Professor Kling Plays Blind Man’s Bank
A couple days ago we had a piece up on National Review Online. Professor Arnold Kling and Nicole Gelinas both comented on it.
Mr. Kling was off to such a great start, and then without warning he’s just gone plain silly.
Some of his confusion is unsurprising. Everyone, but everyone who comments on the crisis seems to buy into the basic moral hazard/too big to fail argument: The reason the banks went bad is that bank executives and investors alike were so convinced the banks would be bailed out that executives took risks they otherwise would have avoided and investors kept investing regardless of these mounting risks.
It all sounds so plausible, for about two seconds. Then it just sounds absurd. Sorry, but bank executives holding hundreds of millions of stock in their own institutions (in poor Dick Fuld’s case almost a billion in Lehman stock) do not cold bloodedly max out on risk because the government might bail possibly, even probably bail them out if they get in trouble. Nor did that actually happen, by the way. Find us the top people from Bear or Lehman or Wachovia who think that betting on a government bailout is a good career move.
Bear and Lehman were known for having especially high levels of executive ownership. Didn’t help them.
In the case of bondholders there is some more plausibility to the moral hazard argument, but the very thing that makes it plausible also reveals it as being at most a minor factor. There is some reason to believe that the major banks throughout the run up to the crash were all able to borrow somewhat more cheaply because of their likely access to government assistance. If this is true, it helps explain how the banks got so big. A discount of 10 or 20 bps off the cost of capital for a bank with a trillion dollar book of business will pay for a lot of toga parties.
The moral hazard argument breaks down because as we now know, the problem was not that Citibank was able to borrow at AAA rates when it should have been paying AA rates. The problem was the Citibank was actually a C credit and markets did not have a clue. Even the most feckless bondholders do not lend to C credits at AAA rates on the possibility that the government will save them.
The spread between what markets were charging Citi for money and what markets should have been charging can only be explained by massive ignorance of Citi’s condition not indistinct hopes of a bailout, hopes which, as the government’s handling of Lehman showed, were not especially well founded.
The absurdity of the moral hazard argument can hardly be made more clear than by quoting Mr. Kling’s own formulation. “If I believe that it is government’s policy to bail out unsecured creditors, then I will invest in debt from Citicorp or Freddie Mac with hardly a care in the world about what’s on their balance sheet or how they manage their business. I know they’ve got Uncle Sugar behind them. They could be transparently bankrupt, and if I think they will get bailed out I have no reason not to invest.” To make the argument work Mr. Kling uses the words (which we have italicized) “believe”, “know”, and “think” as synonyms. The argument only works if bondholders know they will be bailed out and moreover bailed out without fuss or delay. They did not “know” any such thing.
The great exceptions of course are Fannie and Freddie. And Mr. Kling reveals the weakness of his argument in making the exceptions stand for the whole. Markets did believe that Fannie’s and Freddie’s bonds, like FDIC insurance, were ‘all-but’ full faith and credit obligations of the U.S. Treasury. And they had good reason to believe it since Uncle Sam encouraged this impression at every opportunity. And then, while most of the great banks were merely politicized by the government’s give everyone who can spell his name and walk a straight line (though not at the same time) a mortgage, Fannie and Freddie were Congress’s own pet banks.
As it turned out of course the Twins junior bondholders who took the governments winks and nods as a contract were were sorely disappointed when the government decided to roast them over the nearest open fire.
So much for the great too big to fail myth. Then there is Mr. Kling’s complaint that making the banks more transparent, as we propose, would never work because they can never be made completely transparent and therefore risk cycles can never be eliminated. What is there to say except that only a professor of economics could say something so silly. So investors can’t have perfect knowledge. Therefore it wouldn’t help for them to have more knowledge? The risk cycle can’t be eliminated; therefore we should all continue playing blind man’s bank?
Tags: Andrew Redleaf, bankers, banking crisis, banking deregulation, Richard Vigilante, Whitebox
