system.

James Kwak offers a very nice discussion of the “too big to fail” problem in light of the absence of structural rather than supervisory approaches in Treasury Secretary Geithner’s recent regulatory proposals. (And Drum responds.)

I think size does matter very much, but not because small banks are inherently small enough to fail. Drum is right about that: Like a dwarf with a suitcase nuke, a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.

But in practice, a properly defined smallness could add a lot of safety to the banking system:

1. Very directly, limiting size defined by total asset base plus an expansive notional value of all derivative and off-balance sheet exposures limits both interconnectedness and leverage. (Defining size limits by capitalization would suffer from the same drawback as traditional leverage constraints — they encourage bankers to scheme secret ways of levering up.)

2. When a bank appears to be small enough to fail, creditor discipline will backstop regulatory supervision. If a bank is perceived as too big to fail, if its failure in “unthinkable”, then clients and counterparties will be lax in managing or limiting their exposures, leaving always circumventable regulation as the only bulwark against becoming too levered and interconnected to fail. (Insured depositors, of course, won’t provide discipline, and shouldn’t be expected to. But bondholders and derivative counterparties will, if a bank’s credit is potentially dodgy.)

3. Smaller banks, even very levered and interconnected ones, can be unwound, merged, or put into receivership. We’ve managed the failures of even large-ish banks like Drexel, Bear, Wachovia, WaMu, or IndyMac, and we could have managed Lehman in a costly but orderly unwind. But once banks have gone truly mega, we’re not sure we can manage it. A bank that is too big too merge without overconsolidating the industry presents special problems. From a taxpayer perspective, we are generally able to unwind smaller banks without guaranteeing non-insured creditors, while we find haircutting the creditors of larger banks impossible, because these unsecured creditors regard failure as unthinkable and fail to adequately provision for the risk.

4. Political economy considerations mitigate against large banks (arguably more deeply in the United States than in Australia and Canada). Particularly if financial firms are segregated by scope (e.g. investment banking distinct from commercial banking distinct from brokerage distinct from insurance), groups of small firms with distinct industry agendas are likely to be less corrupting than huge, critical institutions with a unified management that acts strategically in political circles.

5. Scale breeds agency problems. Earning an extra five basis points on $100B in assets amounts to $50M in extra income a year, a fraction of which can make a manager very wealthy in an eat-what-you-kill bank. Making that same five basis points on a $100M portfolio earns a small bank 50K, a fraction of which amounts to a nice bonus, but not a lifestyle change. For both managers, the downside if something goes wrong is the same: they lose their jobs. The ability to leverage a large balance sheet tempts managers at larger banks to take risks that managers at smaller banks would not find at all worthwhile. (Drum points out that managers of small hedge funds earn huge sums too, but that’s really apples to oranges. Hedge fund investors, like stock investors, are generally aware of and prepared to manage investment risk, while bank creditors expect that their money is safe. Hedge funds mostly present systemic problems when their use of leverage puts bank creditors at risk. That can and should be regulated, from the bank side and perhaps by eliminating the right of hedge funds to limited liability forms of organization.)

There are very few obvious reasons why large banks are useful at all, other than supervisory convenience if you think Hempton’s regulated oligarchy is the right model. It may be annoying to have to pay other-bank ATM fees, but besides that, there are very few services or efficiencies a large bank can offer that a small bank cannot. Large banks can provide large loans more easily, which is convenient for corporate clients. But that may be a bad thing. Lending decisions can be mistakes. It’s one thing if a lending committee misdirects $300K to a bad mortgage. It is much more costly if that same flawed body channels $3B to a crappy LBO. Raising large quantities of capital should require the separate assent of multiple independent parties. Misdirection of the resources represented by billions of dollars creates social as well as private costs.

My sense is that a lot of people think large banks are here to stay for precisely the reason they should be made extinct. Large banks feel modern, important, powerful. It seems nice, somehow, when you travel across oceans and find a branch of your own bank. It’s like you are part of a winning team. There’s that ubiquitous brand, and it’s your brand. But “brand equity” is an important means by which banks build a mystique that makes their failure unthinkable, and charms bondholders and other uninsured counterparties into offering leverage on much too easy terms. Ironically, if banks felt a bit shabby and penny-ante, and if managed failures were regular events, the banking system as a whole would be much safer.

