08 February 2012

Bondholder Discipline

I largely agree with Bill Black in this EconTalk discussion about fraud in finance. I particularly appreciate that he doesn't make the issue of financial regulation into a Red Team/Blue Team fight.

However, this part of the exchange in particular doesn't sit well with me.
EconTalk | Russ Roberts | William Black on Financial Fraud

Black: But don't forget, in terms of key stuff about moral hazard: the government wasn't the only entity. There were shareholders at most of the worst places. And there was subordinated debt at many of the most fraudulent places. And of course in economic theory, it was supposed to be subordinated debt that was the perfect form of private-market discipline. You had the right incentives; you had the sophistication; and you should have done something. But there were zero cases of effective private market discipline by either shareholders or sub-debt holders in the Savings and Loan crisis.

Roberts: So, let me just review that, because we've talked about this in passing in many different podcasts, many episodes of this show. The debt holders have a fixed upside. They cannot make more than they are promised. Their downside is being wiped out. So in general, they are going to be the watchdogs of risk taking and the enforcers of prudence on the part of the people who they've lent money to through this debt. And what I have been worrying about for a long time, and it's a worry I've learned from Gary Stern's work, is: Well, that's true, that under a market system the debt holders are supposed to be the disciplinarians of risk taking, the watchdogs, but if the bond holders think that they might get their money back even when the firm goes out of business, which happened with Continental Illinois in 1984, you might start to not worry so much about that and be willing to accept a fixed rate of return even when there is a chance that the investment will amount to nothing, because you might get your money anyway. Correct?

Black: True, but not basic enough. In other words, you are quite right that Continental Illinois did a terrible thing and it bailed out sub-debt holders. We never did that in the Savings and Loan. We always wiped out the sub-debt holders. And of course they are supposed to be wiped out. That's the concept of risk capital. Despite that, there was never effective private market discipline; indeed there was no even effort at private market discipline. It failed, by sub-debt holders during that entire crisis.
I don't know that much about the S&L crisis; it was before my time. But my instinct is that Black is only looking at half the outcome matrix when he says there was "zero cases" of private market discipline from debt holders.

Anti-lock brakes are supposed to help prevent car crashes. If I looked at 100 cars which got in crashes, and saw that they all had anti-lock brakes, could I conclude that anti-lock brakes always fail to prevent crashes? Of course not! I'd have to consider how many other, non-crashed cars also had anti-lock brakes, as well as the crash rate of cars without anti-lock brakes.

Similarly looking at failed banks and noting that none of their subordinated creditors prevented excessive risk-taking does not allow us to conclude that creditors "never" provide discipline. To reach that conclusion we would also have to know how many other banks would have failed in the absence of discipline from their creditors.

There's another factor to consider, which is the discipline provided by not making the loan to the S&L. Suppose one lender provides an S&L with $10million, and nine others turn the S&L down for $10million each because they believe they are being too risky. If the bank later fails, is this evidence that the market provided no discipline? In Black's view, yes, because the lender who was supposed to prevent excess risk did not. In my view, no, because the losses were only one tenth what they would have otherwise been. It's the potential lender who is most optimistic about the risks who will make the loan, so we should look to the other potential lenders for evidence that market actors judged the risk to be too high.

There's a big difference between "provided no discipline" and "did not provide enough discipline." Since risks can only be minimized and never eliminated completely, it's especially important to recognize that distinction.

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