Thursday, September 25, 2008

The Financial Crisis--A Comment on Lucien Bebchuk and Our Boom Days for Academic Theorizing

The present financial crisis has gotten everyone energized--from the political, to the media to the economic sectors--everyone seems to believe that this is the point of instability in which might be seized for advantage at home or abroad. Academics too sense the upside potential of participating in this market. The first academic out of the gate with a new idea might dominate the field. See Pierre Bourdieu, The Field of Cultural Production (New York: Columbia University Press, 1993).

And, at a critical juncture in the present election cycle, might also leverage the production of an academic consumable across markets to the political markets in ideas. It was with this in mind that I read the excellent twelve page analysis recently circulated by Lucien Bebchuk recently. Lucien Bebchuck, A Plan for Addressing the Financial Crisis, Harvard Law School, National Bureau of Economic Research (Sept. 24, 2008). The paper is worth a careful read, both for its subtlety of its analysis and for the limits of the current frames of analytical reference that tend now to over bind American thinking about the current states of finance.

My purpose in this short discussion is to focus very generally on the later point by looking at the four general suggestions that are at the heart of his proposal. These are, in his own words:
* No overpaying for troubled assets: The Treasury's authority to purchase troubled assets should be limited to doing so at fair market value.
* Addressing undercapitalization problems directly: Because the purchase of troubled assets at fair market value may leave financial firms severely under-capitalized, the Treasury's authority should be expanded to allow purchasing, again at fair market value, new securities issued by financial institutions in need of additional capital.
* Market-based discipline: to ensure that purchases are made at fair market value, the Treasury should conduct them through multi-buyer competitive processes with appropriate incentives.
* Inducing infusion of private capital: to further expand the capital available to the financial sector, and to reduce the use of public funds for this purpose, financial firms should be required or induced to raise capital through right offerings to their existing shareholders.
Bebchuck, supra, Abstract. Let's look at each of these in turn.

The first point (Bebchuk, supra, at 2-3) focuses on two things--the identity of the assets targeted for purchase by a state (or public) entity and the pricing formulas to effectuate those public purchases of private debt. There are a number of issues here that merit some focused attention. It is not clear what assets are troubled. Bebchuk identifies "the presence of “toxic” real-estate paper on the balance sheets." (Bebchuk, supra, at 2). But that is hartdly helpful. The trouble might exist at the level of particular debt instruments--mortgages and other financial instruments evidencing a primary debt obligation. On the other hand, as appeared to be the case with AIG (see Larry Catá Backer, AIG and American Corporatist Socialism, Law at the End of the Day, September 16, 2008), the trouble might be in those entities created to exploit large aggregations of such primary debt instruments. If the trouble is at the level of individual debt instrument, then the nature and complexity of the purchase program becomes tremendously great. There are a lot of loans out there that might be troubled. And the bureaucracy necessary to purchase them would be large, complex and inefficient. The alternative would be block purchases, but then the focus would no longer be on troubled loans but on troubled entities once happy enough to exploit these loans and now less happy about the prospect. If the trouble exists at the entity level, then a different set of interests are involved. At this level of trouble, the better option might be to effect a purchase of profitable assets (and their reorganization in profitable operating companies) or the purchase of the entire portfolio of such entities (effectively through public asset purchase mechanisms at aggregate fair value of the business) for later sale, and provide a streamlined process for resolving the ensuing bankruptcy of those entities, effectively passing the loss (and settling the risk of loss) on those who had bargained for that privilege. Then a focus on troubled loans at the principal debtor level might be more interesting.

Bebchuk, though, focuses on pricing. For that purpose he offers both a carrot and a stick. The stick is the proposition that assets be purchased at fair market value. The carrot is that the fair market value be calculated under presumptions of healthy markets. "Thus, the fair market value that the Treasury would pay would be one that would reflect market outcomes under conditions of adequate liquidity." Id., at 3. So one must conceive of pretend markets for the affectation of purchases for those whose actions produced what is viewed as a distorted market because of the disappearance of capital. But capital has not disappeared--it has migrated someplace else. While the invocation is to the market, the mechanics look elsewhere.