Size isn’t everything: Bankers are famous lemmings, and a whole lot of small banks who pile into the same poor investment can fail together like one really big bank. But a thousand little banks are at least a bit less likely to make correlated mistakes than megabanks, which can turn a bad investment idea into a firm-wide mission. One goal of bank regulation, besides restricting size and leverage, should be to encourage independent lending decisions and supervising the diversity of the aggregate banking system’s portfolio. Regulators should “lean against the wind” of booms that homogenize banks’ asset base by restricting growth of overrepresented asset classes. If there is a good economic reason for a boom, nonbank equity investors can take advantage of the opportunity.

Note: Ideally I prefer a complete separation of the depository and payments function of banks from the lending and investment function. That is I’d prefer we create “narrow banks” that invest only in government securities, and define a new kind of explicitly at-risk investment fund to serve the traditional purposes of bank lending. But this piece is written under the pessimistic assumption that we’ll leave the familiar structure of banking intact.

Is that it, then? You know, the “Public Private Investor Partnership” that the Treasury Secretary introduced on Monday. Are we doing that?

The plan involves the Treasury, FDIC, and Federal Reserve putting hundreds of billions, perhaps more than a trillion dollars, at risk. That should require some sort of Congressional approval, right?

I remember the whole TARP debate last fall. I thought that was a terrible plan. I faxed my senators and representative several times, and urged them not to pass it. I was gratified, and for a brief moment optimistic, when the bill was initially rejected in the House. I felt like it was a miscarriage of democracy that Congressional leaders staged a do-over on that vote, reintroducing substantially the same plan and passing it just a few days later. That battle was lost, but this is a democracy and I am an engaged citizen. There would be other battles, I thought.

In my view, the Geithner’s PPIP includes two mechanisms intended to ensure that “private investors” offer substantially inflated bids for “legacy” assets, and the net cost of the plan will be comparable to that of TARP. I might be wrong about that, but I might be right. Much of the risk will be due to loan guarantees offered by the FDIC. Is there any legal basis for using the FDIC this way? Aren’t the laws describing how the FDIC is and is not supposed to behave?

And isn’t Congress supposed to have the power of the purse? A loan guarantee is a contingent liability, a cost in real terms. Can the US Treasury spend money without Congressional approval, as long as it promises to spend only if a coin flip comes up heads? That’s exactly what the Geithner plan (along with the scandalous but already active “Temporary Liquidity Guarantee Program” program) does. Is that even Constitutional?

FDIC is a full-faith-and-credit agency of the Federal government. There’s been a lot of commentary trying to explain the recently high CDS spreads on US sovereign debt. After all, wouldn’t the government just print money to pay its debt rather tha default? Well, here’s a scenario: Suppose the FDIC’s loan guarantees come badly acropper, putting taxpayers on the hook for hundreds of billions of dollars. Suppose FDIC is short the cash, and has to come to Congress for an allocation. Given that neither Congress nor the public ever signed on to all these guarantees of bank assets, and that in fact FDIC is behaving in a manner precisely contrary to the laws under which it is chartered, the level of anger might be high enough that the public might just say no. Welcome to the world of full-faith-and-credit default.

Maybe that’s why Chris Dodd wants Congress to give the FDIC a $500B loan commitment. Maybe it explains the apparently limitless appropriation of “such sums as are necessary” to the FDIC that Justin Fox noticed in a proposed bill that would actually authorize these sorts of liability guarantees. (The bill would also authorize FDIC receiverships of systemically important non-banks — yay! But it leaves out the “least cost resolution” stuff from the traditional FDICIA, and would give the Treasury Secretary and the FDIC complete discretion over whether firms are to be taken over or just bailed out in any of a number of ways.)

It seems to me that committing hundreds of billions of taxpayer dollars should still be considered a serious business. It seems to me that if Congress wouldn’t approve the Geithner plan, in a democracy, that ought to have some meaning, and not just get written off as populist outrage and then extralegally ignored.

So I’ll ask again, who passed the Geithner plan? What deliberative assembly gave the plan a pass? What’s that you say? The stock market went up by nearly 500 points when it was announced on Monday? Oh. I guess the buys have it, then.

