Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

18 October 2008

Our Woebegone Banks


[To see why Powell’s endosement rates a news flash, click here.]

Coddling Bad Management
The Low Interest Rate
Treating All Equally
Encouraging Concentration

Remember Lake Woebegone? That’s Garrison Keillor’s fictional Minnesota plains town, where “all the children are above average.”

With a stroke of their pens, the bailout geniuses in the Bush Administration have converted our financial sector into the economic equivalent of Lake Woebegone. In the world that they have made, there are no consequences for failure, the government gives money away, all our bankers are above average, and all are bailed out equally, regardless of their success or failure.

We were all so thrilled that our glorious followers accepted Britain’s decisive leadership that we failed to notice the difference in details. We cheered, and markets rose, as they pledged to inject much-need new capital into our rotten financial sector. But as we should know by now, in finance (as in most things) details matter. The details of our own brand of bailout, which differ strikingly from those in Europe, make it look much more like socialism for the rich.

Coddling Bad Management

In Britain, the government took power to appoint board members and limit dividends, causing the resignation of top management of several banks. Our own bailout did little to remove or limit the options of our failing banks’ top management, which remains in place.

So much for cleaning house. You would expect as much from an administration that gave George Tenet the Medal of Freedom for presiding over 9/11 and That Idiot Rumsfeld fulsome praise, upon his grossly belated firing, for presiding over the debacle in Iraq.

No doubt there are some smart men and women among the managers thus spared unwanted scrutiny by markets or shareholders. But they also include the very folks whose greed, stupidity and denial of reality created the problems we are trying desperately to solve.

Keeping top management of failing institutions in place and unrestrained has three undesirable consequences. First, it allows bad actors to continue to draw outsized compensation for failure. Every sophisticated analyst expects CEOs to circumvent whatever rules again excessive compensation the government puts in place. But they can’t draw undeserved compensation if they’re no longer there.

Second, failing to remove or limit bad managers missed a golden opportunity to build political support for the bailout. As members of Congress know full well, the public is rabid for heads to roll. The government could have garnered immense political good will just by making a few examples.

But Paulson & Company didn’t do that. Maybe they wanted to give the next administration (probably Obama’s) the stinky “gift” of a still-rabid public. Maybe they just couldn’t stand to humiliate their buddies and members of their own social class.

Finally—and most important—failing to curb bad actors missed a chance to reduce moral hazard. Merely by aping the British, Paulson & Company could have gone a long way toward re-establishing a business culture in which failure has consequences for the people causing it, not just for others. But they didn’t.

The Low Interest Rate

The second important detail is the dividend rate on preferred shares the government gets in exchange for its injections of capital. Warren Buffet got 10% for his $ 3 billion investment in GE. The British charged 12% for their bank bailout. Here in the supposed home of muscular capitalism, the taxpayers get 5%.

Why did Paulson & Company secure for our taxpayers half (or less) of the going rate of return? There are two possible reasons. First, Paulson was uncomfortable with a true (albeit partial) government takeover of private enterprise. The purpose of the exercise was to avoid a Great-Depression-style meltdown at all costs. But apparently Paulson had a higher goal. He wanted to preserve the illusion of a free market based on voluntary transactions among free capitalists. Denial continues apace, even at our government’s highest levels.

So Paulson balked at injecting capital and imposing harsh terms by fiat in exchange. Instead, he tried to cajole our Masters of the Universe, including the idiots among them, to do a “voluntary” deal.

By interviews after the fact, the Wall Street Journal managed to crack the door [subscription required] to the extraordinary meeting in which Paulson presented the bailout terms to CEOs of nine of our biggest financial institutions. Expecting resistance, he had scheduled a possible second meeting. But when he presented his plan in a termsheet, there was quick acquiescence after a little grumbling. There was no need for the scheduled follow-on meeting or any real arm twisting.

At the time of the meeting, the LIBOR (London Interbank Offered Rate) was hovering around 4.5%—an extraordinarily high figure by historical standards. The LIBOR is supposed to be a nearly risk-free rate, the rate sound banks charge each other for short-term loans. Here institutions that might have been failing (some of which were not banks) were “ordered” to accept a rate about half a percentage point higher for an infusion of capital of indefinite duration. Any self-interested commercial party (such as Warren Buffet) would have charged a much higher rate based on the longer term of the “investment” and the increased risk of default.

