Ownership and control

The line between state-owned and 'private' firms starts getting messy in bailout-worlds. 

AUT's excellent Akshaya Kamalnath provides an interesting example with the bailout conditions on Air France - KLM.

There’s much to say on the topic of airline bailouts unfortunately. Today’s post is about Air France-KLM and the strings its bailout comes with. (My previous posts on this are here and here.)

Apparently the French government will make a loan of £6.15bn to the airline on the condition that it scraps domestic air routes. The stated motivation for this is environmental do-goodery. Bruno Le Maire, the economy minister, provided the following reasoning: “When you can travel by train in less than two and a half hours, there is no justification for taking a plane.”

We talk about conflicts of interest in corporate law all the time. Usually, this is in the context of board decisions. Let’s use the same lens to examine this bailout condition and ask, who owns the French Railways (SNCF). No prizes for guessing that it is fully state-owned. Incidentally the SNCF has also been running under losses since before COVID-19 and the situation has only worsened after COVID-19.

(Thanks to Leonid Sirota for inspiring this post.)

And Leonid is also at AUT in laws. Huh. I'd known they had an interesting econ department doing lots of administrative data work; hadn't twigged that both Leonid and Akshaya were at the law school there.

Foreign students fleeing to New Zealand could consider putting together an interesting joint degree between the two departments.

Contagion risk

Why bail out banks and financial companies? Capitalism is about profit and loss; if you bail out the losers, there's no end to the cost. Well, unless there's substantial risk that one bank's falling over wrecks the balance sheets of a pile of other banks, inducing them all to fall over too.

U Southern Carolina's Jean Helwege presented at Canterbury this past week. She and Gaiyan Zhang painstakingly went back through the balance sheets to examine the real contagion risk of Lehman's failure. Financial theory tells us that no firm will want to have too much of its balance sheet in any one asset. That's one of the main points of the Capital-Asset Pricing Model: you diversify away from non-systemic risks. And, regulations on banks and financial services mandate that they not have all of their investments in one place. So it wasn't all that surprising then that there really weren't any firms at strong risk of going bankrupt if their Lehman paper stopped being worth anything.

They open with Bernanke's analogy from a CBS interview:

Interviewer: “Mr. Chairman, there are so many people…who say, ‘To hell with them. They made bad bets. The wages of failure on Wall Street should be failure.” 

Bernanke: “Let me give you an analogy. If you have a neighbor who smokes in bed…If suppose he sets fire to his house, and you might say to yourself, you know ‘I’m not going to call the fire department. Let his house burn down. It’s fine with me.’ But then of course,…what if your house is made of wood? And it’s right next door to his house? What if the whole town is made of wood?...What needs to be done to make sure this doesn’t happen in the future? How can we fireproof our houses? That’s where we are now. We have a fire going on.”  

Turns out, there were already pretty big fire breaks and sprinkler systems in place; we seem to have paid for expensive water-bombers to put out fires on worthless garbage barges out at sea.

They conclude:

We find that counterparty contagion is significant but limited in magnitude. This owes to the fact that most of the counterparties have rather small exposures to the bankrupt companies. The largest exposures, revealed in the list of the largest unsecured creditors in the bankruptcy petition, often belong to the trustees of publicly traded bonds and since these bonds are widely held, the exposure of a single financial firm is substantially smaller. Outside of the trustees, we find that many of the creditors are financial firms, which supports the description of financial institutions as highly interconnected. However, financial creditors are rarely at risk of failing as a result of another firm’s troubles because these  firms hold diversified portfolios, as is often required by regulation. We find stronger counterparty contagion effects for Lehman Brothers and AIG but even these extreme events did not involve sufficient counterparty contagion to cause numerous cascading bankruptcies in the financial system.

We could laugh at the Americans, but we did have our own particularly ridiculous bailouts here in New Zealand.