The last point suggests a criticism of the second element of Bebchuk's proposal. (Bebchuk, supra, at 4-8). Bebchuk understands that capital has not disappeared, it is just elswhere. He suggests liquidity through the addition of a power in government to invest in new instruments offered by those firms whose offer of old instruments was critical to the process of market threat. (Id., at 4-5). He sensibly limits the suggestion to still solvent entities (id., at 6); but why subsidize solvent firms directly when they might be able to access capital on their own? Of course, he might argue, that is the problem--inducing capital to fund fund able entities. If so, then the focus should be on inefficient entities. If the problem is entity inefficiency resulting in insolvency (or its near cousins), then selective financing might not prove to be enough to jump start a collective sense of market integrity necessary for liquidity. Thus it may be true that new capital must be injected in order to save the underlying industry. But does that man that new capital must be directed to the old firms? Perhaps permitting new securities to be issued by new firms would make better sense. In that case the United States would serve, in effect, as the "market" for the industry and provide the framework within which such transfers and infusions could occur. That would serve the public purpose--preserving market integrity and capital liquidity--and provide a safe environment in which the individual discipline of the market could be elaborated (on the bodies of those persons and entities that took the risk, enjoyed the rewards and now must absorb the downside of their risk taking strategies). Entities like these are reconstituted all the time. And there are a great number of smart ambitious and able managers at the middle levels both eager enough and talented enough to take over without causing the sort of panic engendered by the idea that bureaucrats and bureaucratic thinking (the American nomenklatura--even if drawn from financial sector cadres) would take over this sector. Now is the perfect time to encourage middle level management LBOs and purchases of viavble operating entities, or the sale of aggregations of profitable debrt to such entities. That is the sort of activity that might require cooperation from the state (the Treasury and the SEC perhaps most importantly) but hardly requires an intrusive oversight by the State. From this perspective the other shoe dropping--Bebchuk's suggestion of bailouts for insolvent firms while encouraging direct investment in solvent ones, is unconvincing--though a better idea than the government's proposal Bebchuk criticizes.

Thus market based discipline is possible (Bebchuk's third point)--not through the ossified mechanics of state takeover and resale to those who engaged in behavior that caused the fuss in the first place but through others. For that purpose, Bebchuk suggests the lesser of two evils--the purchase of the services of financial sector middlemen to effect the government's intervention in (and for the salvation of the integrity of) the market. (Bebchuk, id., at 8-9). He is right, as far as he goes. People whgo know what they are doing, and who can be disciplined by the market for their services are always to be preferred to someone whose incentive structure and experience do not. But so what? On the plus side Bebchuk's ideas might serve to unfreeze the market by paying off its middlemen (an argument that Bebchuk makesmore elegantly, Bebchuk, id., at 10-11). And Bebchuk is right to suggest that shareholders of middlement entities risking insolvency ought to look to their shareholders for more money to avoid a greater risk to their investment. (Bebchuk, supra, at 11, nicely citing Raghuram Rajan, Desperate Times Need the Right Measures,”, September 19, 2008). But the reconfiguration of assets into attractive packages might serve the same ends. The ultimate service performed but the market is a ruthless disciplining of those persons and entities that take risks that provide no reward. Bebchuk, like the current Administration's personages would invert that purpose to subsidize not markets but classes or elements of that sector. And for all the best reasons of course--stability, fairness and preservation of markets and liquidity. But this traditional focus is both unnecessary and unnecessarily inefficient--except in preserving class position. But that is not the purpose of markets--even markets in ideas.

And thus to the heart of the matter, the infusion of capital, Bebchuk's last point. And of course, reduced to its essence this is the only thing that matters if the goal is the preservation of market integrity (and confidence) and its consequence a necessary minimum of liquidity trickling down to all social sectors. It is at this point that everyone turns to the Treasury. And why not?--it is an open pasture richly provisioned and controlled. The right mix of media suggestion, pronouncements of highly paced members of strategic elites (economic, political and academic) and presto! Funds. But there is a lot of money out there that is neither governmental nor necessarily thoroughly public in character. And here I speak of sovereign wealth funds. It seems odd that at this time neither the financial sector elites nor the political elites have thought much about the pool of money represented by those funds. I can think of some reasons--those funds might be too effectively disciplining. A government can be controlled in the methods and exactions it will seek in return for setting things right. If one controls the saving entity one can save oneself with less bother. Who better than Mr. Paulson to use the power of the state to salvage the financial markets (in general) and firms and the entities they spawned (in particular) by infusing inefficient economic actors with funds (one way or another) and preserving the leadership role of those entities and their officers and directors. It is not clear though, that is approach is more or less market distorting.

