Menzie Chinn: The Role of Looting in the Subprime Mess

For the record, Menzie Chinn is thoughtful and measured, and had a much less inflammatory heading to his post on the need to prevent “looting” in any regulatory reform that comes out of the subprime train wreck.

Chinn uses the term looting in a very specific fashion, using George Akerlof and Paul Roemer’s analysis of the savings and loan crisis as a point of departure. They define looting as when companies can and do pursue a strategy of “bankruptcy for profit.” As they wrote in a 1993 Brookings paper:

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values…

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters’ current extractions with no regard for future losses….”

Chinn argues, correctly, that this issue is different that the moral hazard argument that has been leveled against various forms of proposed government intervention in the housing or financial markets. Moral hazard, stripped to its core, is an efficiency argument: these initiatives wind up salvaging the foolish, careless, and incompetent. They increase the likelihood of future busts by keeping less capable players in the game, and by rewarding, perhaps even encouraging, heedless risk-taking.

But Chinn via Akerlof and Roemer warns we need to prevent “the next round of looting.” He admits to not having a clear prescription, beyond

…a much more complicated and difficult task of insulating the regulatory authorities from political pressures (see “avoiding regulatory capture“). It also probably requires expanding and integrating regulatory charters.

The revival of the notion of looting is an important addition to the discussion. Heretofore, observers of the credit crisis have been most critical of certain types of parties engaged in obvious self-serving behavior, such as mortgage brokers putting borrowers in mortgages almost guaranteed to go pear shaped and hopelessly compromised ratings agencies Yet other parties whose culpability may be less obvious could well wind up getting off too easily when the powers that be get around to rewriting the rule book.. Framing the situation instead as a form of economic pillage and isolating the root causes reduces the importance of assigning blame and instead puts the focus on how to mitigate the effects of bad incentives.

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8 comments

  1. Carl

    Great post and I second the Merry Christmas! Insulating the regulators from political and other pressures is the paramount consideration in my view. Better regulations are very important, but a regulator who is expected to toe the party line instead of following the rules that were laid down for the benefit of all will always fail. How you get to that ideal from here is the prime problem, isn’t it?

  2. Anonymous

    Im concerned that this banking problem is being “fixed” at such a rapid pace, i.e, the billions swept under the rug seem to be a non-issue now that “everyone” has come clean. This fix is as bogus as the breakdown! Call it distrust!

  3. Anonymous

    I should have added that tis “fix” reminds me of correlations to the Mark Foley meltdown with republicans last year. I think business, banks have realized its not good for business to have rumors drag out too long, or to have perceptions that something is wrong, thus as these banks mismanged money and bet the wrong directions in unison, they all seem to have collectively agreed to come clean on page one headlines and sweep this massive collusive mess away in the blink of a few weeks. Meanwhile, nothing much in the way of investigations, and as if planned, bank stocks are trading higher on extreme bad news, and for the most part, everyone believes its over…..just like with Mark Foley slipping away to rehab for The Cure! Very bogus!

  4. Anonymous

    Among the issues the U.S. Securities and Exchange Commission is looking into is how financial firms priced mortgage-backed securities and whether they should have told investors earlier about the declining value of those securities, the source said.

    Earlier, the Wall Street Journal, which first reported the news, said the SEC was also examining Morgan Stanley (MS.N) in addition to previously reported investigations of Merrill Lynch & Co Inc (MER.N) and Bear Stearns Co Inc (BSC.N).

    Representatives for the SEC, UBS and Morgan Stanley declined to comment.

    The number of investigations has increased since June, when the commission said it had launched a dozen probes into collateralized debt obligations linked to subprime mortgages and created a working group to focus on subprime market problems.

    The regulators are also probing whether Wall Street firms should have moved some off-balance-sheet entities holding mortgage securities to their books earlier, the Journal added.

  5. Lune

    I think one part of the solution would be to make sure the decision makers of a company (e.g. the CEO, board, etc.) feel the pain of bankruptcy.

    If bankruptcy courts could garnish the future wages of a CEO declaring bankruptcy (even if the govt. absorbs the underlying debt), then you can be sure he’ll try everything in his power to avoid a bankruptcy.

    I think it’s appalling that United Airlines, for example, is considered a model of “using the bankruptcy courts strategically”. Glowing articles have been written in the business press about how United was able to use the protection of the bankruptcy courts to force wage concessions, cancel debts, fire workers, etc. and emerge stronger than before. In other words, they screwed over their workers, their suppliers, their lenders, and their owners (much of their stock was owned by the workers through their unions, a double helping of misery). And this was held up as shrewd business acumen. Perhaps it was; but if the courts declared that management had to take the same percentage wage cut as the workers did, and that future bonuses would be garnished by the same percentage as the company’s debt was cancelled, then even without any change in the underlying bankruptcy protections, I’m certain UA’s management would have thought long and hard about every wage cut and loan cancellation they asked for.

    Corporations, especially in the U.S., have severe problems of agency. The “agents” (CEO, board) and the “owners” (shareholders) typically have very different interests (not to mention management vs labor). We need to make sure that bankruptcy is equally painful for everyone involved.

    When an individual goes bankrupt, they typically lose everything (sometimes including their house, depending on state laws), and they face difficulty accessing credit for the next several years (although perhaps not so much these last few years :-). That’s why people try their best to not declare BK. Why shouldn’t a CEO face the same personal responsibility for his actions? And before you argue that CEOs aren’t always responsible for their company’s demise, just remember many personal BKs are due to job loss and/or medical illness, not due to spendthrift ways.

  6. Anonymous

    The November/December 2007 issue of “Dollars&Sense” magazine has a blistering critique of the economics of banking that, among other things, criticizes economists for ignoring the Akerlof/Romer anaylsis of looting. The author, William K. Black, discusses the looting of S&Ls, in particular. There’s a website, dollars&sense.org, but I’m not sure about the availability of articles.

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