Student Blogger - Bailout Panel: Picker, Cochrane, Baird, and Henderson

Update: You can now listen to a podcast of this panel.

The current financial period is--according to Professor Randy Picker--an "interesting time." On Wednesday, October 15, the Law School Republicans and Democrats co-hosted a panel on the bailout featuring Professors Doug Baird, Todd Henderson, and Picker from the Law School and Professor John Cochrane from the Graduate School of Business across the Midway. The panel demonstrated just how interesting these times are with a lively discussion.

What academics try to do is understand, and Picker laid out a plan for doing so with respect to the bailout. He will teach a seminar winter quarter on bailouts with the help of Baird and Henderson, and the Law School will host a conference in the spring on the current crisis and response. The desire for an immediate response prompted this panel. If the seminar and conference are the final 451-page bailout package, this panel is like Paulson's 3-page proposal--only more successful.

Picker started with an overview of the legislation of the past 72 hours, presented through the medium of--surprise!--PowerPoint. First, the government executed the first level of the $700 billion Trouble Assets Relief Program (TARP) by buying $250 billion of preferred stock in banks. Originally, the government planned to buy distressed assets from banks rather than take a share but instead decided to follow Europe's lead. (Warren Buffett received much better terms from Goldman Sachs for his $5 billion. Picker noted, "Buffett is smarter than the government, but we knew that.") TARP has "shockingly broad" language covering "any other financial asset." Baird interjected that even language that broad may be insufficient because some instruments may not take the form of an IOU. Second, the FDIC took advantage of previously granted emergency powers to guarantee several new types of debts besides depository accounts. Third, the Federal Reserve commenced a new commercial paper program using its emergency powers under § 13.3 of the Federal Reserve Act.

Cochrane first described what the problem isn't. He distinguished a credit crunch from a change in supply or demand of credit. In a credit crunch, borrower and lender preferences do not change, but something prevents the transactions from occurring, trapping the market at an artificially low amount of lending. He analogized a credit crunch to a situation where people want to buy corn, other people have corn to sell, but all the trucks are broken down. If the preferences of borrowers or lenders change, however, the market still reaches equilibrium; the change is that the equilibrium is at a lower level of lending. The takeaway is that a reduction in lending does not necessarily indicate a credit crunch. Banks may be unwilling rather than unable to make loans. During the question-and-answer period, a student asked the necessary follow-up: how do we know which is which? Cochrane indicated that the current situation is probably not a credit crunch because banks have access to money from each other and from the Fed, so the mechanisms are all in place. People just aren't using them.

The real danger, according to Cochrane, is political risk, the uncertainties of constantly changing rescue plans, and a "contagion" of bailouts that will do nothing to help the banking system. As the economist on the panel, he offered a forecast: new bailout plans every 72 hours. Politicians do not know when to quit, or even what to do (go to 3:37). He did not express confidence about the plans, including a proposal for a second fiscal stimulus package. Cochrane quipped, "The premise of a fiscal stimulus is that Americans do not borrow enough and do not spend enough. Enough said."

One source of the current problem, Cochrane continued, is bankruptcy law. While taking time to sort out all the obligations is fine for "Joe's Hardware Store," the system does not work so well for financial institutions. A bankrupt company should be quickly liquidated so others can make better use of its assets in the market. Baird, though not wanting to be defensive, rose to the challenge during his portion of the presentation and pointed out that Lehman Brothers went through bankruptcy in a single work-week, starting Monday and selling off assets Friday afternoon. Most financial instruments are not subject to an automatic stay, so they are not locked up for a long time. Cochrane wondered, if everything worked so well, why were so many people concerned about investment banks winding up in bankruptcy court. Baird admitted that many transactions will require the banks as necessary counterparties, which may actually tie them up in bankruptcy court for significant time.

Henderson drew a troubling comparison between today's political climate and the Great Depression's. First, Hoover and FDR raised taxes in the wake of the crash. Today, complaints abound about rampant deficit spending, and raising taxes is an obvious way to correct that problem. Second, the government implemented protectionist measures such as the famous Smoot-Hawley Tariff. Today, NAFTA's popularity has declined since the 1990s, and concern is widespread about jobs moving overseas. Third, many people "prosecuted and persecuted" those who have done well in this market. Today, commentators often blame greedy capitalists and decry golden parachutes and growing income inequality.

The solution is, of course, freedom. Free trade and lower (or at least not higher) taxes are a place to start. The government should let more institutions become banks; Wal-Mart, for example, wanted to enter the banking market a few years back. Increased immigration could absorb the excess housing in the market. (Henderson exclaimed, "I could break into a Neil Diamond song here.")

An alternative Neil Diamond song is "Thank the Lord for the Nighttime":

I'll talk about plans now Baby, I got plenty

Nothing ever seems to turn out the way it should

Talk about money, girl, I ain't got any

Seems like just one time I'm feelin' good

Comments

[LAK]

Wait, did Todd Henderson have a straight face when he gave his talk?

