Deconstructing the Put-Option State
posted by Nate Oman
Larry and David Zaring have a thoughtful piece making the case against an overly exhuberent regulatory response to the financial crisis. There is a lot of wisdom to what they say. At its bottom, however, it seems to me that the keygovernment failure lay not in our regulations but in our political culture. As Simon Johnson (of the must-read Baseline Scenario blog) observes in the most recent issue of The Atlantic, our current debacle looks less like Wall Street circa 1930 than Indonesia circa 1997. The problem is not that we are reaping the whirl-wind of unregulated markets run amok, but rather that we are reaping the whirl-wind of a system where politically powerful business actors get the up-side of huge risks, while they can push the downside on to the public. We are living in the put-option state.
The put-option state is not the same thing as the deregulated state. Of course, by definition it is always possible to say ex post that any particular crisis could have been solved by better regulation ex ante. After all, if set of actions X had horrible consequences, it is tautalogical to claim that we could have avoided those consequences had we forbidden set of actions X at the outset. Hence, every problem can be seen as a failure to regulate ex ante. What the failure of regulation story doesn’t tell us, however, is why institutions engaged in self-destructive behavior in the first place. Yes, they did so because they were allowed to do so, but why did they want to?
The answer, of course, is that they didn’t think that they would have to pay if the whole thing blew up. They had the “Greenspan Put.” They could force the government to buy their bad investments at a mark-up and save themselves from bad decisions. This is not really what happened in 1929, but it is what happened all over the emerging market world in the late 1990s. Bankers in Thailand, Korea, and Indonesia with powerful political connections made out like bandits on risky or self-dealing transactions with the knowledge that they could bend the state (and through it the tax payers) to their benefit if things went bad.
The put-option state, however, is not a regulatory creation. There was no explicit government guarantee of the GSEs. There was no explicit government guarantee of money market funds. There was no explicit government guarantee of the commercial paper market. There was no explicit government guartantee of AIG, CitiGroup, Bank of America, Bear Sterns, or the rest. The put options on which these institutions built themselves don’t exist in our laws. They still don’t exist in our laws, as each of these bailouts has been conducted on an ad hoc, transaction by transaction basis. The put-option exists at the level of political practice rather than at the level of enacted law.
What this means, however, is that fixing the real problem — the put option state — is not a matter of simply changing our regulations. It is a matter of changing our political culture. It was the political culture, not the laws, that gave the put to the barons of Wall Street. What is needed to fix this is not a new relationship between the SEC and the CFTC. What is needed is political leadership that can shift the political culture itself. It is here, I believe, that the Obama Administration has made its gravest errors. It looks as though the stress tests are going to result in a further rescue of “solvent”-but-still-mysteriously-in-need-of-capital banks by converting billions of dollars in government preferred shares into common equity. In short, the tax payer goes from creditor to investor in order to save institutions that cannot save themselves by raising capital in the real market. We simply continue the put-option state.
The truth is that our current regulatory system actually has in place a set of procedures for dealing with insolvent banks, albeit procedures that would need to be beefed up to deal with current volume. When a bank is insolvent we put them in recievership, wipe out the equity and perhaps the junior debt and then sell off the profitable bits that are left. New managment is installed. The bank never shuts its doors. Money continues to flow in and out. Depositors and other senior creditors are protected. For any other kind of institution we would call this process bankruptcy, and it is blessedly where Chrystler has finally ended up (although it should have been there months ago). In the patois of the put-option state, however, this orderly process of liquidation and reorganization of the insolvent (the process that actually exists within our legal structure) has been tarred as “nationalization,” in order for the government to take even larger equity positions in banks. This is Orwellian rhetoric of the first order.
To paraphrase Cassius, the fault is not in our laws but in ourselves that we are underlings. As much as we may need regulatory reform, we need a new political culture more.
May 9, 2009 at 1:55 am
Posted in: Bankruptcy, Corporate Finance, Politics, Uncategorized
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Responses (4)
Frank - May 10, 2009 at 7:48 pm
These are all excellent points. Charles Morris’s Trillion Dollar Meltdown tells a similarly sad tale (at 153):
“Martin Wolf, the economist and commentator for the Financial Times, recently noted that over the very long term, global financial services profits are about twice as high as those in the rest of industry. That runs counter to a fundamental proposition of free-market economics, that profits across enterprises should even out over time.”
“The reason for the permanent advantage . . . is that they don’t really compete in free markets. . . . [I]n financial services, although the high profits accrue to managers and shareholders, their losses are usually partly socialized.”
Given that this pattern of privatized profits and socialized losses appears inevitable given the power of the financiers, shouldn’t we limit leverage?
I also agree with you on the need to change political culture. But if the Obama administration were to have “gone Swedish” (as Thomas Hoenig, President of the Kansas City Federal Reserve, has urged), it would have been slaughtered by the CNBC and Club for Growth crew. The name of the political game now is to avoid tripping on certain words….”socialism” is the preferred cudgel for the right, just as “privatization of Social Security” will be a cudgel of the left against entitlement reform.
I also think that if Obama had liquidated and reorganized the zombie banks, the negatively affected financial potentates would have organized a massive, “Harry and Louise” style political campaign against him. The parallel to health care doesn’t end there…that’s also an industry riddled with fake competition and governmental favors. I predict you’ll see a banking industry that looks a lot like the health care industry in a few more years…except with no obligations to look out for the disadvantaged and elderly!
Brian - May 10, 2009 at 9:18 pm
Is there any empirical evidence that then institutions that engaged in this self-destructive behavior did so believing and calculating that they had the political power to get a bailout if things went badly? This argument seems to be cut from whole cloth.
David Zaring - May 11, 2009 at 11:40 am
Nice post, and thanks for the kind words. I’ve got to say that I’m not totally sure that put options explain everything. Every shareholder in every one of these financial institutions wishes they hadn’t invested in those firms. They owned them, and they didn’t have a put option. So I think something else needs to explain why the owners of the firm failed to monitor their investments.
Frank Pasquale - May 18, 2009 at 3:01 pm
DZ asks “why the owners of the firm failed to monitor their investments.” I have a sense that fraud suits like this one:
http://online.wsj.com/article/SB124112607580674555.html
will help answer that question.
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