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Years ago, when I was teaching finance more regularly, I read The Squam Lake Report and thought its recommendation to improve corporate governance by requiring deferred compensation (in cash) for top management made sense. Why should a manager with significant oversight responsibility be paid in full today if the firm does not survive well into the future? It is a straightforward approach to moral hazard when the consequences of a manager's actions take some years to be fully realized. Put a portion of the payment in escrow, and hold it there until reasonable performance has been demonstrated.

I'd like to propose two other applications of the same basic idea to areas I have been thinking about for teaching and research of late. Consider the payments that are made by the public sector to organizations that operate prisons. Why should a prison be paid in full today to incarcerate an inmate who recidivates shortly after release? One estimate puts the rate of recidvism at 40% within 10 years. The prison operator has considerable control over the inmate's daily activities while incarcerated. That time should be used to help prepare the inmates to stay out of prison upon their release. If it is not used productively, it shouldn't be just the taxpayer who bears the financial cost to re-incarcerate the prisoner. Why not condition a portion of the payment to the prison operator on the released inmate staying out of the penal system for some period of time? Put the payments in escrow, and release them to the prison operator slowly over time, based on the released inmate's law-abiding behavior. The low cost of interventions like prisoner education and job training compared to the relatively high cost of re-incarceration suggests that prison operators have room to do a better job.

The other example is higher education. Policy makers are currently wrestling with the issue of what to do about student debt repayment. By some estimates, 1 in 6 borrowers are severely delinquent. Why should a university be paid tuition in full based on the proceeds of a loan that may not be repaid? The university has every opportunity to convey knowledge and teach skills that increase the likelihood of repayment. But it does not bear the financial consequences of a loan not being repaid. Instead, put a portion of the tuition payment in escrow, and release it only as the student loan is repaid. This arrangement provides a financial incentive for universities to provide a better education and to avoid enrolling students who are unlikely to be able to convert this education into enough earnings to repay their loans. These two issues are at the heart of our student debt repayment problem. The problem is financial -- the solution should also have a financial component.

This month, The New York Times in Leadership will be featuring a short post from me with some reflections on what we have learned about leadership in the six years since the onset of the financial crisis. It is based on a session I have done a couple of times for the Rockefeller Leadership Fellows program at Dartmouth. Here's the conclusion:

Ironically, the leadership lesson of “Too Big to Fail” is that we must lead proactively before a crisis so that leaders can remain comfortably on the sidelines when a large financial institution works its way into trouble.

Read the whole thing.

One of the reasons I enjoy Ezra Klein's writing so much is that he will occasionally spin out a column like this one, "How Wall Street Takes Advantage of the Ivy League's Failures."  It is quite provocative, but let me reply with a question.  Has there ever been a time when the Ivy League's graduates have not gone in large numbers to the highest profile, most socially or financially rewarding occupations after college?

I'm going to venture that the answer is no.  The difference today is that the most socially and financially rewarding occupations tend to be disproportionately in finance (or Teach for America, as Ezra repeatedly interrupts himself to note).  And some of what we see in the financial industry today is grotesque, and that's what gives Ezra and the rest of us pause.

I will add, from my own point of view, that the typical Ivy League education needs to be more carefully reconsidered than what most of the Ancient Eight institutions are doing.  If you are curious to see what we are doing in this regard under my direction at the Rockefeller Center at Dartmouth, take a look at our student opportunities.

This post by Brad DeLong, America's Financial Leviathan, provides a valuable taxonomy of the roles that a financial sector is supposed to play in a market-driven economy.  By my count, our current financial system is going 3 for 5 based on his classification:

  1. Insurance and diversification
  2. Finance of large, illiquid assets with small, liquid liabilities
  3. Enabling current borrowing against future, uncertain income streams
  4. Reducing transaction costs
  5. Promotion of better corporate governance

Brad notes, and I think it is pretty clear, that our financial sector is doing #1, #2, and #4 well and doing them better over time.  The financial sector is doing #3, but when done to less than fully rational customers, this is not an unambiguous win.  The biggest failures in the financial crisis were associated with the misuse of debt (and you could argue that some of them belong in #1 and have a point).  The financial sector may be doing #5, but the obvious places where it is not are just so glaring -- starting with publicly traded firms in the financial sector itself!