James Surowiecki has been pushing the idea (first mooted by John Hempton) that since bank financing always involves non-recourse by taxpayer (via government deposit insurance), it’s no big deal that the Geithner Plan is built around generous non-recourse lending. Surowiecki:

There is one detail of the plan, though, that people are particularly bothered by, and that is the fact that the plan involves the FDIC guaranteeing loans to private investors. (The way the plan to buy pools of mortgages is set up, investors will be able to borrow six dollars for every one dollar they invest. If their bets go bad, they lose only the one dollar they invested—the FDIC is responsible for paying back all the borrowed money.) Paul Krugman, for instance, calls this the “central issue,” and argues that because the non-recourse loans are a massive subsidy to investors—which they are—the plan will distort the prices that investors are willing to pay for these assets, and therefore “has nothing to do with letting markets work.” Ezra Klein, similarly, argues that because the plan relies on these “non-recourse” loans, the prices it will produce will be in some way “artificial.” Their point is that the Geithner plan, among other things, is supposed to produce real market prices for these toxic assets, which will then give us a better picture of banks’ balance sheets and allow us to avoid valuing these assets at prices that the government thinks have become unduly low because investors are so risk-averse. But by creating a plan in which investors have only a small downside and a big upside, we’re supposedly creating fake prices.

There’s no doubt that the non-recourse loans constitute a big subsidy: while investors’ downside risk isn’t eliminated, since they can still lose all the money they invest, that risk is significantly limited, while their potential upside is significantly increased (since they’re leveraging every dollar they invest six-to-one). Yet for all the criticism of this subsidy, the truth is that the plan’s reliance on non-recourse loans is not an especially radical idea. In fact, it’s essentially the same kind of subsidy that the entire U.S. banking system has depended on for the last seventy-five years. What are FDIC-insured bank deposits, after all? They’re non-recourse loans to banks. You deposit money with a bank—that is, you lend it your money. The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it’s invested. All the rest of the bank’s losses are paid for by the FDIC. This is precisely the same arrangement — down to the loans being guaranteed by the FDIC—that the Geithner plan sets up. In effect, it just extends to outside investors, for the purpose of acquiring toxic assets, the same subsidy that banks have been receiving since 1933.

Surowiecki is right in a superficial way, but he misses crucial details. His analogy breaks down in ways that I think are informative.

Non-recourse financing involves bundling a valuable put option along with a loan. The value of that option hinges on the details of the arrangement: An “at-the-money” option is more valuable than an “out-of-the-money” option. The “moneyness” of the implicit put option in a non-recourse arrangement is determined by the degree of leverage the borrower is allowed. The Geithner plan permits a maximum leverage of 7:1 assets to equity. As Surowiecki points out, that degree of leverage is less than the leverage of a traditional bank.

But notional “moneyness” is not the only thing that determines the value of an option. In particular, options are most valuable when the assets that underlie them are very volatile. In order to limit the degree to which banks maximize the value of the deposit insurance option at the taxpayers’ expense, banks are supposed to submit to onerous, intrusive regulation that limits the riskiness, the volatility of the assets they can purchase.

Under the Geithner plan, the government will extend its non-recourse option to investors without preventing them from “swinging for the fences” on risk in order to extract value from the option. On the contrary, the government is insisting its loans be used to purchase assets that have already proved themselves unsuitable for purchase by a regulated entity, by virtue of being volatile and difficult to price. It’s as if an insurance company that ordinarily refuses to cover homes in hurricane states suddenly offered policies only to purchasers looking to build homes on Gulf-coast barrier islands.

