Leonhardt on the Looters

Arguing that financiers' government "put" caused the crisis

The New York Times’s David Leonhardt has the must-read of the day today.

He focuses an early 1990s research paper by two eminent economists and uses it to make a persuasive case that what we saw out of bankers who created the crisis was “looting”:

In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”

Sound familiar?

We’ve talked a lot about the problem of moral hazard in this bust, and “looting” is essentially a synonym for that. But it’s a conceptual leap at the same time. “Moral hazard” is hazy and academic. “Looting” is precise and visceral. Its long been used by Wall Street’s ideological foes, but it doesn’t seem like hyperbole anymore.

Leonhardt explains how government distorts the markets:

The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.

And so they are. Isn’t it refreshing to see AIG, Citi, and Fannie called “looters” in a non-Bob Herbert column in The New York Times?

The problem here is that I think Leonhardt leans too heavily on government bailouts as the sole explanation for why markets get themselves in trouble:

Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess.

He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.

Well, yes. But there are other reasons beyond government involvement. The fact that Wall Street went public in the 1980s and 1990s had much to do with the crisis, mostly for the same reasons that the prospect of government bailouts did: It offloaded risk onto other bagholders, ie shareholders.

When the firms were private partnerships, each banker had the incentive to make long-term decisions (and to be on the lookout for colleagues’ foolish decisions) or face having their wealth be wiped out. When they went public, the incentives moved from a generational horizon to one that was much shorter—months and years—leading them to focus on generating short-term profits to goose annual bonuses and offloading much of the risk to shareholders.

But also, the theory is a bit too neat without either of these. Capitalism, after all, has always had its periodic blowups (except for a long stretch there from the mid-1930s to the 1970s. Hmmm) long before the government got in the bailout business.

Still, Leonhardt’s and the academics’ theory explains much of the current crisis, as he explains in distinguishing their idea of “looting” from classic moral hazard:

With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.

Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.

What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

When you look at it in this light, doesn’t the case for clawing back some of those ill-gotten gains look much better? Think about Warren Spector of Bear Stearns who was fired in 2007 and made out like an, um, bandit. Think he should cough up some of that $600 million he made from 1992 to 2006?

Leonhardt is right to say there’s nothing we can do about this crisis now. This goose is cooked. Without bailouts the system will just shut down and I’ll finally get to fulfill my longtime wish of seeing what life really was like for my grandparents in Dust Bowl Oklahoma.

But it’s imperative to end the government “put” as best we can. Here’s what Leonhardt and his economists suggest:

But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.

Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.

Great. That’s all needed.

But we also need to shift our thinking about antitrust laws and banking-merger regulations. If companies are “too big to fail”, they’re too big to exist. Prevent them from getting so big and break up the ones that already are. This is imperative (and it is not limited to banks), and it amazes me that it isn’t mentioned more in the press.

Sure, we’ll lose some of the “efficiencies” that arise from having a Bank of America on every corner. But we’ll return banking more to its roots in the communities, prevent the government from having to bail out ones that get into trouble, and eliminate some of the trickle-up effects on pay disparity. CEO’s can’t get paid as much if they have far less revenue. Plus, I’d think owners are better operators and more attuned to their community’s needs than salaried branch and regional managers.

And hey, newspapers: More companies means more advertisers. Remember the days before Wal-Mart?

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.