So Paulson’s was an “order” the CEOs could hardly have refused. That’s why, when he called the meeting, he had told Morgan Stanley’s CEO, “I think you'll be pleased.”

The second possible reason for the low rate is a bit more complex. Paulson & Company might have intended the low rate to provide a less transparent taxpayer subsidy for shaky institutions. It doesn’t take much skill as a banker to make a profit on the virtually free money that Paulson was providing long term. The low interest rate helped the banks beyond the face value of the bailout, thereby encouraging them to lend, since virtually any borrower would pay a higher interest rate for loans of any similar term.

Although rationally related to the main goal of financial stability, these effects, too, increased moral hazard. Applied indiscriminately to strong and weak recipients alike, they reinforced the immunity of bad management.

Treating All Equally

One of the key characteristics of socialism is treating everyone the same. It’s the thing that free marketers and conservatives rail against. If everyone gets the same reward, regardless of skill or effort, there’s no incentive to succeed, or even to work hard. Society devolves to its lowest common denominator, and the laziest and least skilled among us sets the pace of progress. That’s pretty much what happened in the Soviet Union.

The railers are right about this. The great dilemma in our mixed economy is how to provide a safety net and a reasonable standard of living for all while maintaining the enormous economic incentive that private markets provide. Treating everyone the same is not the answer, although treating everyone with a minimum level of decency and humanity undoubtedly is.

Paulson’s bailout was not precisely equal, but nearly so. Of our four biggest banks—Bank of America, Citigroup, JP Morgan Chase, and Wells Fargo—each got $25 billion, except for Wells Fargo, which got $20 billion. The two big investment banks, Goldman Sachs and Morgan Stanley, each got $10 billion, although Goldman is far healthier. Two smaller banks—State Street and Bank of New York—each got $3 billion. Apparently there was no attempt to calibrate the amount of each bailout to the recipient’s strength, need or quality of management.

For the two investment banks, Paulson may have pleaded insufficient information to discriminate, as some of their activities are unregulated and opaque. But national banks? All of the five biggest banks are national banks regulated and regularly examined by the Comptroller of the Currency, a Treasury Official who reports to Paulson. Surely with a little effort Paulson could have determined which banks were better managed, whose borrowers had fewer existing and imminent defaults, and (perhaps) which had fewer toxic assets. Similar analysis applies to the two smaller banks, which are regulated by the FDIC. Yet Paulson treated them all the same, except for size, just like the most doctrinaire Soviet commissar. It was a puzzling and anomalous performance.

Encouraging Concentration

As I’ve outlined in another post, the corporation is one of the greatest social inventions in human history. It diversifies and decentralizes economic activity, economic power, and economic decision making. It weakens the grip of political and central authority on a nation’s commerce and industry.

Human history over the last 400 years (the era of corporate activity) confirms this point. Societies with robust corporate spheres (Holland, England, the United States and more recently China, Germany, Israel and Japan) have succeeded far better than societies characterized by centralized power.

This is so no matter what the excuse or goal of centralized authority. It applies to authoritarian regimes based on religion, such as Italy, Spain and Latin America during their colonial periods and Iran today. It applies to left-wing authoritarian regimes, like the Soviet Union, former “Red” China, Cuba, and Venezuela today. And it applies to right-wing authoritarian regimes like Nazi Germany, Fascist Spain and the various, now mostly vanished fascist regimes of Latin America. The most dramatic example is China, whose economic miracle began when it forsook central control over its entire economy for its present regime of weakly authoritarian capitalism. Human beings simply do better when they can work, build, create and innovate without asking permission from central power. The same rule even applies in our computer industry.

Until recently, one of our secrets as a nation was that we understood this truth better than most. Our free-market economy recognized the power of diversification and decentralization and discouraged concentration. Whether under “conservative” or “liberal” government, Republicans or Democrats, we never lost our basic faith in the corporation, large or small, as the fundamental and autonomous unit of economic activity.

