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Looting: The Economic Underworld Of Bankruptcy For Profit


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HOLA441

Full introduction to this article is at the further down.

http://www.nytimes.com/2009/03/11/business...ml?ref=business

Sixteen years ago, two economists published a research paper with a delightfully simple title: “Looting.”

The economists were George Akerlof, who would later win a Nobel Prize, and Paul Romer, the renowned expert on economic growth. In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”

On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.

Now, it would have been nice if the Fed had shown some of this regulatory zeal before the worst financial crisis since the Great Depression. But that day has passed. So people are rightly starting to think about building a new, less vulnerable financial system.

And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.

Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess.

He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.

The term that’s used to describe this general problem, of course, is moral hazard. When people are protected from the consequences of risky behavior, they behave in a pretty risky fashion. Bankers can make long-shot investments, knowing that they will keep the profits if they succeed, while the taxpayers will cover the losses.

This form of moral hazard — when profits are privatized and losses are socialized — certainly played a role in creating the current mess. But when I spoke with Mr. Romer on Tuesday, he was careful to make a distinction between classic moral hazard and looting. It’s an important distinction.

With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.

Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.

What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

I understand this chain of events sounds a bit like a conspiracy. And in some cases, it surely was. Some A.I.G. employees, to take one example, had to have understood what their credit derivative division in London was doing. But more innocent optimism probably played a role, too. The human mind has a tremendous ability to rationalize, and the possibility of making millions of dollars invites some hard-core rationalization.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Unfortunately, we can’t very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can’t function without credit, which means the financial system needs to be bailed out.

But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.

Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.

Mr. Bernanke actually took a step in this direction on Tuesday. He said the government “needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm.” In layman’s terms, he was asking for a clearer legal path to nationalization.

At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

Mr. Akerlof and Mr. Romer finished writing their paper in the early 1990s, when the economy was still suffering a hangover from the excesses of the 1980s. But Mr. Akerlof told Mr. Romer — a skeptical Mr. Romer, as he acknowledged with a laugh on Tuesday — that the next candidate for looting already seemed to be taking shape.

It was an obscure little market called credit derivatives.

Damning article.

Edited by interestrateripoff
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HOLA442

I had a boss once who when confronted with someone who thought that they where too important to the business to sack - he deliberatley sidelined them and got in resources to replace them. This was not an act of getting rid of someone in case they usurped him - no - he did it so that the business was resiliant.

He used to say, if they are too important to the running of the business then they are too risky to keep. All businesses and economies should be run this way.

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HOLA443
I had a boss once who when confronted with someone who thought that they where too important to the business to sack - he deliberatley sidelined them and got in resources to replace them. This was not an act of getting rid of someone in case they usurped him - no - he did it so that the business was resiliant.

He used to say, if they are too important to the running of the business then they are too risky to keep. All businesses and economies should be run this way.

As an old boss of mine was fond of saying "The graveyards are full of men who were indispensible"

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HOLA444

Excellent article - people who cry out about the failure of the free market should read this. This wasn't a free market as some people weren't exposed to the consequences of their actions, and importantly, knew they weren't exposed at the time they were making their decisions.

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HOLA445
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HOLA446
I had a boss once who when confronted with someone who thought that they where too important to the business to sack - he deliberatley sidelined them and got in resources to replace them. This was not an act of getting rid of someone in case they usurped him - no - he did it so that the business was resiliant.

He used to say, if they are too important to the running of the business then they are too risky to keep. All businesses and economies should be run this way.

Getting other people to replace someone who is "too important" to sack may of course backfire, the person sidelined ay leave before the others are up to speed on what they are supposed to do. It swings both ways. If someone is very good and does things better than others, but gets sidelined for doing so, then the company ends up not utilising the person properly. However it is the case that it makes the business more resilient, but probably more mediocre. Many such "good" people will ultimately end up running their own business, upon which others will depend anyway. Risks in business can never be removed, only transferred.

