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Robert Samuelson misunderstands

Writing in The Wilson Quarterly, Samuelson weighs the left and the right’s explanations of the crisis and finds them both wanting. Here is his summary of the left’s argument:

From the Left, the explanation is greed, deregulation, misaligned pay incentives, and a mindless devotion to “free markets” and “efficient markets” theory. The result, it’s said, was an orgy of risk taking, unrestrained either by self-imposed prudence or sensible government oversight.

Then the right’s explanation:

The Right’s critique blames the crisis mainly on government, which, it is alleged, encouraged risk taking in two ways. First, through a series of interventions in financial markets, it seemed to protect large investors against losses. Portfolio managers and lenders were conditioned to expect bailouts. Profits were privatized, it said, and losses socialized. In 1984, government bailed out Continental Illinois National Bank and Trust Company, then the nation’s seventh-largest bank. In the early 1990s, the Treasury rescued Mexico, thus protecting private creditors who had invested in short-term Mexican government securities. The protection continued with the bailout of the hedge fund Long-Term Capital Management in 1998. After the tech bubble burst in 2000, the Federal Reserve again rescued investors by lowering interest rates.

The second part of the Right’s argument is that government directly inflated the bubble by keeping interest rates too low (the Federal Reserve’s key rate fell to one percent in 2003) and subsidizing housing. In particular, Fannie Mae and Freddie Mac—government-created and -subsidized institutions—underwrote large parts of the mortgage market, including subprime mortgages.

After explaining why the left’s explanation is weak, he writes:

If anything, the Right’s critique—Wall Street became incautious because government conditioned it to be incautious—is weaker. It’s the textbook “moral hazard” argument: If you protect people against the consequences of their bad behavior, you will incite bad behavior. But this explanation simply doesn’t fit the facts. Investors usually weren’t shielded from their mistakes, and even when they were, it was not possible to know in advance who would and wouldn’t be helped.

Samuelson is right–equity holders weren’t bailed out in the past or in the current crisis. It was creditors and bondholders who were bailed out, typically 100 cents on the dollar. Equity holders were almost always completely wiped out and received pennies or less than pennies on the dollar.

But Samuelson misunderstands the important difference between creditors and equity holders. Creditors–lenders and bondholders–only care about one thing–that the firm survives. They don’t care about the upside because they don’t get any of it. If they don’t think the firm will survive, they stop lending it money and buying its bonds. This is the natural deterrent to successive leverage. But if lenders and bondholders think the government will backstop them, or if they think there is some probability that that will happen, then they may continue to lend money.

Creditors police recklessness and imprudence. Cushion the fall for creditors and you get more recklessness.

What about equity holders? They don’t want to be wiped out, but they enjoy the upside. They’re willing to take on some risk of being wiped out if the potential upside is high enough. They don’t police imprudence. They add it to their portfolio and if enough of those survive and pay off they get a nice return. So if you held Bear Stearns stock or Goldman Sachs, you were playing with fire. But if you got out in time, you made a killing on Bear Stearns before it died. And if you diversified with enough Goldman, you still might have made out OK.

And what about the execs who held so much stock and got totally wiped out? Surely they had an incentive to avoid bankruptcy. Well they didn’t want to get wiped out, but they also made an enormous amount of money on the way. Jimmy Cayne and Richard Fuld, the heads of Bear Stearns and Lehman Brothers, each lost over a billion dollars when their firms died. But as I point out in this essay, the worst-case scenario was still pretty rosey:

The worst that could happen to Cayne in the collapse of Bear Stearns, his downside risk, was a stock wipeout, which would leave him with a mere half a billion dollars gained from his prudent selling of shares of Bear Stearns and the judicious investment of the cash part of his compensation.38 Not surprisingly, Cayne didn’t put all his eggs in one basket. He left himself a healthy nest egg outside of Bear Stearns.

Fuld did the same thing. He lost a billion dollars of paper wealth, but he retained over $500 million, the value of the Lehman stock he sold between 2003 and 2008. Like Cayne, he surely would have preferred to be worth $1.5 billion instead of a mere half a billion, but his downside risk was still small.

When we look at Cayne and Fuld, it is easy to focus on the lost billions and overlook the hundreds of millions they kept. It is also easy to forget that the outcome was not preordained. They didn’t plan on destroying their firms. They didn’t intend to. They took a chance. Maybe housing prices plateau instead of plummet. Then you get your $1.5 billion. It was a roll of the dice. They lost.

When Cayne and Fuld were playing with other people’s money, they doubled down, the ultimate gamblers. When they were playing with their own money, they were prudent. They acted like bankers. (Or the way bankers once acted when their own money or the money of their partnership was at stake.39) They held significant amounts of personal funds outside of their own companies’ stock, making their downside risks much smaller than they appeared. They each had a big cushion to land on when their companies went over the cliff. Those cushions were made from other people’s money, the money that was borrowed, the money that let them make high rates of return while the good times rolled and justified their big compensation packages until things fell apart.

Rescuing creditors 100 cents on the dollar creates the most moral hazard. Wiping out equity holders gives the illusion of punishing risk-takers. It’s an illusion. The creditors are the key.