Sometimes an option is costly to exercise. Exercise costs reduce the value of an option to its owner along with the expected liability of the option writer. The traditional deposit insurance option was very costly for banks to exercise. Banks were only allowed to exercise the option by being put out of business. That sharply limited the value of the FDIC option to bank employees and shareholders. Usually the “franchise value” of a bank is greater than its regulatory capital. In order to extract value from the option, bank stakeholders must take bets whose (probability-weighted) payoff in a good outcome exceeds not only the loss of regulatory capital, but also the value of the business as an ongoing concern. Moreover, if we are valuing the “traditional” FDIC option, we should go back just a few decades to when most banks were privately held and run by lifers. A typical bank’s owners and employees had an illiquid, undiversified exposure to the well-being of their institution. Calculating franchise value from the price/book of Citi pre-crisis would dramatically underestimate the value of a traditional bank to its controlling stakeholders. Exercise of the FDIC option used to be costly indeed for the owners and managers of banks. There were, if you’ll excuse the terms, “synergies” between regulation and a high cost of exercise: If triggering a deposit insurance payout is very painful, strategies designed to monetize the option need a fly-to-the-moon upside to be worth the risk. But spaceports are more likely to be flagged by regulators than an extra 100 bps on a “AAA” CPDO.

Unlike deposit insurance, the non-recourse option offered to investors in the Geithner plan is completely costless to exercise, once it is in the money. Surrender of the collateral constitutes fulfillment of the lending contract full stop. Pace Megan McArdle, it is not like the non-recourse option implicit in the typical home mortgage, where exercising the option involves a hit to ones credit. There is no default of any sort involved in surrendering the assets rather than repaying the loans. The right to do so will be written into the deals.

Finally, the FDIC option didn’t used to be free. Banks paid a fee in exchange for the deposit insurance. Under the Geithner plan, borrowers will be charged a fee as well, but then they’ll be borrowing at rates dramatically lower than they could on their own. This works with Surowiecki’s story — banks borrow very cheaply from depositors because of the FDIC guarantee. But, as always, the question is price: Given the volatility and uncertainty surrounding the underlying assets and the near-zero cost of exercise, will the FDIC charge a fee high enough to cover the expected liability of the option? I’ll leave that for readers to decide.

Surowiecki’s analogy does work pretty well if we compare the Geithner plan not to traditional banking thirty years ago, but to recent practices of the industry. Thanks to hands-off government and structured-finance shell games, banks were recently able to amass high risk, high yield investment portfolios despite being ostensibly regulated institutions. Institutional changes, including changing norms about the length and terms of bank employment and dominance of the industry by large, heavily-traded limited-liability corporations, decreased the expected cost of exercise to bank employees and informed shareholders, making volatility maximizing strategies more attractive. The option premium, the FDIC fee, was severely underpriced (it was reduced to zero from 1996 to 2006).

If Surowiecki wants to argue that the non-recourse option embedded in the Geithner plan would basically reproduce the subsidy to the banking system offered circa 2006, I’ll readily agree. But it is not reasonable to argue that non-recourse loans offered on generous terms to unregulated investors for the express purpose of purchasing unusually volatile assets represent the “same subsidy that banks have been receiving since 1933.”

The Compulsive Theorist has written a truly excellent post on bank bailouts (ht Mark Thoma). I’ll excerpt a bit below, but do read the whole thing:

I sympathize with the point of view which says that the political window of opportunity is narrow and the need for action urgent, so let’s accept the bailout plan for now, and deal with… wider issues later on. But the very fact that political momentum is limited means that if these wider changes are to be brought about, the process has to begin in earnest at once. Does anyone seriously believe that in a years time, if following massive government support the banks are stable — or can be made to appear stable — there will be any political will to break up very large institutions, or any real change to underlying norms in the financial sector?

However, absent these deeper changes, it is entirely possible that we will see a replay of the crisis — but on a larger scale — in a few years time. Naturally, one cannot say with certainty that such a cataclysm (and if it were much larger than the current crisis, it really would be a cataclysm) will occur. But if it does, the resulting costs will be huge. Martin Wolf has written persuasively about the costs of major economic dislocation. Net of unemployment, political instability and even wars, the human costs of a sequel could dwarf even the current crisis. Then, the choice in the present between the “bailout” and “restructuring” plans hinges on whether expected cost (in the broadest sense), conditioned on the “bailout” strategy is higher than expected cost conditioned on “restructuring”. One could formalize this argument as a decision problem, but it comes down to a judgement call on the relative probability of such a cataclysm under the two strategies and the magnitude of the dislocation. My feeling, admittedly subjective, is that the gloomy cataclysm scenario is substantially more likely under the “bailout” than “restructuring”, and that the costs would be immense.