It was too much "freedom" in the first place that allowed banks to spread mortgage risk so thinly system wide that the whole industry became, had to become, one (fee generating, bonus genreating) bubble. (Looking back, what was the social utility that securitizing mortgages added anyway?) It was too much freedom in the first place that allowed AIG to come up with unregulated credit swaps to further fuel the fire. Brilliant! It's like offering insurance to homeowners against fires, except with the caveat that if one house burns, they all burn. It's a bit funny to me how there is little comment about how we got into this mess in the first place, just how we should deal with it once we got to this point.

I wonder of Henderson thinks Dick Fuld's compensation was still justified. I guess it would be by his reasoning if a bankruptcy trustee said it was.

Yes clearly the answer is to double down by adding consumers in the form of immigrants and inflating the dollar. The last bastion of mediocre economists.

[Nathan Richardson]

LAK, you're right that there was less said about the past relative to the future in this talk, but I think that has to do with the fact that there were two bailout talks in quick succession; the earlier one (also posted here, I believe) focused more on what went wrong.

However, I don't think you understand either a) Henderson's arguments about executive comp or b) his point about immigration.

Re: a), Henderson didn't say any particular exec's pay was "justified," or stick up for Fuld. If you think his or anyone's pay needs to be "justified," though, you're missing his point. Execs get what pay the market sets for them, regardless of what you or anyone else thinks. Sometimes that's a bad deal of the firm - it certainly looks that way in Fuld's case. But that's no more of an issue after the fact than it is if you overpay for a used car - or if Lehman had decided to invest the cash they paid Fuld in some other dodgy venture. The way you put it, we all need to "justify" how much we are paid based on the "value" we add - and capitalism just doesn't work that way. You get paid, roughly, what the market says you're worth. That depends on your productivity relative to others also selling their labor, the availability of capital, and other factors - but not on some concept of what you deserve. Your arguments lead down the road to "equal pay for equal work," which even mediocre economists will tell you is a silly, long-discredited concept.

Re: b) in what sense is allowing immigration "doubling down," and how would it contribute to inflation? Even if it did have inflationary effects, what makes this one negative an valid refutation of the idea, without considering other benefits? A properly managed liberalization of immigration policy increases the average productivity of Americans both directly and indirectly, which, as you know, equals GDP growth. Even if you think this growth is intolerably inequal, you can still redistribute it and make everyone better off. You also don't address the simplest argument made in the talk for immigration - we have too many empty houses. If we've overinvested as a society in housing stock, we have a depreciating asset on our hands. Leaving them unused carries a substantial opportunity cost. There are, of course, non-crazy reasons to oppose immigration, but your snide one-sentence dismissal of the proposal doesn't contribute anything and fails to address the good arguments for it.

You might have some good points, but conclusory statements + unsubstantiated ad-hom attacks don't make a very good argument.

[LAK]

"If you think his or anyone's pay needs to be "justified," though, you're missing his point. Execs get what pay the market sets for them, regardless of what you or anyone else thinks. Sometimes that's a bad deal of the firm - it certainly looks that way in Fuld's case. But that's no more of an issue after the fact than it is if you overpay for a used car - or if Lehman had decided to invest the cash they paid Fuld in some other dodgy venture."

I’m missing the point? No. Actually you are. You seem to suggest that the outcomes of the “free” market are somehow self-justifying even if any number of alternative outcomes could result, and fail to recognize that the particular outcome here occurs within a game that actually does have rules that factor into the result. You seem to imply that the outcomes of this “free” market preclude any ethical considerations about the distribution of wealth or are misplaced in situations where you think that magical invisible hand is at work. Executive compensation is no more ethical or rational than millions of teenaged girls making Brittney Spears a wealthy star at the same time she teaches them to hate their bodies and themselves, or grown women determining that the handbags of one particular designer are worth $10,000 each.

In fact, I find it somewhat bizarre that anyone would argue that the outcomes of the “free” market are of any particular relevance or merit or are somehow so magical they need no ethical scrutiny or justification with the background of major economic collapse happening, itself the result of more sheep-like human behavior. A major fear cascade that is only rivaled by the greed cascade it followed is hardly the context in which you want to be arguing for the merits of free market efficiencies or that its results are somehow immune from ethical considerations.

Further, it isn’t just like overpaying for a used car. It is more akin to having to use a buying agent and only being able to hire that buying agent out of a select group of used car salesmen who are buying cars from each other on your behalf. All used cars are overpriced that way. Or have you not noticed the overlap of directors and CEOs at our major corporations? Having grown up with the super wealthy, I can tell you who sits on what corporate board often has to do with what country clubs you belong to and whose charities you support, or what eating club at Princeton you belonged to. The idea of “independent” directors on corporate boards is a relatively new one, and even then they tend to be chosen from the ranks of the corporate ruling class.