In related news, I probably have the only kids on the planet who can be encouraged to eat the less tasty parts of their dinner on the promise of getting to watch this one for the n= (large and increasing)^th time:



It is ridiculously cute when a 2.5 year old girl pleads for "Keynes and Hayek!"

Best is when she demands the video with breakfast; no better way to start the day, really. "Eye of the Tiger" for economists.

Posting will remain light while I remain mired in grading hell.

Dunedin aftermath

Given that Dunedin chose to burden itself with a ridiculous stadium investment, it then became optimal for Dunedin Council to bail out the local rugby team - it cost less than Council would have lost in rental revenues from the stadium if the Otago Rugby Union went bankrupt.

Here's Dunedin Mayor Dave Cull (who was on Council but wasn't mayor when Council decided to build the stadium; he had voted against the stadium):

The ORFU was bailed out because "the financial model around the so-called private sector funding component of building the stadium is dependent on revenues from the games that professional rugby play there.

"I'd have to say, before it was being built and right up until now, that was the most imprudent, risk-laden way of financing anything. It was basically pretty stupid, but we've got it, and we have to find a way of maintaining the revenue stream for that, or it falls back on the ratepayer. This deal has avoided that,'' he told Radio Sport.

The NZ Rugby Union had previously said the new stadium would be key for the Otago team's viability; I doubt they expected it to be key in ensuring a Council (and NZRU) bailout.

Meanwhile, there's an investigation into what the stadium actually did cost the city.

Previously...

Angry words

Matt Nolan over at TVHE takes a swipe at the folks apparently scheduled to protest outside of RBNZ tomorrow.

I understand why people feel worn down, I understand the power and importance of non-violent protest, but I have to say something that will likely upset the protesters and many of my closest friends:

This protest and its message are wrong, and by doing it you both ignoring the real issues in the world and acting in a selfish way – and for that reason I think less of every single one of you.

That’s a pretty damned cutting statement – so let me discuss why I believe this.

Matt's right that RBNZ has made less a hash of things than the US Fed. Where I was worried about signs of impending inflation in early 2008, they rightly read the stats and saw hell about be unleashed.

People in the US are protesting because there seems to be no rhyme or reason to this change – furthermore, unemployment has been at 10% for a very long time, and all hope appears to be gone.  The fact that so much “corporate welfare” exists in the US is also very upsetting – as it should be.

But in NZ we haven’t had any of this – in fact incomes have risen sharply across the board, unemployment is still below the levels it was a decade ago (and employment rates are much higher), and we don’t have ridiculous corporate welfare policies.  We have great institutions – including the Reserve Bank – which have helped to ease the pain from the drastic global events on New Zealand.

… and yet the protesters are standing outside the very places that HELPED New Zealand during the crisis.  I’m not sure if this is because they don’t understand what is going on, or because they just think it’s a great way to get attention – but it is an extremely poor idea to protest there.

If you want to “show solidarity with the US”, do it at the US embassy – not in front of the very places that have helped all New Zealander’s out during a time of global crisis.

I'll quibble, but only ever so slightly. The RBNZ and Treasury were forced into a deposit guarantee scheme that provided one-way bets for folks investing in dodgy finance companies. For that I'd put more blame on Cullen and Key than on either RBNZ or Treasury. If you're going to be mad at one of the bureaus about it, Treasury might might be the better target. But both did the best they could in rather a bit of a mad rush.

It's right to be angry that South Canterbury Finance's losses were socialised. But I suspect that the Wellington protesters would not have supported that SCF investors take the haircut themselves; I'd also expect the protesters wouldn't particularly want AMI's customers/owners to take the insurance haircut after the Christchurch earthquake.

I'll entirely endorse Matt's conclusion:

There is another underlying issue that exists here, one that is very important to me.

There is all this talk about “inequality” and “helping the poor” … and yet none of these people want to help the poor or reduce inequality – they just want to take from the extremely rich and give to the very rich, which happen to be themselves.