The larger context of Brad's post is to question whether the financial sector's increased share of GDP over the past six decades has contributed to economic growth.  Given how much of the financial sector is no more socially useful than a casino, I don't see how that could be the case.  Worse, the "house" and several of the "players" in this casino have used their growing resources to subvert our political institutions into believing that their institutions are "too big to fail."

I confess: I get annoyed beyond measure when I read articles like this one from Alan Zibel and J.W. Elphinstone of the Associated Press, which ran in my local paper this week. It manufactures drama where none is warranted. Here's the hook:

Just when consumers and the U.S. economy need banks to lend more freely, the mortgage industry is making it harder to borrow — even for those with good credit.

Mortgage insurers, whose backing is required for borrowers who can't afford the traditional 20 percent down payment on a home, have already flagged nearly a quarter of the nation's ZIP codes where they refuse to insure some home loans.

I'm already annoyed in three ways, and it's just two sentences in:

  1. Consumers and the U.S. economy do NOT need banks to lend more freely. Banks lending too freely is what got us into the current mess.
  2. The traditional 20 percent down payment for a home exists in part because mortgages are nonrecourse loans--the property is the only security the lender has in the transaction. While some reductions of that number may be appropriate, it was the abandonment of sensible lending standards that got us into the current mess.
  3. The word "some" in the last sentence smuggles in quite a lot. If the meaning of "some" were made plain early in the article, we would stop reading and disregard the article as not worth our time.

We do find out what "some" means later on in the article:

In recent weeks, mortgage insurers have flagged more than 9,600 ZIP codes in at least 34 states where they won't insure certain types of home loans — those for investment properties or second homes, those with riskier adjustable-rate or interest-only mortgages, or for buyers making down payments of less than 3 percent.

"Some" home loans are now revealed to be loans that are extremely risky--loans whose pervasive use are what got us into the current mess--in areas where house prices are declining the most. So a shorter version of the article is that mortgage insurers are now not willing to insure loans that they shouldn't have been insuring earlier. That this is a good thing has completely escaped the notice of the two authors.

Ben Bernanke would be played by Harvey Keitel, reprising his role as Winston Wolf if we're lucky or Victor the Cleaner if we're not.

The responsibility for this financial meltdown does not rest with him. It was his predecessor, Alan Greenspan, whose stewardship of monetary policy set the stage for the debt-laced consumption rampage of the American consumer and the leverage-soaked financial carnival of mortgage lenders and investment bankers. (If you're keeping score at home, Greenspan still doesn't get it.) Based on his performance so far, I'm nominating Ben Bernanke to the All-Madden team of central bankers.

Bernanke has two broad categories of options:

1) Damned if He Doesn't

Bear Stearns just collapsed--it cannot pay its creditors. What was a liability to Bear Stearns was an asset to some other investor. That asset now has no value. If the other investor was also a financial institution, then it has fewer assets relative to its liabilities and is now less solvent. It may not be able to pay all of its creditors. And so on, all through the leveraged financial sector.

The Fed can act to prevent or mitigate this cascade. Looking at the prospect of contagion, the Fed has acted on two fronts. It has lowered short-term interest rates to prop of asset values across the economy. As discounting for risk has increased, discounting for time has decreased. The Fed has also intervened in specific episodes, directly backstopping private actors like JP Morgan who have stepped in to assume the liabilities of the likes of Bear Stearns.

Bernanke can't sit idly while large financial institutions crumble. There is a perception, if not the reality, of too much collateral damage in the process.

2) Damned if He Does

The Fed is supposed to be the economy's lender of last resort. If a solvent but illiquid bank needs short-term cash and cannot find it on the private market, the Fed should make credit available. Without this backstop, financial institutions would be less willing to take leveraged positions in support of beneficial economic activity.

