Anmol On Bailouts

Anmol On Bailouts

The Great recession which hit the US in 2007, and later spread to the rest of the world had a severe impact on the modern world. The business cycle is cruel to all those it affects, at least, when there’s a downturn. The reason for this, as usual, amongst many was due to weird financial instruments on wall street, horrible foresight, and the easy accessibility to credit. What intrigued me the most about this crisis, or at least the reaction to it, was the bailout of the banking sector. Americans realized, after the collapse of Lehman, that a collapse of one bank threatened the entire sector, and hence all large banks were now “too big to fail”. If you look at the risks that these large banks were taking, and look at the consequences of their downfall, you soon realize that the probability of a financial meltdown is much more than we think it is.

The banking crisis started in March 2008, when the New York federal reserve bailed out Bear Sterns so that it could be sold to JP Morgan Chase, to the outrage of many tax-payers. This outrage made the government reluctant to bailout the investment bank Lehman brothers when it was close to bankruptcy, and it’s collapse led to the instability of Wall Street. This of course led to TARP, the $700 Bn bailout fund for banks which was expected to cost US taxpayers $300 Bn, but ended up costing them only 19 Bn, because most of the banks who took TARP funds have already paid them back/ are on track to pay them back. $19 Bn is a very small price to pay to save the banking sector of a country as large as the US, but people still continued to oppose the bailout. This article is not going to be a summary of the great-recession, but a theoretical discussion about whether or not bailouts should be given to these institutions, and whether or not there is a way to improve the current system of bailouts.

Let’s take a brief look at the problem. In the recent Republican debate, it was brought up a few times that the biggest 6 banks in the US, accounted for 2/3rds the nations GDP. If these banks were to somehow fail simultaneously, then the US would face a crisis 3 times worse than the great depression, and the knock-on effects (small banks failing due to failure of the big banks), could make it even more significant. Now, there is no guarantee that this will happen, but if it were to happen, I can’t emphasize enough how large the crisis would be. Imagine 2012. It would be worse.

The main counter argument against bailouts, as I have learnt is that bailouts are moral hazard. If companies know that they’re going to get a bailout whenever they fail, then they need not fear failure, and can take a series of unnecessary risks. If the risks succeed, they all become billionaire’s, if they fail, then they get bailed out by the federal government. Very convenient indeed. However, we really don’t want all our large financial institutions taking unnecessary risks with our life savings, while their executives get 10’s of millions of dollars in bonuses. At the end of the day, wall street rewards risk takers. The way wall street works is that employees get a small basic salary, just enough to cover costs of living, and large bonuses based on performance. Let’s say that an employee loses a large amount of money, say $100 Mn. They still can’t take away his basic salary, so he gets paid his basic salary. Now, let’s say the employee gains $100 Mn, he’ll get a large bonus, probably in the millions of dollars. Now, if he does nothing, he’ll get a bonus, but a small one, perhaps $50,000-$100,000 at most. Looking at this from an individual point of view, why wouldn’t he take the millions or bust, and forgo the $50,000? Even if there’s only a 10% chance of him making the millions, it’s a good risk for him , but a 10% chance of gaining $100 mn, and a 90% chance of losing $100 Mn is definitely bad for your life savings. I understand that the reason why bonuses are so large relative to basic salary is to reward performance, but the problem is that there are no disincentives for making large mistakes. Even if the employee gets fired, he can easily find a job which pays close to his basic salary on Wall Street, which is what he would get despite an incorrect decision. There is effectively no downside to being wrong.

There are other hazards with the bailout package, such as the fact that the TARP loans were given out at very low interest rates, close to 0%, which was significantly lower than the free-market interest rate. As Ron Paul said “They’re borrowing money from us at 0%, and lending it back to us at 3%!” Yes, Ron Paul included the exclamation mark. This is a fairly simplistic understanding of the crisis, even though he does have a point.Companies would never take large loans, just to exploit the low interest rates, because of the various federal government restrictions placed on them if they accept TARP funds, such as a cap on executive pay at $500,000/year. To put that into perspective, a few years ago George Soros’ hedge fund paid him $2,400,000,000. No executive would willingly take a pay cut of possibly 100s of millions of dollars, just to get low yields on bonds from the federal government. However, as I said earlier, his point is still valid, if the banks were indeed as successful as they were touted to be, the government could’ve charged the market interest rate, or at least what the bank pays to its depositors.

