Too big to fail?

Too big to fail?

Gary Stern, former president of the Minneapolis Fed, co-authored a book called "Too Big To Fail" with Ron Feldman.  At first glance, this book could be tossed into the pile of books flooding out of the wake of the financial crisis of ought-8.  Except that this book was published in 2004, and sounds incredibly prescient based on Stern's conversation with Russ Roberts on Econ Talk. 

Economists and libertarians regularly sound the alarm about "moral hazard", whether it's in relation to this most recent financial crisis, or in many areas of public policy.  To put it as succinctly as I can, moral hazard means that you will act differently if your actions are insulated from any risks that your actions engender.  So you will probably bet more aggressively with someone else's money than you would bet with your own money, especially if you get to keep any winnings garnered by your bets.

The moral hazard argument goes that bailing-out a firm is bad because the people taking the risks get paid if the risks pay out, but the tax-payers take the loss if the risks don't pay out.  This sounds an awful lot like gambling with someone else's money, and it creates perverse incentives for future decision-makers to behave irresponsibly because they know that they will be bailed-out.

Before we move on, it's important to understand what, exactly, happens when there is a bail-out.  My understanding is that, in general, bond-holders get bailed-out while equity-holders get wiped out.  What does this mean?  Equity
holders own stock in a company, so they reap large profits if the company does
well, but they can lose their entire investment if the company goes
bust.  A bail-out of a trouble firm usually forces equity-holders to take big losses.  Bond-holders, on the other hand, are essentially the firm's creditors:  They loan money to the firm at a fixed interest rate, and expect to be paid back their principal plus interest, regardless of how well the firm does.  Bail-outs usually protect bond-holders from big losses.

Why does it matter that bail-outs protect bond-holders but wipe-out share-holders?  One of the counter-arguments is that, while bail-outs do create a moral hazard, there is still tremendous pressure from equity-holders for the firm to act responsibly because the share-holders don't want to lose their investment.  The bond-holders, who are usually the ones who get bailed-out, don't really care if the firm acts irresponsibly because they are going to get back their investment anyway.  So they're not exerting any major pressure on the institution because they're protected one way or the other.

Here's the key insight I took from Stern and Roberts.  The pressure exerted by equity holders for firms to act responsibly is greatly, greatly exaggerated.  Why is this the case?  The majority of people and institutions who own stock are almost universally well-diversified, which means that they never own too much of one company (or one sector) that if that company goes bankrupt that they'll lose very much.  There simply aren't any equity holders who have so much at stake with the success of one company the they're going to bother putting much pressure on that company to act responsibly.  And the bond-holders don't own the company in the same way that the share-holders do, so they couldn't exert much pressure even if they wanted to.  And bond-holders don't really care anyway because they are the ones that get bailed out.

This brings us to the decision-makers---the investment bankers and managers and CEOs---who are running the company.  What are their incentives?  As Stern and Roberts point out, investment bankers get paid a big salary, but they also get paid stock options.  So they themselves are equity holders in the company and have an incentive not to bankrupt the firm.  However, employee stock-options are rarely structured such that employees can cash out everything all at once, so the stock options are a little more theoretical than shares of stock you or I might have purchased in the firm with funds in our IRA.  Now, throw onto this mix the fact that many managers are paid bonuses based on the "performance" of their firm, and you can see the moral hazard for excessive risk-taking start to take shape:  You'll be paid more in bonuses if your risky bets pay off, and while you'll lose your stock options if those risks don't pay out, you can't exercise all of those stock options anyway, so there's nothing truly lost out of your pocket.  Plus you're being paid a very large salary all along the way, and you'll be able to exercise at least a small number of your stock options.  So why not take excessive risks to jack up your bonuses and the value of the few stock options that you can exercise?

The point is that there is no single investor on the hook for enough losses when a firm fails to put pressure on that firm to act responsibly.  Equity-holders are either diversified investors with a plethora of other stock, or employees of the firm who can't exercise all of their stock options anyway, while the bond-holders get bailed out if the firm goes bust.

There's much more great information in the podcast, and I'm sure there's even more information in the book, such as a history of bail-outs over the last couple of decades.  But one thing is for sure:  I'm much less sanguine about the claim that some firms are too big to fail, and much more critical of why we let some firms get too big to fail in the first place.