But sovereign wealth funds, one might suggest, are also governmental (public) and thus more dangerous to both market and state. There is a certain allure to that argument. See Larry Catá Backer,State Subsidies and the Character of the Market Transactions of Sovereigns: The Case of EADS Law at the End of the Day, May 29, 2008. Yet it may be more effective as scare tactic than as reality. It represents a failure to understand an emerging reality of financial markets and the character of its participants, as well as the conflation of public and private activity. I have suggested that when sovereign wealth funds invest, they might best be understood as public entities acting in a private capacity--as market participants rather than as regulators. This is especially the case where such investment occurs outside the territory over which the governments funding these entities can legislate. See, e.g., Larry Catá Backer,Sovereign Wealth Funds And Hungry States: Adjusting the Borders of Public and Sovereign Activity Across Borders, Law at the End of the Day (June 6, 2008). As private investors they are as subject to regulation and the discipline of the markets as any other entity. Now here is a possibility for infusions of capital that are finely disciplinary and not essentially interventionist from a regulatory perspective. But the cost for those who are now responsible for the financial services sector might be too harsh for them to bear. Markets work best when they work to discipline others. That is perverse effect indeed.

Lucien Bebchuk has put his finger on the problem. He has effectively sought to find some sort of middle ground that stays true to some semblance of the market ideology to which Americans elites are meant to subscribe. But ideology must be made palatable to those with the power to effect its policy implications and the systems spawned thereby. And where the discipline of those systems means to discipline those at the top, then one faces the truest test of the system. And that, perhaps, is the most fundamental of the issues to be tackled--will the salvage plan privilege system or individual actors, the market or certain entities.

Bebchuk means to split the baby. He focuses on pricing and efficiency. And he is willing to accept the Treasury's focus on the financial market, writ large, rather than the housing crisis that is said to underlie it. "Because the Treasury’s plan would infuse capital through overpaying for troubled assets, it would impose massive costs on taxpayers and might not channel needed capital to its most valuable uses." Bebchuk, supra., at 12. And he is willing to accept the Treasury's focus on the financial market, writ large, rather than the housing crisis that is said to underlie it. Id., at 12-13. "Thus, additional government intervention in connection with the housing market may be warranted alongside the intervention in the financial markets that has been the focus of this short paper. Whether and what intervention would be warranted is a question that is beyond the scope of the present paper, however, and I plan to consider it in separate work." Government intervention in the housing market--and the difficulties of squaring economic theory with a public policy that has sought to subsidize home ownership for several generations is, as Scarlett O'Hara used to say, a problem for another day.

That approach is sensible from the perspective offering advice. It provides the means both for "staying in the game"--the market for influence and producing highly values commodities in the market for academic discourse and prestige. Perhaps that is the best we can hope for now. But it might have been better had we been able to envision a financial market globally integrated in fact as well as form, in which capital could move freely from public and private funds, in which investment remains private even when undertaken by public entities, in which the focus is on liquidity and integrity of markets rather than on the entities and players currently in control of inefficient business ventures and profitable operating entities. There is an important role for the state in all of this. First as a regulator to protect the integrity of the market and then as a participant to make liquidity real. But the welfare of the current crop of financial entities, their instruments and the middlemen that made their financially irresponsible ventures (in retrospect at least) happen is not the business of the state as either regulator or participant. On the other hand, the welfare of householders and the stability of the real estate market might be. But not as a matter of preserving the advantages of the commodification of mortgage instruments, or their packaging for the benefit of investors, but as a matter of state policy about public welfare. The ultimate problem of the financial crisis--and one that cannot be adequately answered either by the Government's current proposal or Bebchuk's imporvements thereto is that it is ony partially a problem of markets, and more foundationally a problem of social policy. Until both elements of the crisis are unpacked and dealt with properly the crisis will con tinue to morph and the unintended consequences grow.

1 comment:

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