Wednesday, January 13, 2016

Disaster, barely averted

In recent years we have gone through one of the great financial meltdowns.  It was a disaster for everyone but as usual the greatest pain and suffering accrued to those on the bottom because they have the least in reserve against hard times.  That such a thing should not be allowed to happen again is something we all agree on, but unfortunately figuring out how we should respond is beset with misunderstanding and confusion.

The standout example of how much people misunderstand the financial crisis is the fate of the money the US government invested in saving banks and insurance companies.  A lot of people, even people that generally I consider really informed, seem to be under the impression that governments just handed billions and billions to bankers and all that money vanished into executive bonuses and investor dividends.  It just isn't true, and understanding how these things unfolded is key to figuring out how, when, and if the government should preform such rescues in the future.

I am reading a book about Ben Bernanke entitled The Courage To Act, which describes in detail what Bernanke did throughout the crisis as the leader of the Fed in the US.  For example, when AIG was running out of liquidity and on its way to failing the Fed gave it a $85 Billion dollar loan.

That wasn't a gift.  It was a loan at an exorbitant interest rate.  Part of the condition for getting the loan was that the government took over 80% of AIG.

A few years later the Fed had the loan repaid entirely and it had resold the stock of AIG, netting a tidy profit of $23 Billion.

Profit, not loss.

The financial system was protected from a potentially catastrophic loss, and the Fed *made* money.  Of course part of the desired outcome is that the people who made terrible decisions suffer for those decisions.  The company couldn't simply be handed money to make up for its idiocy and hubris, and it wasn't.  The investors lost nearly everything, so anyone thinking to do such things in future could be reasonably sure that if things go bad they stand to lose 95% of their investment when the government chooses to step in... hardly a comforting thought.

This sort of resolution is by far the standard in government interventions of this type.  There have been many times in the past that governments have stepped in to hand huge chunks of cash to big companies that are failing and this is the standard story.  Normally the government gets its money back, usually with a profit.  Not a big profit, mind, but when stabilizing a disastrous situation and preserving major employers you don't have to make much of a profit before it is worth it.

Clearly we don't want the government to be giving money to banks, and it is incredibly galling when executives of a failing bank that required a bailout collect huge bonuses.  That said, when we are faced with a potential catastrophe I definitely want the government to act as a last resort to keep things from tipping over into disaster, especially because history tells us that when they do this it is primarily wealthy investors who take a bath and average employees who benefit.

I should note that not all government interventions went well.  Irish banks did some really dumb things and their government foolishly and without decent information decided to guarantee their creditors against loss.  That was a colossally foolish move, made in haste, and it cost them dearly.  Not all interventions are sensible, but when speaking of them it is critical to understand the difference between the best case and the worst, and why it is sometimes (not always!) right to step in and bail people out.

By far the better solution to the problem is to do things like we have in Canada, which is to have strong government regulations on banking to keep them from doing stupid things and getting themselves into serious trouble.  That worked during the recent crisis and it should be the standard going forward.  Deregulation just invites people to do more stupid things that risk everybody else's security.  But when disaster does come, and it will, we have to be ready to support the government when it steps in to block the leak in the dam.  Of course the fools who created the leak should be made to pay, but them paying is exactly what happens.  Let us not be so eager to spite the bankers that we end up watching the dam explode and drown us all.


  1. The problem is, that isn't something we can all agree on. There are plenty of people who think the poor deserve to be poor and have no problem with them suffering disproportionately in a downswing.

  2. No, the people who created the problem did not pay. Executives who made the decisions that led to the collapse were paid fantastic bonuses for those decisions (prior to the collapse) and not only got to keep money they earned fraudulently (because some of it was actual fraud) but many kept their positions and started writing themselves big checks again almost immediately.

    Even if some did lose their positions ignomiously, they still got to walk away with a fortune. If they *feel bad* about only having a few million dollars to show for their efforts, that doesn't seem like a bad thing happened to them to anyone else.

    The people who paid were a diverse bunch from wealthy investors to people who just lost their retirement savings.

    In Iceland right now about 1 in 10 people in prison is a banker in prison for corruption connected to the financial collapse. My understanding is that in America one single person went to prison.

    If the government made a $23 billion profit on an $85 billion investment over 7 years then that's an interest rate of 3.4%. Considering that the world was in a liquidity crisis and AIG was going to collapse, yes, that is a bailout and a gift. Considering that the government could be earning an effective interest rate of 15%, 25%, or maybe up to 70% by investing that money in roads and education, it is a fantastic gift, mostly to rich people who were going to be rich even without it.

  3. Well, you know I agree with you about executive pay. I also agree that if bankers broke laws they should face prison time - there is a real problem with people not seeing white collar crime as real crime because the people involved don't 'look like criminals' even if the things they do are really destructive.

    On the numbers though - that $23 billion was made in more like two years rather than seven. Then the total can be invested in roads, schools, whatever else. However, no one is suggesting that government investing like this should be the norm, but in a crisis the government was also purchasing stability. If the contagion spreads and the economy implodes and millions more are thrown out of work that is a catastrophe, so the government was getting a small return on their main purchase of "the country isn't completely boned".

    I would much rather we have strong regulation rather than bailouts, but I think it is important to understand that once we were in a disastrous situation, the bailouts were necessary to prevent things getting worse and didn't actually lose the government money. We should know how the decisions work so we can decide when, if ever, to make them.

  4. I'm not convinced things didn't get worse.

  5. I am not convinced the US Government didn't lose money on the bailouts. AIG was going bust because they had insured CDOs assuming the default rate on mortgages would not exceed a certain level. The US government spent hundreds of billions to ensure that the default rate stopped increasing. Moving money from your left pocket to your right pocket does not make you richer.

    The US deficit was significantly lower in 2008 before the bailouts, than any year since.

  6. @Dave

    AIG didn't cost the government money in the long run. The company lost a boatload of money, but because of the government bailout they survived. The government turned a profit, albeit a modest one.

    The US deficit was high, for sure, but that is because of all kinds of things like the shrinking tax base due to high unemployment, stimulus funding, ongoing wars, etc. The downturn was a major fiscal problem but the actual bailouts made the government money, and they helped prevent the problem becoming even worse than it was.