This case can be put very simply: if we do not use current political momentum to fundamentally reform a system which has shown itself to be unstable and even dangerous, a second opportunity may come at a very high price. And this is not a gamble I wish to see our leaders make.

I often wish I were Mark Thoma. If I were Mark Thoma, I could be smart and paying attention without being bitter.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Unfortunately, I have a darker temperament, a spirit less generous and optimistic than Mark’s. I am filled with despair, not because what we are doing cannot “work”, but because it is too unjust. This is not my country.

The news of today is the Geithner plan. I think this plan might work very well in terms of repairing bank balance sheets.

Of course the whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by legacy bankers.

I think that critics of the Geithner plan are missing some of its tactical brilliance. My guess is that behind the scenes, Geithner has arranged a kind of J.P. Morgan moment. You know the story. During the Panic of 1907, J.P. Morgan locked a bunch of bankers in a room and insisted they lend to stave a panic. We’ve already seen one twisted parody of this event, when Henry Paulson locked a bunch of bankers in a room and insisted they borrow money from the Treasury. This second one is more clever. I don’t think the scandal of the Geithner plan is going to turn out to be the subsidy to well-connected investors embedded in the non-recourse loan put option. On the contrary, I think that Treasury has already lined up participants for the “Legacy Loans Public-Private Investment Fund” and persuaded them to offer prices so high that despite the put, investors will expect to take a major loss. My little conspiracy theory is that the Blackrocks and PIMCOs of the world, the asset managers who do well by “shaking hands with the government“, will agree to take a hit on relatively small investments in order first to help make banks smell solvent, and then to compel and provide “good optics” for a maximal transfer from government to key financial institutions.

Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner’s plan, PIMROCK’s $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK’s $10B is wiped out entirely, as is the Treasury’s investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss. But, as Calculated Risk, likes to say “Hoocoodanode?” These were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they’ve received assurances that if we can get the nation out of the financial pickle it’s in, there will be no haircuts on those bonds. “Shaking hands with the government” means that nothing ever has to be put in writing.

Welcome to America, 2009. Change we can believe in.

The scenario I’ve presented is a variation on this by Karl Denninger (ht Tyler Cowen).

I liked this post today by Matt Yglesias:

My biggest concern about the PPIP approach to the banking system is that even if it works, what it does essentially is return us to the pre-crisis status quo — banks that are so large that they’re too politically powerful to regulate effective and too systemically important to be allowed to fail. That’s a recipe for dishonest transactions that produce short-term profits at the cost of blowups. One appealing element of nationalization is that it can easily be made to end in a world in which there is no institution named “Bank of America” or “Citi” and no such gigantic institution.

On the bright side, I’m thankful that we have people like Paul Krugman, Simon Johnson, and Willem Buiter, who fight the good fight while being too eminent to ignore.

On the dark side, try here, here, and here.

The most troubling thing about trying to tax back jackpots paid by firms that are now on public assistance is that an effective measure would have to apply retrospectively. That is, the people who are responsible for the terrible decisions made at systemically important financial institutions have already been handsomely paid for their mistakes. Nearly all of them were paid well before December 31, 2008. A measure that only interferes with current and future pay would simply teach the next generation of “rational agents” that if they cash out fast and early, nothing can be done to them. That was precisely what the current crop of malefactors expected. The whole point of a tax clawback would be to violate that expectation, and to eliminate it going forward.

The House has passed a very poor tax clawback bill (ht Conor Clarke). It is almost prospective — the law would apply only to payments made from January 1, 2009 forward. But almost prospective is like half pregnant. The bill is retrospective for just long enough to clawback the politically fetishized AIG bonuses, while leaving those who made out during the thick of the toxic credit bubble completely untouched. It has all of the philosophical distastefulness of an ex post law, and no offsetting benefit whatsoever, other than punishing a few trophy miscreants from AIG. I would support a well-designed tax clawback, but this ain’t it. Hopefully the Senate comes up with something better.

I think a good tax clawback

• would apply to employees of all firms that have received public capital and that are unable to repay that capital prior to some reasonable deadline several months in the future (so that healthy banks persuaded by Paulson to accept money can be excluded).

• would tax compensation paid (or accrued) to individuals during the period of the credit bubble, maybe from January 1, 2004 to December 31, 2008.