There are other moral problems associated with Wall Street. Despite coming cap in hand to the government, begging for bailouts whenever there’s a recession, these firms strongly advocate, and lobby for de-regulation, i.e. removal of government from their markets in the boom years. As the famous saying goes, “People are capitalist during the booms, and socialist during the busts”. I can see why they act in this way, it seems to help them immensely, but this makes average citizens see corporations as evil-corporations, understandably. These firms almost seem two-faced in their agenda. So, basically the three moral problems are moral hazard, low interest rates, and the two-faced nature of large corporations. The problem with letting them fail, is financial apocalypse. Isn’t there a middle ground? The next part of this article will be about possible solutions.

Firstly, let’s assume that we let all the banks fail, just to teach the risk-taking Wall Street fat cats a lesson, and we somehow miraculously recover from the economic downturn. They have been shown by government that their risk taking will not be rewarded, and according to rational logic, the banks should then become more stable. Unfortunately, this isn’t the case. History has shown that people in positions of power, have poor knowledge of history, and occasionally come up with ridiculous assumptions. One of these situations was the options debacle, when a couple of Mathematicians came up with a perfect formula on the pricing of options, and estimated their risk of going bust at 1 in 10^24. Of course, they went bust, as was inevitable. They didn’t account for large stock market crashes, such as the one in 1987 while making their model, and one such crash made their company fail.It’s fairly ironic that both of them are Nobel laureates, but such is the field of Economics. We can only assume, that banks will act in the same way, even if we punish them once. Also, it’ll take a very long time for a country to recover from a loss of its banking system, and possibly 80%+ of its GDP.

There’s a popular theory going around nowadays which says “too big to fail, is too big”. I can’t say that I disagree with that view, but there’s a reason why big institutions exist, and why they’re efficient. Let’s say there’s a small institution, worth $1 Mn. They bet $1 Mn on a 60-40 chance, and 40% of the time they go broke, thus ruining all their investors. Now, let’s look at a large institution worth $50 Bn. Let’s say they make 500 bets of $100 Mn on a 55-45 chance. It’s highly likely that they end up ahead, because their risk is spread out, thus reducing it significantly. Although big institutions do take risks, their risks aren’t limited to one field, so one crash won’t necessarily bring them down. That’s why it is a big deal when a big institution fails, because it signals that the entire market crashed, and not just one segment. Unfortunately, the entire market crashing is not independent of one segment crashing, so there still is a lot more risk than we would like.

I feel that the people responsible for taking risks are executives, and the losers are the customers. If there’s a solution which punished executives, while protecting consumers, I feel that’s optimal. I think the banks should be bailed out, and that executives should be penalized in some way. The way to penalize them can be worked out later, but it satisfies the need for punishment of those responsible, while protecting the average citizen. Perhaps, government can limit leverage on banks which asked for TARP funds, for a fixed period of time, say, 10 years, thus making them less volatile, and less prone to swings.

There were three main reasons why the recession became as serious as it did:

1) The interconnectedness of the entire financial system. People used to give away subprime mortgages, then sell them to the a bank, which would then sell them to a larger bank. The larger bank would bundle up the mortgages, and make AIG insure them, as “securities”, which AIG would then sell to another bank, which would eventually be sold to somewhere completely random, such as a Norwegian town council. It’s almost like Chinese whispers with large amounts of money. Therefore, when the housing bubble eventually burst, all these people suffered, thus bringing down a much larger segment of the economy than it should have. Homeowners also suffered because the values of their houses dropped.

2) Banks were over leveraged, i.e. they had were risking too much money, relative to the number of assets they had. Lehman brothers was leveraged at 30:1, which meant that a 3% drop in their shares, meant that they lost 90% of their assets. Due to the volatility of markets, this eventually happened, and busted Lehman.

3) The collapse of Lehman sent ripples across the entire banking system, and made the Dow Jones Industrial Average, and various other indices crash, as people began to fear a wide banking sector collapse. This then made the banking system weaker, which people then reacted to. Sort of like a self-fulfilling prophecy. This cycle would’ve continued unless government interfered which it did.

In conclusion, I must say that government should never distort prices, as they did by reducing interest rates for sub prime mortgages (interest rates too are a price), to help every American have a home. We also need to be better at predicting these crises, as it was widely assumed that house prices would continue to rise infinitely, as gold is seen today. It would also be helpful if we found a way to control moral hazard, although risk is embedded in the psyche of all Wall Street executives. I still support the bailouts, and feel that if we come up with any method of punishment, it will increase fairness in the market.