The real inequality is not within nations, it’s between nations (a good example of how to view this was given by Nigel Pinkerton a couple of weeks back) – the calls by people in the US to introduce protectionism against China, the complaints in NZ that foreigners are “taking our jobs”, are further signals of the DISGUSTING self-interest that exists in these views.

These people aren’t interested in the poor, they are interested in themselves – either that or they haven’t thought about the issue, which is pretty slack when you are going to go out and protest about it.

If we want to help the real poor we need to open borders, and make a concerted effort to help increase capital and opportunities in foreign countries – rather than just focusing on ourselves.

When I here people complain that they are the “99%” do they realise that only the top 1% of people in India have a living standard greater than the bottom decile of people in the US?  Do they even care about the sheer number of people born without any opportunity to live the sort of privileged life we get.

Seriously, when I hear the complaints from these people, this is what I hear in my head:

“We want cheaper coffees and iPhones for ourselves, and people with lots of money should buy them for us”

But we can’t do anything about overseas, we can do things at home!

What a bleeding load of crap this reasoning is.  If the majority of the country put pressure on politicians to open borders and send tax money overseas of course they would – it would get them frikken elected.

In reality there is a reason people need to identify themselves as part of the “99%” … its because these protests are about them getting things for themselves – not about doing what is right.

And for this reason I find the protests insulting, pure and simple.

Americans are dead right to be very very angry about Wall Street crony capitalism that gives one-way bets to investment bankers in the name of preventing systemic risk. Two years ago, it was high time that a few banks go bankrupt, the depositors get paid out, and the bondholders get burned. Now, it's past due. It's obscene that Slovak taxpayers be asked to provide a bailout that covers rich German bondholders of Greek banks. We've fortunately not seen a lot of that kind of nonsense in New Zealand. We just don't have the same cause for protest.

But protests aren't really about policy anyway.

Insurance bailouts

The New Zealand Government has provided a backstop guarantee to Christchurch-based insurer AMI. Nolan at TVHE hits the main issues. Too much of AMI's book was Christchurch-based for the amount of re-insurance cover it had for a sequence of major Christchurch events. Yes, two huge earthquakes in Christchurch was a low probability event. But it's relatively cheap to insure against low probability events.

Nolan rightly points out:

• This introduces serious moral hazard for other insurers
• The intervention was poorly targeted

Here's what I told the National Business Review yesterday, now in today's print edition:

University of Canterbury economist Eric Crampton said his biggest worry about the AMI bailout “is the signal it sends to New Zealand insurers. Why bother carrying reinsurance over and above the statutory minimum and why bother ensuring you have a balanced client base if the taxpayer will bail you out if anything really bad happens?”

He said the government was right to worry about systemic risks to reconstruction posed by an AMI collapse. “But I’m not convinced a bailout was the best option. AMI policyholders, myself included, enjoyed lower rates because AMI had underinsured against the risk of local disasters. And, as it was a mutual, we don’t really have anybody else to blame.

“News reporting suggests AMI had sufficient capital and reinsurance to cover the costs of the Christchurch disaster but then would have had nothing left against other adverse events.

“Under those circumstances, I could have expected a haircut to Christchurch claimants or a surcharge on AMI members to help in recapitalisation and to fund the purchase of additional reinsurance against other large events.

“It isn’t as though there would be no payouts to Christchurch claimants absent a bailout; rather, the company would likely have been wound down subsequent to paying out on claims.”

NBR left out my last line, which I think is an important one (culled due to space constraints I'd expect):

Transitional assistance during that wind down could have been enough to avoid systemic problems while keeping sharp incentives for other insurers, and their clients, going forward.

The NBR piece continues:

University of Auckland Business School BNZ chairman of finance David Mayes was skeptical about possible “moral hazard” from the bailout. “I’m very cagey on moral hazard – very few companies are running on the hope they will be bailed out.”