• would apply to all forms of compensation (not just bonuses), but only above some fairly high floor. (In a previous post I suggested $200K, but I think that’s too low. $500K or $1M would be better.)

• would apply at a high rate, but one that is arguably not confiscatory or punitive. 50%, maybe 60%, would be reasonable. 90%? No.

• would be justified in terms of cost-sharing between taxpayers and highly compensated employees when weakness of a systemically important firm occasions public financial assistance.

Future compensation at firms already on life support oughtn’t be regulated via so roundabout an instrument as a tax clawback. Henry Blodget has an excellent post on how dumb the House measure is looking forward. If we want to control pay levels at zombie firms, the government should put them into receivership and manage them properly. Setting compensation policy via the IRS no way to run even a very bad bank.

Update: Oh, one other thing that Congress really needs to do already is to restrict the ability of systemically important firms, somehow defined, to file for bankruptcy without first providing an opportunity for the government to intervene. Obviously, a broader regime for resolving sick uberbanks (as called for by Ben Bernanke) would be ideal, but at the very least, firms ought not have the power to play chicken with the government by threatening a disorderly collapse. This is not a new problem, but it’s relevant here because if a serious tax clawback were to be passed, a ruthless CEO wishing to avoid the tax could return the TARP money and take a troubled firm into bankruptcy, provoking a large-scale panic.

Monday night, when I wrote about tax clawbacks, I was afraid that the idea would be written off too quickly based on an oversimplistic view of the law. Two days later, it’s like a movement. At least six members of Congress are on record as trying to craft some sort of tax clawback, Conor Clarke has Larry Tribe opining that a well-crafted clawback would be Constitutional, and widely read bloggers like Kevin Drum and Felix Salmon have considered the idea supportively. Tonight Bloomberg reports that

The senior members of the Senate Finance Committee from both parties proposed taxes totaling 70 percent on bonuses at AIG and other companies getting federal money during the U.S. financial meltdown. House Speaker Nancy Pelosi directed committees there to draft several alternatives and said her chamber may consider a bill as early as this week.

If we’re going to do this, and it looks like we might, we had better get it right. Regardless of the legal technicalities, a tax clawback does represent a kind of escalation. It sits awkwardly with norms and ideals that are less a matter of law than we think but that are nevertheless an important part of American political culture. In our better moments, we dislike “collective punishment” and try not to change the rules of the game out from under people midstream. On balance, I think the benefits of a well designed tax clawback could exceed its costs. But a poorly designed clawback would set a corrosive precedent for no other purpose than to salve and misdirect public rage.

The main benefit of a tax clawback would not be to punish bankers for the looting they have already done, but to set a precedent. Many commentators (e.g. Surowiecki) have pointed out that during the credit bubble, market discipline failed not so much because shareholders expected to be bailed out, but because the employees who run financial firms could cash out short-term gains regardless of long-term costs to shareholders and taxpayers. The precedent of a tax clawback would put future employees of systemically important financial institutions in jeopardy. They would know that if their mistakes provoke a taxpayer bailout, their personal wealth would be on the line. Eliminating their sense of inviolability, making it impossible for bankers to simply walk away from the losses they impose on investors and taxpayers, would, I think, result in structural changes to financial institutions. Risk-takers would congregate in definitely-small-enough-to-fail boutiques and hedge funds. Managers of systemically important banks would lobby for regulation to prevent competition from forcing them into risky practices that might provoke a clawback of their personal net worth when things go bad.

The dumbest possible tax clawback would be a punitive one-off designed to recoup the AIG bonuses. The brazenness of those bonuses has galvanized public anger, and served usefully as a tipping point, but in the scheme of things recovering less than half a billion dollars of a multitrillion dollar bailout will not matter very much. In order to set a useful precedent, a tax clawback needs to be broadly and rationally targeted. That is, employees of any and all institutions whose weakness necessitates a public bailout must be subject to the clawback. The Paulson Treasury, as a matter of insidious policy, made it difficult to distinguish between failing and healthy banks by forcing solvent banks to suck up TARP money along with the zombies. A good clawback proposal would encourage healthy banks to return any public assistance they’ve received over a period of several months, and then claw back funds only from employees of banks that are unable to return the funds without violating capital or liquidity requirements. (The law would have to address wrinkles like how to let banks “return” noncash assistance such as asset guarantees.)

