Playing with our money

by Russ Roberts on November 25, 2009

in Financial Markets

Seekingexports comments on this post:

Mr. Roberts, when you wrote “playing with our money” did you mean TARP funds or the funds from institutional investors such as government employee 401B funds (ie. U of V retirement)?

Even though I don’t think that Lehman and Bear Stearns received rescue funds I think the ones who did, like B of A or Wells Fargo, may be making risky trades now with taxpayer money. They are too big to fail and they know it.

What I meant was too subtle. The people who lent Bear and Lehman money were playing with taxpayer money. Not literally but eventually it was the same thing.

Suppose I lend you money to do something incredibly risky that will make money for a while and then will either be OK or collapse. As a lender, this is really stupid  because I don’t share in the upside. I have a fixed upside–the interest I earn, and I risk being wiped out. So I normally wouldn’t do that. But if the guy in the corner, Uncle Sam tells me he’ll cover my losses, then I lend you the money, knowing that I can’t lose. You take my money and pay yourself a really high salary in the meanwhile out of my funds and the short-run returns.

If the investment collapses and you go bankrupt, you shrug and count the money you’ve been paying yourself in salary. I shrug because the government pays me the money you owed me. The taxpayer is left holding the bag. Who was really financing the investment? It wasn’t me. It was the taxpayer. I was effectively using their money when I made the loan.

It is the creditors who get bailed out. That’s what matters. Bear Stearns didn’t get bailed out. Their creditors did. AIG did get bailed out. But what’s important is that their creditors did. The only creditors that didn’t get bailed out were Lehman. As far as I can tell, their creditors were mostly Asian banks. Not enough political clout. No cronies there.

The cronies in crony capitalism are the creditors and the people who make money along the way borrowing the money. That includes Bear and Lehman execs and Goldman execs and many more.

If creditors know they’ll be bailed out, aggressive investors borrow from them, leveraging their returns and paying themselves a lot of money along the way, justified by the short-term profits.

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  • George J. Georganas
    Nice to see the author shifting his focus and starting a new thread.
    First, the paper cited in his original thread deals with executive compensation and not with the bailout of Bears and Lehman creditors.
    Second, who is to judge what is "incredibly risky" and what is "credibly riskless"?
    Apparently, the "free market", with considerable help from friendly regulators, has again not proven itself to be up to the job. We know financial crises existed before government regulation. So, faulting the government in this case is barking up the wrong tree.
  • netsp
    Hi Russ,

    I have recently grazed on the outskirts of your world and tried to explain the mechanics of how "Too-big-to-fail" amounts to a transfer of money to the rich and how dangerous it is. I have tried several approaches and I must say that you you have a hard job. Here is what I have found:

    1- Analogies or no analogies? I have found that my analogies are best left out. This is all to subtle to really explain by analogy. Politicians & the media overuse analogies terribly & they can be used in the service of laziness. The other person will probably try to repeat what you say in analogy form themselves. When its' their own analogy analogy it gives me an indication of how on track we are.

    2- There are two core concepts that must be tackled separately & then put together in context.

    The two concepts:
    - Leveraging. How companies make a lot more money by having slightly lower interest rates. (I found that this went best with a little pen & paper. Not much.)
    - Pricing risk. How interest rate is really a price for risk. (I found that this went well with a hypothetical converstation/negotiation. Will you loan me $100? Will you loan some guy on the street $100? How much interest do you want? etc.)

    Most people do not have a front of the mind understanding of both of these. Once you have those, then you have the layer of seeing what an explicit guarantee makes.

    - Effect of guarantee on the price of risk. (This part is easy.)

    The glue:
    - What happens to company profits when they get their loans at such a low interest rate?

    If you succeed, you might get some sort playing without money analogy played back to you.

    *Do not mention that the lenders were also the borrowers in this case. Especially not halfway through.
    ** Choose. Either illustrate the gains to lenders or the gains to borrowers. Doing both is too complicated. I prefer illustrating the gains to borrowers.
  • PerKurowski
    You are talking here mostly of how they settle the bets from when they really played with our money.

    When we deposited our money in a bank and the regulators told the banks that if they lent that money to a normal unrated entrepreneur then they needed to put up 8 percent of their own equity, but if they lent to an AAA rated client or the government then 1.6 percent or zero percent respectively will do… that´s when they really play with our money!
  • Methinks1776
    Yes, the effects of moral hazard are delightful. I can see why the Fed was so eager to create more of it. I'm sure the negative consequences are all behind us now and there's nothing to worry about.

    Russ, do you think Bear's creditors thought they would be bailed out when they lent to Bear? I have always thought they did - as a worst case, one in 10,000 year event sort of thing. I also don't think they thought there was a high probability of a such a day arriving in their lifetime.

    What you leave out of your scenario is the shareholders. I can understand the lenders getting overly confident. But what were the residual owners of the company thinking as they watched Bear pile on the debt and get into riskier and riskier businesses? The stock kept going up.
  • russroberts
    In the paper I'm working on, I argue that the shareholders aren't very relevant. We always think of the shareholders as a group of people with a lot at risk. But the smart ones (and they weren't all smart of course) knew that there was a lot of risk. So they might hold some of their wealth in Bear stock or Fannie Mae stock of Goldman stock. Depending on when they bought and sold, they made a killing. Or they were wiped out. But it's like any other high risk, high reward investment. You don't put all of your eggs in one basket. But putting a few in there can be quite lucrative. The point of this post and the one before it is that the execs who had a huge amount in the one basket still made a killing.
  • Sorry Russ, disagree. They're very relevant, and about to become moreso.

    Define “shareholders.”

    That a very large faction, a very disorganized, nebulous crew. If they’re you and I, they’re small, but if they’re CalPERS, or any state pension fund, they’re probably very, very large.

    That size definitely matters. And there’s a lot more in back of who’s harmed when Barney Frank's hobby horse falls apart. If unqualified people made those investments, then you have a qualification problem, not a compensation problem (well, you sort of have that too, but it's part & parcel).

    I hope you take that into account as well in your forthcoming paper.
  • Methinks1776
    Yes. And there's nothing stopping creditors from both diversifying across many industries and from hedging with derivatives.

    Shareholders matter. It's impossible to finance all operating activity with debt alone (unless you're talking about buying a house - a completely illiquid asset and usually the only siginificant asset of the borrower, then 100% debt financing is totally safe and appropriate. End Sarcasm).
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