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Obama’s (i.e. The Volcker) bank plan

Those of us who aren’t American but still follow U.S. politics were quietly giggling (okay, openly guffawing) into our latte’s last week when Scott Brown won the special election to replace the late Ted Kennedy.  The Daily Show’s take on the whole affair (I think it was broadcast the night before the election day) was spot on and I urge anyone with the capability to hunt down that episode.  In short, the Democrat’s handling of the event is a classic example of why the word clusterfuck was invented. What in blazes they now intend to do in passing any reasonable kind of reform in health-care (and the ideas on the table weren’t really all that reasonable to start with) is beyond me.

Anyway.  I tip my hat to the newest federal Senator in the United States for an expertly handled campaign.

I was then surprised to (finally) see some equally smart politics from the White House in the form of Obama publically supporting the banking regulation ideas of former Fed chair and octogenarian, Paul Volcker.

The White House had already been making noises about imposing a fee on financial institutions to recoup any losses in TARP.  TARP, if you remember, is the US$700 billion officially set aside under president Bush Jr. to help the finance industry weather the storm.  Of course, a large fraction of TARP was diverted to help the car (that’s “auto” for any Americans in the audience) industry and not all assistance to the financial industry was included in TARP.  Still, it’s the closest thing to an easy target with a pronounceable name.  If you care, you can read my incredibly brief thoughts on the levy here and, more importantly, here.

But the Volcker plan is an entirely different kettle of fish and can be boiled down to a simple and beautiful phrase:  “Too big to fail is just too big.”

It calls for constraints on the scope and the size of US banks.  It seeks to ban proprietary trading at institutions that hold retail deposits.  It’s an armchair commentator’s wet dream come true!  It’s also, unfortunately, staggeringly unlikely to ever become reality.  There are two reasons for this.

First, as expertly described by the Economics of Contempt, the White House has no intention of pushing this through anyway.  Instead, it was …

… a fairly transparent political stunt — the White House needed to do something to take the media’s focus off of health care 24/7, so they flew in Volcker and announced some proposals that sound good to the media. The two Senate staffers I talk to regularly both said their offices were basically ignoring Obama’s proposals, because even if the White House fights for them (which they won’t), Chris Dodd has no intention of inserting them into his committee’s bill. I like how some people think Obama’s proposals represent a fundamental turning point on financial reform, because….well, clearly this is their first rodeo. (Hence the uber-quixotic language they use to describe financial reform.)

[Update: Just to clarify, when I said Obama’s announcement was a “fairly transparent political stunt,” I wasn’t criticizing the Obama administration. We live in a political world, and political stunts are often useful. If I were Rahm Emanuel, I’d be a dick have done the same thing. I think it was probably a savvy move, and if health care reform ends up passing, then it was worth it.]

Second, the U.S. Supreme Court, in the second move in the space of a week to leave the America-watchers of the world chuckling, decided to reverse decades of precedent and assert that when it came to political speech, corporations, unions and other groups of individuals have more power than individuals.  Not only can corporations, unions and the like directly fund political campaigns, but unlike individuals, they are subject to no limit on their donations.  It’s great.  You’re going to end up seeing major political events sponsored by Pepsi.  You’re going to have unlimited funding available to opponents of any politician that does anything that runs contrary to a company that employs people in his or her district or state.  In short, you will never, ever again see anything serious passed in an election year in the United States unless it has not just bipartisan, but unanimous support.

So, no, as much as I like what Obama said, I don’t think it’ll ever become law.  It certainly won’t in 2010.

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The Chrysler bankruptcy

This is not a post about how Chrysler might work going forward, nor a post about how dastardly the hold-outs are.  This is a post about the distribution of haircuts and the move from White House-led negotiation to bankruptcy court.

There are broadly four groups of creditors:  The (sole remaining) shareholder, the union/pension-fund, the bond holders and the US government.

Clearly the shareholder should be wiped out.  The question is how much of a haircut everybody else should take.

I believe that by law, the US government would take the smallest haircut (get the largest fraction of their money back) as they’re super-senior, then the bond holders in decreasing order of seniority and the union/pension fund should get the biggest kick in the teeth.  The hold-outs were secured creditors, which means that if the company is liquidated they get a pretty senior claim on the proceeds.