And I understand Henderson’s arguments pretty well. Something like that the collective action problems in shareholder oversight and the associated agency costs don’t play the role most rational academics claim they do in inflating CEO pay because if you look at bankruptcy, where that collective action problem and agency costs are not present, CEOs are still paid the outrageous salaries even when there are single shareholders in charge of making the decisions about whom to hire and what to pay. This argument is not at all compelling because the way the world works, even if I don’t have to hire a buying agent to buy me a used car, I’m still buying a used car with an inflated price. And if I try to avoid that by buying a car from someone other than that group of used car dealers, nobody is going to ride in it because those dealers have convinced the market those other cars are unproven or unsafe.

Calling for increased immigration to create demand for the imbalance in supply and plummeting prices is not to recognize or address the conditions that created the oversupply in the first place. That aforementioned, highly irrational and inefficient greed cascade that the lack of meaningful regulation almost guaranteed. Increasing immigration to increase the consumer base is not the way to go about addressing a top heavy house of cards. Building a stable house is. I did not suggest it contributes to inflation. The other answer that conservatives ironically seem to have is to throw money at banks to handle the fear cascade credit crisis (and then being forced to require them to lend it out), which will be inflationary when other countries wise up and stop buying our debt.

Nathan, my advice to you is to take a few classes across the Midway on legal philosophy and ethics, take a behavioral law and economics course and above all else, avoid the kool-aid at the Federalist society socials.

[Nathan Richardson]

You've written a lot, but haven't said very much. Again, you've spouted lots of ad-homs and unsupported statements, hoping to blind your audience into buying what you're selling. You still haven't addressed my points or Prof. Henderson's, instead pointing repeatedly to a "greed cascade" - that's nothing but a loaded, pejorative adjective tacked to an meaning-free noun. You might have a point, but I can't tell - you haven't advanced any facts or theories to support what you say.

And seriously, is giving me a list of courses to take and accusing me of narrowmindedness ("drinking the kool-aid"? really?) your idea of useful discourse? Chill with the hate and make an argument if you want to convince anyone.

[Uzair Kayani]

I think the problem with CEO compensation is similar to the problem with some recently maligned derivatives, in that CEOs are very difficult to price. Note that the price of (compensation paid to) a CEO is typically a mixture of (a) a base salary, (b) bonuses, (c) stock or other security options, (d) individualized benefits plans, and (e) expense allowances, and (f) severance. Because the payment scheme is fragmented in this way, it is difficult to price, or to compare.

For example, two CEOs might have similar stock options, but one might choose to pay stockholders dividends, while the other might pay them by repurchasing their stock. The stock repurchase will typically increase the value of the second CEO's stock options. Alternatively, the CEO might have his options repriced if he performs badly and the stock price falls, so that he has no downside for messing up, but does have upside for making stock prices climb. Expense and severance agreements are likewise difficult to compare insofar as they are customized and renegotiable.

A second problem is the supply of CEOs. The supply of potential CEOs for companies like Lehman etc is small. We could spin this positively and say that the thin market shows how good these CEOs are (maybe), but it also may show that the market is not competitive. The small number of potential CEOs can charge exorbitant fees. The interesting question is whether the limited supply of these CEOs comes from their extraordinary management skill or from some meaningless entry barrier. If it is the latter (say nepotism or the boys' club effect) then we should remove that barrier and expect CEO compensation to fall. Easier said than done, though: entry barriers abound in farming, government work, licensed professions (including the law, of course), and these, coupled with old school networks, create Jurassic Parks of overfed dinosaurs within these professions. There is indeed a market, but not a very good (competitive) one.

Two more perennial problems that make CEO pay difficult to judge are ambiguities in accounting rules (accountants have had mixed results "self regulating") and conflicts of interest.

Having said all this, I still think that the vast majority of CEOs do look out for their shareholders' best interests. I suspect these good apples are ignored for cultural reasons. Atypical groupings of any kind, including "business executives," are usually judged by their worst representatives.

Excuse the length.

[Karl T. Muth]

Uzair's comments would be true in a "level world" but the passing mention of conflicts of interest is simply not sufficient. If you look at the CEO pay cases that bring shareholder lawsuits, they tend to be CEOs that are so close with the boards that bring them on that it's effectively impossible for the board to complete its central function. I would argue that, in its oversight of management on behalf of the shareholders, the board essentially has only two jobs: 1) meet as required 2) hire and fire the CEO. To the extent that it cannot complete #2, the board is (in my opinion) failing at 50% of its job description. When you look at the types of salary negotiations that occur between "friendly" boards and prospective CEO's, I don't think it's that hard to argue that the board is appeasing a friend rather than "pricing" a CEO. And I say this as someone who is usually very, very skeptical of any accusations of "excessive" compensation for any person who has negotiated his or her salary.