Not Quite Crony Capitalism?

I haven't read this yet, but Lucas Puente -- a PhD student at Stanford -- has an interesting-looking article in the new PS (I don't see an ungated version). Abstract:

I investigate one mechanism through which financial institutions could have used political influence to receive preferential treatment in the US Department of the Treasury-administered “bailout.” I find that neither proxies of political influence nor other political variables, such as public interest in specific deals, can explain variance in the sale price of warrants (a type of financial asset) Treasury acquired through TARP's Capital Purchase Program. Moreover, I find that the more politically active the firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This conclusion is not consistent with recent studies investigating the role of such variables in the initial administration of TARP and can be interpreted as good news for American taxpayers.

PS summary (bold added):

In the wake of the recent global financial crisis, many have suggested that the US government's administration of the taxpayer-funded rescue of the financial industry offered disproportionate benefits to politically active firms. However, quite the opposite occurred. Puente's research into Treasury's handling of the disposition of warrants (assets similar to stock call options) acquired through the Capital Purchase Program (CPP) shows that, at least in this phase of the "bailout," political variables did not matter. That is, lobbying expenditures, campaign contributions, and connections with Secretary of the Treasury Geithner, among other independent variables, cannot explain variance in the percentage of market value Treasury received for these warrants. Moreover, according to Puente, the more politically active a firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This suggests that Treasury is attempting to counter-act allegations of preferential treatment. Taxpayers should be pleased. By insulating itself from politics and making efforts to maximize the taxpayer return on the warrants, Treasury may have prevented billions of dollars in taxpayer losses.

I personally don't find this very surprising. Nor would I find it surprising if preferential treatment came mainly through less transparent channels, e.g. the Fed. It looks like Puente might be investigating that question in his ongoing research.

OMG WTF Federal Reserve Fact of the Day

Via Felix Salmon:

At the end of 2010, the Federal Reserve system had $2.423 trillion in assets and $2.367 trillion in liabilities, which means that the simplest measure of its total equity — assets minus liabilities — comes to $56.6 billion. The Fed also managed to earn net income of $80.9 billion in 2010. Which means that its return on assets was incredibly high at 3.3%, while its return on equity was an astonishing 143%.

I think it’s fair to say that no bank in the history of the world has ever had income of anywhere near $80 billion in one year: that’s over $700 per US household. Somehow, the Fed is making roughly $60 per household per month, and remitting that money straight to the Treasury.

Much of this is TARP, but also QE1 and QE2. On net I'll take it as a good thing that the Fed is giving billions to the Treasury, but the scale of interventions in asset markets is so large that it can't but make me nervous.

This is also another reminder that the U.S. Federal Reserve is the most powerful and important actor in the global economy, bar none. Its actions have far-reaching ramifications, and its capabilities are enormous. Sometimes that's good. Other times, probably not.

Or, it's better to say that when the Fed acts, it can help some groups quite a lot, and can devastate others.

Why TARP Was Good, and Why Bailout Guarantees Are Necessary

The CBO has once again lowered its estimate of the cost to taxpayers of TARP. It's not down to $25bn, from an expected $109bn in March. At this rate, the program might make a profit overall, rather than just a profit from the bank portion of the program. Even if it loses $25bn, it's hard to argue that that's poor value for money, as Ezra Klein and Jon Chait point out.

Ryan Avent is not convinced. He says that the success or failure of TARP cannot be measured solely in dollars, but also in how it reshaped the political economy of finance in a way that exposes taxpayers to future defaults:

But to cite the dollar cost of the bill and declare it a roaring success is to totally misunderstand what TARP actually did. ...

What's important to realise is that built into the rise in value of the companies backed by the government (the banks especially) is the government's guarantee against failure. The government hasn't yet withdrawn this guarantee, and so it's still on the hook. President Obama could go before the country and say, "Ok, having sold our shares we now promise to never again bail out troubled companies". Markets would go "Ha ha ha", and continue behaving as if the government was still on the hook. Because it is. ...

But having convinced markets that the banks won't be allowed to fail, the government has accepted some set of unknown future obligations, which are growing all the time thanks to the moral hazard of the government guarantee. ...