But sometimes financial institutions take these leveraged positions in support of exceedingly risky activities. This is particularly true when they hold a put option to sell the activity to someone else if its value falls. Any intervention by the Fed extends that put option to would-be speculators, if not today, then certainly in the future.

You can call this Samwick's Law if you like:

If an institution is deemed too big to fail, then it is only a matter of time before it finds a way to get big and fail.

When you provide insurance against outcomes that a financial institution cannot control, you distort incentives on the activities it can control. Specifically, they take on more risk. To address the immediate problem, Bernanke invites the next one. Snotty bloggers two or five or ten years from now may be hanging the next crisis--runaway inflation, a persistent liquidity trap, even more spectacular bubbles in financial markets--around Ben's neck.

The task of finding the least worst way to do the wrong thing is a thankless one, but Bernanke is persevering admirably. Let's see what he does at 2:15 today.

My commentary on the Bear Stearns bailout aired on NPR's Marketplace this evening. Here's the teaser:

The collapse of Bear Stearns prompted the Fed to once again cut interest rates. Commentator and economist Andrew Samwick says whether you call it a bailout or a rescue, all Americans have a stake in the outcome.

And here's an excerpt:

Two questions immediately come to mind: Is this fair, and should we care? The question of fairness is easier to answer -- of course it isn't fair. Bear Stearns' fall from grace was its own fault. It was the high-wire act in a leverage-soaked financial carnival.

And yet those in the corridors of power have intervened on the perpetrators' behalf. Some people call this "socialism for the rich." Even that's too generous -- under socialism, the rich would be paying higher taxes during the boom times. No, "fairness" is not a word that describes this bailout.

So life is unfair... Does that mean we should care?

Enjoy!

We'll give FDIC Chairman Sheila Bair credit for this bit of lonely prudence in a financial sector gone mad:

"There are significant uncertainties regarding our projections, and given the challenges facing the banking industry and the likelihood of more bank failures, I believe preparedness should be our overriding concern," said Sheila C. Bair, FDIC Chairman. "Because we are anticipating more difficult times, it would be prudent to continue to build the deposit insurance fund at the pace allowed by the current rates and the remaining credits. As we build up the insurance fund, banks and thrifts should be taking steps to bolster their capital and reserves.

This was her very sensible justification of the FDIC's board's decision to keep the assessment rates charged to insured banks and savings associations unchanged for 2008. And into the fray jumps Wayne Abernathy, now the executive vice president at the American Bankers Association, who is quoted as follows:

The decision today could mean that as much as $20 billion or more of bank services will now not be available to invest in new jobs and new businesses this year, precisely when new jobs and new business investments are most needed.

So, according to this logic, it makes sense to blame the FDIC for its prudence rather than the worst offenders represented by the ABA for their recklessness for the absence of $20 billion dollars from the banking system in the near term.

It is amazing what a change of employer and address can do.

As the old saying goes, when America sneezes, the rest of the world catches a cold. A second day of selloffs in overseas markets prompted the Fed to cut 75 basis point cuts in both the discount rate and the federal funds rate. From The New York Times this morning:

The Federal Reserve, responding to an international stock sell-off and the likelihood of a sharp drop in America on Tuesday morning, cut its benchmark interest rate by three-quarters of a percentage point.

The Federal Open Market Committee lowered its target for the federal funds rate on overnight loans between banks to 3.5 percent, from 4.25 percent.

In a statement, the Fed said: “The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households.”

“Moreover,” the statement continued, “incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.”

In a related action, the Fed approved a 75 basis-point decrease in the discount rate, to 4 percent.

Within minutes after the announcement, trading in stock-index futures, which had been presaging a deep slide on American stock exchanges Tuesday, retraced much of their earlier declines, which had been driven by a second sour day in Asia and Europe.

The reaction of the overseas markets is what strikes me as excessive. Conditional on that, a rate reduction of some magnitude (if not 0.75 percentage points) is not much of a surprise. It should make for an interesting week in the financial markets.