Our antitrust laws—once the most robust in the world—reinforced this trend in the private sector. They kept us free from excessive concentration of economic power wrought by private, nongovernmental means. As a result, our banking sector is the most diversified and decentralized in the world, with over 9,000 separate banking entities [Figure 4]. Up to now, those features have made it the most efficient and effective financial sector in the world.

So why in hell did Paulson & Company give half the bailout money to nine of the largest financial institutions in the nation, including some that should have been allowed to fail? Why did they “invest” $ 10 billion in Morgan Stanley just so Japan’s biggest bank would buy a roughly equivalent share? They missed a golden opportunity to strike a blow for deconcentration and reverse (at least in part) the strong recent trend toward mergers and consolidation that is rapidly making our financial sector more like Europe’s and Japan’s.

That failure was a huge step backward. It is ludicrous to argue that even financial wizards sitting on the forty-second floor of an office tower in Manhattan can do a better job of lending to small business in Portland and Peoria than bankers in those towns. The locals know the communities, the local business environment, and the businesses themselves. They regularly socialize with local business leaders. They have a chance to observe character and management style up close and personal, not just balance sheets. Their social and professional reputations, as well as their economic success, are on the line every time the make or don’t make a loan. And if they fail, it won’t be long before another local institution will pick up the dropped ball. So why not use this crisis to strike a blow for diversification and decentralization, rather than consolidation?


Those of us of a certain age remember how long, hard and often Republicans railed against the welfare state and every attempt to create a safety net for the least among us. Life is a Darwinian struggle, they said. Only the strong survive. We can’t treat common people equally (or even humanely), lest they grow weak and lazy and their weakness and laziness infect us all.

Yet when time and chance—even gross incompetence— threaten their rich buddies, they treat them all equally, regardless of brains or strength, just like the socialist government in Animal Farm. The irony would be hilarious if the policy weren’t so dishonest and dangerous.

Not only does our bailout treat all banks of similar size much the same. It gives even the little banks no risk, no reward, and no incentive to improve. Our government could easily have applied market incentives to them, without any direct investment of taxpayers’ money. As I’ve suggested in another post, it could have published their reserves, financial health, and percentage of tainted assets on the Internet, thereby encouraging depositors whose money was not insured to move it from weak and silly banks to strong and sound ones.

Most money would not have moved, because the government already had insured accounts up to $250,000. But some larger business accounts would have moved, providing a gentle and gradual reward for sound management and an incentive to replace bad managers.

Sure, some banks might have failed, wiping out shareholders, depleting the FDIC fund, and perhaps causing FDIC insurance rates to rise. But we’re talking about little banks here, not the behemoths “too big to fail.” Failure of a few dozen additional small banks, coupled with a general increase in insurance rates, might have given all bankers a salutary reminder the reality of risk in their profession and the problem of moral hazard.

Instead, our government opted for socialism for the rich. It guaranteed all non-interest bearing accounts (mostly checking accounts), regardless of size, thereby removing any incentive for small business to move its money.

It remains to be seen how the government will apportion the remaining $125 billion of the first $250 billion tranche, which is reserved for little banks. Will it attempt to reward sound management and punish idiots? Or will it treat the little banks, like the big ones, as if they were all above average?

I don’t mean to belittle the complexity of what Paulson & Company are attempting. Their work is complex, time is short, and some relevant data have yet to be collected. But no serious person expects the so-called limits on executive compensation or “golden parachutes” to have any real effect. At most, bad managers will suffer a slap on the wrist for a few months or a year while their lawyers figure out how to circumvent the limitations or challenge them in court.

The next administration may make examples of some. But, as always happens, most will escape punishment as our government rightly turns its attention to more urgent matters. Being momentarily humiliated in grandstanding congressional hearings is no incentive for proper conduct when applied to people making tens or hundreds of millions a year. Offer me that kind of money, and I’d be happy bear similar humiliation once a month. Meanwhile, the underlying housing-mortgage meltdown still smolders, with no solution in sight.

It’s hard to avoid the conclusion that the details of our bailout reflect a desire to preserve the status quo and Wall Street’s predominance as much as a desire to get credit moving again. But a sector of our economy based on the values of Lake Woebegone will not long survive harsh global competition, let alone the harder times yet to come.


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