He said AMI’s mutual structure presented problems both in terms of raising capital and selling the company. Getting approval from policyholders was “more difficult than doing it through a shareholders’ meeting,” he said.

Reserve Bank spokesman Mike Hannah said the government bailout of AMI shouldn’t be seen as setting a precedent due to the unique situation. “This is not how you would deal with a distressed insurance company in normal circumstances. However, this is a very unusual set of circumstances.”

David is certainly right that few companies run on the hope of being bailed out. But they may underinsure in reinsurance markets against low probability events that would draw political sympathy. Here's the Sunday Star Times, HT Hickey:

Sunday Star-Times calculations show AMI invested 3.7% of premium income in reinsurance. Other insurers exceeded 10%, with Lumley General reporting 16.3%.

And the NBR reports elsewhere (subscription):

Rival insurers are privately fuming at the government’s decision to provide a support package to AMI policyholders in case the insurer’s reserves run out.

An insurance industry source told the NBR this morning that, when discussing with colleagues the possibility of an AMI bailout, there were two main responses.

“The first one was, the government is going to get into even more debt, and the second one was, what about moral hazard?”

However, the source said AMI’s rivals would be unlikely to speak out against the bailout because “they don’t want to annoy the government in case they need a bailout themselves one day.”

The source said AMI was understood to have had a lower level of reinsurance than other comparable insurers, meaning it was able to charge lower premiums than it would otherwise due to the reduced reinsurance cost.

AMI customers benefited from those lower premiums and, now that they were being backstopped by the government, other insurers with more prudent levels of reinsurance were being "punished."

What I most want to know is why AM Best gave AMI an A+ rating, about the same as the other folks insuring NZ property, when AMI had this kind of risk profile. I'm insured with AMI and have a claim sitting with them for damage to our swimming pool and sidewalks consequent to the February quake; EQC is likely covering the rest.

Here's what went through my head when we bought insurance after moving to New Zealand:

AMI has better rates than the other folks and the same credit rating. They seem to be mainly locally based, so they might be subject to problems if there's a big Christchurch event. But that kind of risk has to be cheap to lay off through reinsurance and, besides, if they haven't, there's no way the government would fail to bail out in the kind of local event that would take out the insurer. I'll go with the low rates.

I don't always like to have my expectations fulfilled.

I don't think that moral hazard problems generated by this would really hit the big insurers: anybody internationally based would have international resources to draw down in the event of a disaster and so wouldn't be bailed out. Rather, the industry as a whole winds up with too many locally-based mutuals that can lay off risk on the government.

Sue them... sue them all....

Buyer's remorse? Worry not! If celebrity product endorsement led you astray, the government's here to help! At least in the finance industry.

Among measures likely to find their way into law by the end of the year are moves to tackle celebrity endorsements of financial products.

In Cabinet papers released yesterday, Mr Power said collapses in recent years had highlighted the issue.

"In at least one case, a celebrity specifically endorsed the strength of a finance company," Mr Power said in what appears to be a thinly veiled reference to All Black legend Sir Colin Meads' endorsement of Provincial Finance as "solid as". Provincial failed in 2006, owing investors $300 million.

...

Mr Power said that "advertisements of this nature can have a strong influence on the decision-making process of investors when they are assessing investment options".

He had asked officials for options to tackle celebrity endorsements including "the possibility of celebrities being liable to investors for untrue statements" in the same way investment "experts" already are.

The law relating to untrue statements already allows for financial penalties, as well as compensation for anyone who loses money on an investment made on the strength of an expert's advice.

This has things precisely backwards. The problem isn't celebrity endorsement of investment product. Rather, it's folks willing to accept ex-rugby stars and former TV news announcers as providing expert investment opinion. Does Simon Power really think that but for the celebrity endorsement, the folks who put their life savings into dodgy finance companies paying a point or two above a Rabobank term deposit would suddenly become enlightened investors putting their money into passive diversified index funds?