A good tax clawback would not have to be very punitive. While getting back the money is an important purpose of a clawback, establishing the principle that the people who run financial institutions will be made responsible for cleaning up their own messes is far more important. Levying a 100% tax on bonuses might be satisfying, but so draconian a law would only pass if it were uselessly addressed to a single scapegoat rather than applied to financial institutions broadly. I’d recommend a 50% tax on compensation above maybe $200,000 in any year during the four years prior to the public assistance. Since this tax would represent an unexpected expense to the people it would affect, I’d allow the liability to be spread out over a period of several years. In general, the law should be structured and justified as a means of having the parties responsible for a financial disaster bear part of the cost of the cleanup, not as punishment.

One might worry that if the tax is too mild, future bankers might not be discouraged from taking foolish risks at critical institutions. If a big bet can get you a $10M bonus this year, but you’d have to return $5M if things go wrong next year, it might still be worth taking the bet. I think there’s less to this than meets the eye. Once a firm precedent is established that previous years’ compensation is fair game to pay for a taxpayer bail out, bankers would have to keep in mind that tax rates can always change, and that legislators might be less reticent next time around, when the use of clawbacks would not be novel and controversial. The law might even establish a higher tax rate for future failures.

In order for an ex post tax to be Constitutional, it should apply broadly and have some legitimate purpose besides just punishing someone. Kevin Drum gets a bit sardonic about this:

So it looks like the answer here is simple: even though the purpose of this tax would pretty clearly be punitive with extreme prejudice, we need to carefully pretend that it’s not. And we need to make sure the legislative history shows that it’s not (it should be “manifestly regulatory and fiscal” Tribe says). Then everything is kosher! We can tax their socks off!

While a lot of us might want to be “punitive with extreme prejudice”, this is too cynical a view. The requirements of the Constitution seem perfectly consistent with imposing a clawback that permanently alters the incentives of the people who run systemically important banks. A good law would be both retrospective and prospective. It would help defray the costs of the current crisis while firmly establishing the principle that the individuals who run critical financial institutions can be decompensated if they let those institutions melt down on their watch. The analogy to Superfund is quite close, I think. If we do this, we oughtn’t conceptualize what we’re doing as finding a loophole we can use to shaft the f@kers. We should craft a good law that lets us to recoup some of the cost of cleaning up existing messes, and that defines a framework for sharing the cost any future messes with the people most responsible for them.

Rep. Carolyn Maloney is circulating a bill that would try to claw back bonuses taken by employees of firms that had to be bought by Uncle Sam. I’d quibble with the terms of her proposal, and, although I’ve suggested something like it myself, I’m not sure this is a road we want to start down.

I am sure, though, that this idea — levying a special tax on people who were paid very large sums of money in recent years by firms that have been expensively rescued by the Treasury — deserves to be a part of the mainstream debate. Let it be thoroughly vetted, then enacted or rejected after careful consideration.

Conor Clarke suggests that such a bill would be unconstitutional on its face. I think he’s wrong about that. He cites the following line from the US Constitution:

No Bill of Attainder or ex post facto Law shall be passed.

I am not a lawyer, but I don’t think this prohibition would much apply, as long as the tax is civil and remedial in nature, rather than criminal and punitive. Consider the so-called “Superfund” law, which made polluters liable for cleaning up environmental messes, even though that liability may not have been written into law at the time when the polluting was done. The current banking crisis strikes me as quite analogous to the Superfund situation: A large class of private actors have caused harms that must be remedied. While the state has no choice but to pick up some of the tab, it also identifies the responsible party and holds them partially liable for the mess they have made. We even use the same words: It’s all about “toxic waste”.

Thanks to Google books, I can quote Daniel E. Troy, of all people, the former chief counsel of George W. Bush’s FDA. (There’s something fitting and ironic about that. Look him up.) In Troy’s book Retroactive Legislation (1998), he writes

Carefully assessed, the argument that CERCLA [Superfund] is unconstitutional is in tension, at least, with the Supreme Court’s current interpretation of the ex post facto and bill of attainder clauses. It may also be at odds with the original understanding of those clauses.

