Moral Hazard for Corporations, part 2
I agree with Mark Kleiman's main points here, but this one, as my previous post would suggest, I think is a mistake:
Mark Kleiman goes on to discuss the role of moral hazard for creditors, and of course that is the real story. Since stockholders have limited liability, they always have an incentive to take excessive risks, unless the creditors prevent them from doing so (usually by threatening to withdraw credit). The real reason for avoiding bailouts is that the prospect of a bailout takes away the creditors' incentive to provide discipline. OK, I'm not going to repeat more of what I've said like three times already, and I'm not going to quibble with the subsequent wording of the post that I cited. It's worth reading for itself, although the argument is not too different from what I've been saying in recent posts.
Why shouldn't the government bail out a private company that isn't a regulated bank? Moral hazard. You don't want to protect AIG shareholders from the consequences of the bad bets made by the management, or you offer every big firm the chance to gamble on a "heads I win, tails you cover my losses" basis.(Just to be clear, he isn't defending his own overall position with that statement; he's just discussing one consideration to be weighed.) As I argued in my previous post, whether or not any "bailout" is attempted, the shareholders are automatically bailed out by the limited liability that is part of the definition of a corporation. In a failure, their stock might become entirely worthless; in a bailout it just becomes almost worthless -- not an important distinction. Prudent stockholders have portfolios of stock, so it's not like a stockholder is someone who will personally be left with nothing in the case of a failure but still have a little bit to keep in the case of a bailout. Typical stockholders will just see changes in the values of their portfolios, and the difference between a 90% drop and a 100% drop in one stock will make only a tiny difference to the value of the portfolio.
Mark Kleiman goes on to discuss the role of moral hazard for creditors, and of course that is the real story. Since stockholders have limited liability, they always have an incentive to take excessive risks, unless the creditors prevent them from doing so (usually by threatening to withdraw credit). The real reason for avoiding bailouts is that the prospect of a bailout takes away the creditors' incentive to provide discipline. OK, I'm not going to repeat more of what I've said like three times already, and I'm not going to quibble with the subsequent wording of the post that I cited. It's worth reading for itself, although the argument is not too different from what I've been saying in recent posts.
Labels: economics, finance, macroeconomics
posted by knzn at 9/17/2008 12:22:00 AM
6 Comments:
whether or not any "bailout" is attempted, the shareholders are automatically bailed out by the limited liability that is part of the definition of a corporation
That's a very unorthodox definiton of "bailout" -- that shareholders are "bailed out" by losing 100% of their investment.
E.g.: The entire point of the government bailout of Chrysler was that it prevented Chrysler from going into bankruptcy with the business going to the creditors and the vultures and the shareholders losing everything -- the shareholders kept everything.
By your definiton, if their hadn't been any bailout of Chrysler, there'd have been a bailout of Chrysler's shareholders anyhow -- because they couldn't lose more than 100% of their investment?
You enter a contract that specifies a risk of loss that falls on you up to a contractual maximum. (With owners of common stock this maximum is their investment in the stock).
Then in actual fact by the terms of the contract this liability falls on you.
Your definition seems to be that if you wind up paying your full maximum contracted legal liability but not more than it, you somehow are bailed out.
Most people think they'd be bailed out only if somebody intervened to let them get away with paying less than their legal liability.
The way the word "bailout" has been used recently, it seems that something is still considered a bailout even if the stockholders lose nearly all of their equity. The first version of the Bear Stearns deal is an example. The AIG deal is a pretty good example, too, in that the shareholders are losing 80% of their equity up front and being required to pay an unusually high interest rate on their loan, even 20% of which will eat up much of the remaining equity. If the government had provided the guarantees that Barclay's wanted in order to buy Lehman, that would have been considered a bailout, but the price would most likely have been very low, with the stockholders effectively losing most of the value of their equity. I'm not sure what the "orthodox" definition of "bailout" is, but I'm using the definition that seems to be conventional today.