Why not be consistent: let any buyer sue any celebrity whose endorsement led to buyer's remorse. And the actors on the ads too. I want to sue all the people in the Mentos ads. I've no problem with the mints, but they never make me quite as happy as the folks in the ads promise. And the woman in that irritating cleaning product commercial who implies you can clean up your whole kitchen in about a minute if only you have the product she's selling. That's never worked out for me. And I want compensation.

I was going to embed a video of Weird Al's song, "I'll Sue You". But Sony's geographic restrictions mean I can't even watch it in NZ. I want to sue them too. And any actor who's ever appeared in their commercials. Only their punishment can make me whole. [Update: I also want to sue Weird Al. I had tickets for his Christchurch show. He bailed when the venue fell down due to the earthquake. But I still want to sue.]

If we're going to sue anybody over Mom and Pop investors making idiotic investment decisions, we ought to start with the government. The government's refusal to make credible commitments that they'd never ever bail out the folks who voluntarily chose to invest with risky finance companies probably led more investors astray than did any rugby star. Or maybe we ought to sue those investors who knew that the government couldn't help but bail them out if things went wrong.

HT: DimPost

Nobels that aren't, but someday could be

Willem Buiter in the Financial Times reports on Kornai's soft budget constraint as it applies to bailouts and the financial crisis

In a post a few days ago, (After subverting bank insolvency, our leaders are now about to make a mess of liquidity) , I argued that hard budget constraints were the defining characteristic of a well-functioning market economy. Many/most of the advanced industrial countries were weakening or even undermining the capacity of their financial sectors to intermediate efficiently by permitting a softening of the budget constraints of banks and other financial institutions that were deemed systemically important and/or were too politically connected to fail. I noted that the concept of the soft budget constraint (SBC) came from professor János Kornai, a great economist and a Nobel prize winner (the overlap is by no means perfect - there are type I and type II errors).

I'm rather sure that Kornai has not received a Nobel. I love his work on the soft budget constraint and I would love a world in which his kind of work (like Ostrom's), rather than the latest refinements of statistical techniques, gets Nobels in Economics. Hopefully we're moving to such a world. But we're not there yet.

Kornai gives some rather nice cautionary notes about bailouts.

One strong concern expressed more than once in discussions on the present financial crisis has been this: the interventions by the state are smuggling a bit of socialism into the capitalist economy. This is the side of the debate to which I would like to contribute, as a research economist who has spent several decades examining the socialist system from inside. My subject here is not the post-socialist region, but the rest of the world-though I look upon it with the eyes of one who has himself experienced socialism at first hand.

Back in 1968, when attempts began in my native Hungary to implant “market socialism” into the socialist economic system, the heads of state-owned enterprises were urged to increase their profits. Managers were to do well if their enterprises made money, as they would receive a share of the profits. But there was little cause for concern if the enterprise made a loss and fell into debt: in almost every such case, some kind of rescue operation was mounted. For instance, there might be a bailout funded out of the state budget, or the state-owned bank might extend extra credit, without much hope of the loan being repaid. Losses and debts were unpleasant, of course, but they were not a life-or-death matter for an enterprise.

Managers, based on their experience of repeated rescue operations, could more or less bank on their enterprise surviving. Despite all the stress on the profit motive, the incentive remained fairly weak in reality. Why bother too much about cost-cutting or innovating if there was no threat of insolvency? The financial situation of the enterprise did not place a real constraint on its spending, its borrowing or its expansion. This was the state of affairs that I called at that time a “soft budget constraint” (SBC).
...
Capitalism developed gradually out of the pre-capitalist social environment, by an organic process of growth. As capitalist forms came to dominate the economy, so the influence of business on politics increased. Socialism, on the other hand, did not seep gradually into the fabric of society in Tsarist Russia or post-World War Two China. The communist party became capable under specific historical conditions of seizing political power, taking control of the machinery of state, and then imposing the socialist economic system on society by state force. Every means was used, including merciless repression. The developmental process of the socialist system, unlike that of capitalism, began in the political quarter, not the economic.