A Bill of Attainder? The contention that CERCLA violates the bill of attainder clause may be dispensed with easily. Under the Supreme Court’s current case law, the class “responsible parties” is almost certainly not sufficiently small to warrant treatment as a bill of attainder. The Court, which has not struck down a law under the bill of attainder clause in thirty years, is not likely to consider CERCLA a “legislative punsihment . . . of specifically designated persons or groups.” Moreover, as we have seen, the bill of attainder clause was originally understood to prohibit laws that affected life and liberty only.

An Ex Post Facto Law? Because the ex post facto clauses do not apply to civil laws, Superfund therefore would have to be characterized as punitive in nature to be classified as an ex post facto law. The current Court, though, has suggested that unless a law is exclusively punitive, it will not come within the scope of the ex post facto clauses. Although CERCLA certainly has a punitive element, it is hard to contend, under the relevant Supreme Court test, that it “may not be fairly characterized as remedial, but only as a deterrent or retribution.” [emphasis original]

Speaking personally, I might prefer that Clarke’s naive interpretation of the Constitution were binding. Again, I don’t like the taxback approach, it puts us on a slippery slope to a lot of things I’d find disagreeable. But then I also dislike it when idealistic protections apply to the wealthy and well-connected while ordinary people have their vehicles forfeited ‘cuz the cop said he smelled pot. And the scale of the injustice to be remedied here viz the financial system is immense. I think we should carefully consider all our options, and hire very good lawyers. We certainly oughtn’t take the CEO of AIG’s word for it that nothing can be done.

I would point out that effectively ex post changes to civil law are quite common. Greg Mankiw is teasing Larry Summers today for supporting ex post changes in contracts with respect to so-called mortgage cramdowns. But the 2005 bankruptcy law also amounted to an ex post change in the terms of nearly all debt contracts, as did the original prohibition of cramdowns on a principal residence, which had fallen within the ordinary powers of a bankruptcy judge until the late 1970s.

The law may be the law, but it is also a battlefield upon which people play to win and hypocrisy is everywhere. I’d like to be idealistic, but if that means a kind of “unilateral disarmament” under which the least idealistic run roughshod, we’d better try a different strategy.

Update: Marc Ambinder (ht Clusterstock) reports on a tax clawback proposal by Rep. Gary Peters.

A suggestion for Congress: Tax clawback proposals should be written to apply to a rational and preferably large class of people — singling out AIG bonus recipients won’t fly. I’d suggest setting specific support criteria for firms (e.g. firms to which at least $2B of Treasury funds were provided or $10B of assets guaranteed, with support not returned or relinquished prior to September 20, 2009), income floors for individuals (e.g. applies only to income over $1M in any year between 2004 and 2009), a high but not outrageous tax rate (maybe 50% of earnings above $1M, not 100%), and a generous repayment schedule (payment of taxes under the act due can be spread over a five-year period). All in all, a proposal should be a reasonable means of identifying agents who benefited extensively from activities that induced a government bailout and asking them to contribute alongside taxpayers to a remediation effort.

Update 2: The excellent and widely read Kevin Drum writes about an ex post tax on bonuses, and seems broadly supportive. This idea may yet get a mainstream, public vetting. Drum quotes a Washington Post story

In the House, Reps. Steve Israel (N.Y.) and Tim Ryan (Ohio) introduced the “Bailout Bonus Tax Bracket Act” to create a 100 percent tax on bonuses over $100,000 that are distributed to employees of financial firms receiving federal bailout funds.

This is the most sensible variant so far pursued, but I think going for 100% is too aggressive if the good Representatives are not just grandstanding. Senators Harry Reid and Max Baucus would tax 98% of AIG bonuses only, which I think is not a good idea. (It’s narrow and punitive, so it might not pass constitutional muster, and it scapegoats AIG employees only rather than getting the gatekeepers of systemically important financial institutions broadly, the group that should really be held responsible.)

Update 3: Conor Clarke responds, and gets an opinion from Harvard law prof Laurence Tribe to boot. I think it’s safe to say that this idea is under consideration in mainstream policy circles. Megan McArdle expresses some concerns. Felix Salmon turns populist.