So what has TARP cost American taxpayers? The correct answer is: we don't know. It's almost certainly less than the cost of the Depression that would have resulted from cascading failures at the nation's largest banks. But it's a lot more than $25 billion.

I think this is exactly wrong. The first wrong thing is thinking that a bailout guarantee didn't exist before the crisis. It did. The pattern of U.S. government intervention into financial markets, from the Latin American crisis (using the IMF) to LTCM, always suggested that the government would step into to prevent financial collapse. This was the Geithner plan, forged from his experiences in the Tequila and Asian crises. The Bear Stearns deal in March, 2008 reinforced that pattern. The exception was Lehman, and that's why the Lehman collapse was so devastating: markets expected the government to intervene when necessary. When it didn't, it set off a major panic. That is not something we should be keen to replicate.

The second wrong thing is to think that this is bad. As I wrote some while ago:

At some point in the future some financial institutions will become illiquid. If the government makes a credible commitment to not provide funds to those distressed institutions, then the first sign of trouble will touch off a run on those firms. Bank runs are contagious, so even if only a single firm is affected initially, the trouble could sink the whole system. It's much better for the government to instill confidence in the system by guaranteeing that they will support illiquid firms than to guarantee that they won't.

And:

How do escape the vicious cycle of bank runs? The government intervenes by guaranteeing the funds of depositors. This intervention may be costly, but is much less costly than continuing to let a panic eat the financial system from the inside out. Nevermind the fact that the government cannot make a credible commitment to not bailout systemically-important financial institutions: it would be a bad thing if they could! Such a commitment would lessen confidence in the financial system and thus make runs more likely, not less.

Of course there are concerns about moral hazard, but there are ways to address these without pretending the U.S. government can make a commitment to not bail out financial firms when everyone knows they will if things get bad enough. For example, the government can protect counterparties and depositors while still punishing bank management and shareholders.

In fact, some governments choose to do this. Guillermo Rosas wrote a very good paper (pdf) in 2006 describing why some governments opt for bailouts, while others follow Bagehot's advice to shutdown illiquid firms. Rosas also has a book on the same topic, which I've not yet read.

The point is that we can make the punitive cost of intervention severe enough for bankers to restrict moral hazard, while still working to maintain confidence in markets and prevent runs. This is what we should do. (Note that my view has shifted on this over time; at the height of the crisis I was unconvinced that punitive damages were a good idea, but now I think they are. For management and shareholders at least.)

Avent argues that TARP cheerleading is damaging because moral hazard prices in that we will bail out distressed firms automatically in the future. I worry about the opposite: that the TARP slagging (by progressives and Tea Party types alike) weakens confidence in markets and makes the system more susceptible to damaging bank runs. Perversely, this could make public intervention more likely rather than less. To see an example of this in real time, look at the tepid commitment from the EU to support the PIIGS. If they had made a bigger commitment at an earlier date, the overall cost of intervention would likely have been much lower.

In other words, we don't want the political equilibrium to shift further away from engaging in emergency actions to stabilize teetering markets. That's the world of the 1930s. If we can make a commitment to maintain stability in financial markets (thus benefiting the country at large) without rewarding financial managers and shareholders for profligacy (thus hurting those that took excessive risks without harming innocent bystanders), then we definitely should. I'm not saying that we did that effectively in this crisis, but that should be the goal.

So here's the story we should be telling: TARP was an exceptionally successful program. The best thing about it was that it stabilized markets at relatively low cost, and perhaps even a profit. The worst thing about it was that it was not severe enough towards management and shareholders. But we can fix that the next time this happens. We can pass legislation today that if financial firms require government bailouts, they come with harsh penalties. We should not throw out the good with the bad, and we don't have to. We should always insist that we will do whatever is necessary to maintain confidence in markets, but in so doing we will try very hard not to reward those that make bad investment decisions. They should be forced to bear the cost of their actions.

I'm not sure if there's a winning political coalition for that perspective right now. The financial industry obviously wouldn't appreciate that sort of commitment. Neither would most progressives, libertarians, or Tea Party conservatives. But that's that the narrative we should present.