[Update: Duh.  The government isn’t a super-senior bond holder, it’s a preferred share holder, which means that it’s claims, in principle, ought to be subordinate to the bond holders]

As I understand it, the deal on the table had the order differently.  The unions were getting back something like 60c on the dollar, the government 45c on the dollar and the bondholders 25c on the dollar (those numbers are made-up, but indicative).

That conflict between what would normally happen and the deal on offer was what gave rise to this sort of comment from Greg Mankiw:

The Rule of Law — Not!

Via the WSJ, here is the view from a “secured (sic) creditor” of Chrysler:

“Like many others I made the mistake of buying what I believed was ‘value,'” Mr. Gwin says, adding that investors who bought at the time believed the loans were worth more than their market price. “We did not contemplate having our first liens invalidated by a sitting president,” he adds.

As the President intervenes in more and more industries, a key question is how he does it and what he is trying to achieve. Is he trying to reorganize insolvent firms while, as much as possible, preserving the rights of stakeholders as established under existing contracts? Or is he trying to achieve a “fair” outcome as he judges it, regardless of preexisting rules and agreements? I fear it may be the latter, in which case politics may start to trump the rule of law.

Mankiw has an uncanny ability to irritate me at times and although he has a bloody good point, even a vitally important point, this post did irritate me because I suspect that most bankruptcy arrangements aren’t fair, for a few reasons:

First, bond-holders, like equity holders, are ultimately speculators.  We differentiate the seniority of their claims legally, but the fact is that a guy holding a Chrysler bond is just as much of a punter as the dude holding one of the shares.  They (presumably) had the same access to information about Chrysler’s future and they (hopefully) both knew that their investment came with risk.  The idea of one subset of one factor of production being largely protected from the risk of the company’s failure is silly.

Second, employees are not speculators in the same way that the providers of capital are.  The cost of taking your money out of a company’s bonds or shares and moving it to another company is negligible.  The cost of taking your labour out and moving it to another company is significant.  At the very least, you are often geographically tied down while your money is not.  Therefore the socially optimal decision would help insure the employees against the risk of the company failing but leave the capital to insure itself.  Since US unemployment benefits (the public insurance framework) is so measly, it seems reasonable to grant employees partial access to the assets of the company.

Third, in every company to some extent (although varying depending on the industry), the employees are the company.  At an extreme, ask what a law firm would be worth if you fired all the lawyers.  Therefore, even if labour were perfectly mobile, there is a game-theoretic basis for giving the employees a stake in the game:  Principal-Agent problems exist all the way down to the floor sweepers.  This is an argument for German-style capitalism where the workers are also minority shareholders.  You might argue against workers’ representatives on the board of directors, but I do think they ought to have a share holding.

Fourth, even if all of the above balanced out to zero, there might (might!) be be beneficial social welfare to ensuring that the company is an ongoing concern rather than liquidated.  When they pushed Chrysler into bankruptcy, the hold-outs were doing so because they would get more money under liquidation than the deal on the table.  If there is a benefit to social welfare in keeping the company open, there ought to be a way to force the bond-holders to take a hefty haircut rather than liquidating the assets, even – and this is where Professor Mankiw might really get upset – if it wasn’t Pareto improving (the needs of the many …).

Nevertheless – and this is why Mankiw managed to get under my skin on this occassion – I am glad that Chrysler has gone into bankruptcy.

I am glad because even though I largely agree with the White House’s proposal, and even if my four points are all true, it is not the job of the executive to be making these decisions.    There are entire institutions set up for it.  The bankruptcy courts and the judges who preside over them specialise in this stuff.  By all means the White House might make a submission for consideration (as the executive of the country, not just as a stakeholder), but it should be up to the judge to decide.

I suspect, or at least like to imagine, that Barack Obama knows all this already (he is a constitutional lawyer, after all) and that he pushed the negotiation down the path it has taken because politically he needed to be seen to be trying to “save” Chrysler from bankruptcy and economically ne needed to avoid the market turmoil that would have ensued from a sudden move to bankruptcy rather than the tortuously gradual one we have seen.