Tuesday, December 25, 2007

The role of looting in the subprime mess

(Naked Capitalism) 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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