Of course, letting the firm go bankrupt is not literally a bailout for the stockholders in any sense, but my point is that it is more or less equivalent to a bailout, in the sense that the word has recently been used. When I say that the stockholders are bailed out by limited liability, I'm using the words "bailed out" figuratively to mean that the stockholders are getting roughly the same deal they would get if there were a literal bailout.
That's just a semantic issue, anyhow. The substantive issue is whether a "bailout" in the contemporary sense implies a significant moral hazard issue with respect to the stockholders. I contend that it does not. There is always a moral hazard issue with stockholders because they have limited liability, and therefore they have an incentive to take excessive risks, leaving the bondholders holding the bag for any potential losses above the value of the equity. But the bailout does not significantly increase this moral hazard.
The way the word "bailout" has been used recently, it seems that something is still considered a bailout even if the stockholders lose nearly all of their equity.
The public and press often throw words around indiscriminately and in dim ways, contrary to their "meaningful" meaning, ("bubble", etc. etc.).
If being "bailed out" means taking a 100% loss on the liability you've incurred, the term has no meaning.
But people involved first-hand in such situations don't use it that way. The creditors of Bear Stearns were bailed out (they avoided their loss). But I doubt that many owners of Bear Stearns are walking around saying "Whew, it's so good we were bailed out!"
Using the term to indicate "take maximum loss" is confusing -- when I read you saying bailouts create no moral hazard issues to shareholders and business operators my reaction was: ?????
Of course, if by them being bailed out you mean they lose everything and end up unemployed, it's true, no moral hazard created from that -- but that's sort of an uninteresting (if unorthodox) tautology.
OTOH, if shareholders, top execs and workers (unions) are bailed out in the traditional sense of being allowed by the government to escape the liability and cost that has legally fallen on them -- as in the Chrysler example -- then there are very real issues of moral hazard created on the shareholder/management/worker side of things, as Ritholtz and Leonhardt point out.
This seems to be entirely relevant at the moment, since the bailout now apparently being proposed to have the govt take the toxic loans off the financial firms' hands, to the tune of $700 billion or whatever, seems to fall squarely in this category. With the firms that worst-managed these loans being rewarded with the most benefit, etc.
Among the exigencies of the moment driving such a proposal, creating moral hazard among bank owners and managers may not be the number one concern, but it sure looks to me like its in there.
We're getting in to a tortuous semantic issue here. I was originally trying to make a substantive objection to Mark Kleiman's point, in which he uses AIG as an example. I don't think the stockholders were being bailed out, in the "correct" sense of the word, given that they had to give up 80% of their equity and accept a very high interest rate. It's not quite as bad as losing 100%, but it's pretty close. And, let me repeat yet again, there is a moral hazard that always exists with the stockholders of corporations, and I don't think a "bailout" like the AIG deal produces a significant increase in that moral hazard. In a deal like that, it is primarily the creditors that are being bailed out, and that is where the moral hazard issue arises with respect to the bailout.
As for this new $700 billion fund, that has a bailout aspect to it, but it's also possible to see it another way: there is a reasonably prudent and very deep-pocketed speculator by the name of Uncle Sam, and he is taking advantage of a liquidity premium by buying risky, illiquid securities at a low price and financing that purchase by with low-interest debt. By definition a speculator is taking risk: there is the risk that the ultimate proceeds will be substantially less than the cost, and that is why a speculator with a shallower pocket would not be able to play this game. But the expected return is also very high. You can say that the Treasury is gambling with taxpayers' money, but the odds are surely in their favor.
So actually, I'm not convinced that the moral hazard issue in this case is as large as you think. Most of the banks have already booked substantial losses. They have already suffered the consequences of their individual behavior. The problem now is illiquidity, a systemic problem, not one that is the result of risky behavior by individual banks. The problem is not that the securities are actually worthless, or even that they are worth less than their current book value; the problem is that nobody knows what they are worth, and so nobody is willing to bid on them, and those who are willing to make an educated guess at the value cannot get financing.
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