Some people have said that Americans go to hockey games to see fistfights and go to NASCAR races to see car crashes. This thought occurred to me over the past few days while reading The New York Times online. If there were a New York Times index, it would indicate that the financial crisis is over. I can’t recall the last time a financial crisis-related story was at the top of the home page. (Today’s Fed intervention into money markets may have been on top, but by the time I got there the lead story was Kirk Kerkorian selling stock in Ford.) Instead, we’re back to the presidential election and Iraq. For a while there, it seemed like we might have the car crash to end all car crashes in the financial system, with banks failing left and right. Now, it looks like we’ve just got a boring old recession, where millions of people will lose their jobs. Move along.
But even if the multi-car pileup has been averted, the cars are still just barely limping around the track. The problem seems to be a lack of fuel – credit, in this case. Andrew Ross Sorkin in that same New York Times points out that banks are taking their money and stuffing it into a mattress instead of lending it to companies. (Yves Smith at naked capitalism says that consumers are doing the same thing, which, while personally wise, is not the best thing for the economy.) Now, banks only make money by lending money. So why aren’t they lending?
My homespun theory: Banks are run by people, notably CEOs. CEOs are people like the rest of us (just richer and, often but not always, fatter). They are motivated by two main things: (1) making a lot of money and (2) not looking like an idiot. Maximizing profits for their shareholders is far down the list. Boards of directors are primarily motivated by (2), not looking like an idiot (and getting sued). In good times, when people underestimate risk, this leads to lots of leverage and juiced-up profits. In bad times, both motivations produce behavior that may be irrationally conservative from the standpoint of the shareholders. A CEO with a $5 million base salary who knows this year is going to be terrible and that he won’t get much of a bonus has no incentive to increase profits. He does have an incentive to make sure his bank stays in business – so he keeps getting that base salary – which means being as conservative as possible with cash. He also has no desire to go bankrupt and get hauled in front of a Congressional hearing (motivation #2), which again means being as conservative as possible.
Ironically, this is the flip side of option-based compensation. In the boom, it encouraged people to take too much risk in order to boost stock prices in the short term. In the bust, when my options are underwater, I don’t care about the stock price – I just want to stay in business so I can keep drawing my base salary and hang on until the next boom. (And I will almost certainly go to my board and ask them to reprice my options, but that will have to wait until they’re not mad at me.)
Note that this is irrational behavior for the company as a whole. As a shareholder, I want the bank to take some risk, and I am willing to accept some risk that it will go bankrupt; otherwise I would just invest in Treasury bonds. I can diversify away most of that risk by buying stocks in other companies. The problem is that the people running banks have very concentrated incentives that lead them to behave in ways that are not good for shareholders.
Is there a solution? I don’t know. In some countries, the government would take control of banks (at least by choosing the executives, like at AIG), but Paulson explicitly chose not to buy voting shares, and that was probably necessary to (a) get the banks to agree to the recapitalization and (b) maintain support in Washington and among the public at large, which is still deeply distrustful of direct government intervention. Basic microeconomics says that competition will lead some banks to start lending and take market share from others, but in an oligopolistic situation (I believe the nine banks that were bailed out first have about 60% of all banking assets in the country), that may not happen. Some form of government guarantees for loans may work, although I’m not sure what the details would be. We may have to wait for greed to once again take over from fear in the heads of those CEOs. Luckily, it always happens.