However many bailouts there may be, however much the budget constraint may soften, there is no danger of socialism returning in that sense - which is the most important point. It is meaningless to raise that spectre in the United States, Western Europe or other developed countries, where democracy has sent down deep roots. There may be times when public discontent is stronger and more widespread than in other calmer and more prosperous periods. But only incorrigible revolutionists given to hoodwinking themselves believe such discontent can overthrow the foundations of the system. That prediction indicates a failure to understand the history of the communist system.

In other words, Hayek's mechanism in Road to Serfdom is wrong. Read the whole thing...

All you need is a subsidy ...oops

It's always dangerous to mess with the price system. Even if there are proven positive or negative externalities from particular types of behaviour, and even if you're careful about how you specify the legislation giving form to the tax or subsidy, there often will be unintended consequences.

Case in point: tax credits for use of alternative fuels. US Congress passed legislation back in 2005 providing tax credits for fuels mixing biofuels with normally-taxed fuels. $0.50 per gallon for those fuels. What happens? Christopher Hayes at The Nation explains:

Enter the paper industry. Since the 1930s the overwhelming majority of paper mills have employed what's called the kraft process to produce paper. Here's how it works. Wood chips are cooked in a chemical solution to separate the cellulose fibers, which are used to make paper, from the other organic material in wood. The remaining liquid, a sludge containing lignin (the structural glue that binds plant cells together), is called black liquor. Because it's so rich in carbon, black liquor is a good fuel; the kraft process uses the black liquor to produce the heat and energy necessary to transform pulp into paper. It's a neat, efficient process that's cost-effective without any government subsidy.

So the paper industry was previously using a kind of biofuel for its heating, prior to the tax credit. Great!

By adding diesel fuel to the black liquor, paper companies produce a mixture that qualifies for the mixed-fuel tax credit, allowing them to burn "black liquor into gold," as a JPMorgan report put it. It's unclear who first came up with the idea--Wrobleski told me it was "outside consultants"--but at some point last fall IP and Verso, another paper company, formerly a part of IP, began adding diesel to its black liquor and applied to the IRS for the credit. (Verso nabbed $29.7 million at just one of its mills in the final quarter of 2008 for its use of mixed fuel.)

...

No one in Congress seems to have anticipated this creative maneuver. This past fall the Joint Committee on Taxation computed the cost of extending the tax credit for three months and projected it would cost a manageable $61 million. It now appears that the extension (which was passed as part of the TARP) could cost as much as $2 billion before the credits expire at the end of this calendar year.

In fact, the money to be gained from exploiting the tax credit so dwarfs the money to be made in making paper--IP lost $452 million in the fourth quarter of 2008 alone--that the ultimate result of the credit will likely be to push paper prices down as mills churn at full capacity in order to grab as much money from the IRS as it can.

It's kinda the point of the price system that nobody has to know all of the alternative uses to which resources can be put. When markets set prices, nobody in Congress has to know that the paper industry uses a byproduct biofuel which readily could be adulterated with taxable fuels to harvest a subsidy. When Congressmen instead set prices, there will always be consequences they hasn't thought of, no matter how well-intentioned or careful they've been.

Hayes draws the useful and depressing conclusion:

Whether or not Congress gets around to turning off the spigot, the episode is a useful reminder of the persistently ingenious ways the private sector can exploit even well-intentioned legislation. Considering that the success of the Treasury's recently announced plan to rescue the financial sector depends, in part, on the private sector not gaming the rules, the black liquor story seems particularly germane.

Vengeful economy

The best explanation of the current economic unpleasantness that I've yet seen, courtesy of South Park. If the link doesn't work, just search on (South Park bailout). Brilliant, as usual.

And don't forget their earlier exposition of the perils of migrant labourers stealing our jobs....