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HOLA447
Getting other people to replace someone who is "too important" to sack may of course backfire, the person sidelined ay leave before the others are up to speed on what they are supposed to do. It swings both ways. If someone is very good and does things better than others, but gets sidelined for doing so, then the company ends up not utilising the person properly. However it is the case that it makes the business more resilient, but probably more mediocre. Many such "good" people will ultimately end up running their own business, upon which others will depend anyway. Risks in business can never be removed, only transferred.

It was an illustration that no one company (or economy) can or should be held hostage to a single point of failure. Employees should understand this and so should governments when putting together regulation.

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HOLA448

Sadly, the looting continues on. How much of that 1.7 billion pounds that the Treasury (or RBS, I meant) is going to put into Scottish mortgages is going to go into "investments" with negative expected returns? The majority of high street banks in the UK are no longer lending based on market principles. Government funded property loans are nothing but an open invitation to loot the taxpayers.

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HOLA449
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HOLA4410
It's worse than this - banks are designed to crash the economy.

It's what they are for.

I thought that they where designed to ensure the efficient allocation of capital. Seems they took a wrong turn somewhere - maybe old Greenspan can tell us where? ;)

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HOLA4411

Agood article, but I simply hate the way journos fail to separate the concepts of ownership and operational control.

For instance:

Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.

And yet he blames "investors" for "looting". How can investors benefit if the company they own performs so badly?

Rather it is employees who benefit. It is they who secure the jobs predicated on fraudulent businesses concocted by fraudulent employed management. If equity investment is ever to recover, investors must have greater redress, not less. They must be able to sue management for wrecking their investments and ultimately deprive them of all their remuneration and freedom, much as management have currently deprived investors in lloyds.

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HOLA4412

The behaviour of banks has been very well know since 1929. 'Looting' is what they do.

The government is therefore supposed to regulate it and protect us - failing to do so is the cause of this crisis and all blame should rest with the government regulators.

Part of the reason why they failed to regulate is because a large amount of the looting was from China and the ME sovereign funds.

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HOLA4413
DURING THE 1980s, a number of unusual financial crises occurred. In

Chile, for example, the financial sector collapsed, leaving the govern-

ment with responsibility for extensive foreign debts. In the United

States, large numbers of government-insured savings and loans became

insolvent-and the government picked up the tab. In Dallas, Texas, real

estate prices and construction continued to boom even after vacancies

had skyrocketed, and then suffered a dramatic collapse. Also in the

United States, the junk bond market, which fueled the takeover wave,

had a similar boom and bust.

In this paper, we use simple theory and direct evidence to highlight a

common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which

countries took on excessive foreign debt, governments had to bail out

insolvent financial institutions, real estate prices increased dramatically

and then fell, or new financial markets experienced a boom and bust. We

describe the evidence, however, only for the cases of financial crisis in

Chile, the thrift crisis in the United States, Dallas real estate and thrifts,

and junk bonds.

Our theoretical analysis shows that an economic underground can

come to life if firms have an incentive to go broke for profit at society's

expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government

guarantees a firm's debt obligations. The most obvious such guarantee

is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large banks, student loans,

mortgage finance of subsidized housing, and the general obligations of

large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline

and to limit opportunism by shareholders, governments make continued

access to the guarantees contingent on meeting specific targets for an

accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after

all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the

owners than maximizing true economic values.

If so, the normal economics of maximizing economic value is re-

placed by the topsy-turvy economics of maximizing current extractable

value, which tends to drive the firm's economic net worth deeply nega-

tive. Once owners have decided that they can extract more from a firm

by maximizing their present take, any action that allows them to extract

more currently will be attractive-even if it causes a large reduction in

the true economic net worth of the firm. A dollar in increased dividends

today is worth a dollar to owners, but a dollar in increased future earn-

ings of the firm is worth nothing because future payments accrue to the

creditors who will be left holding the bag. As a result, bankruptcy for profit

can cause social losses that dwarf the transfers from creditors that

the shareholders can induce. Because of this disparity between what the

owners can capture and the losses that they create, we refer to bank-

ruptcy for profit as looting.

Unfortunately, firms covered by government guarantees are not the

only ones that face severely distorted incentives. Looting can spread

symbiotically to other markets, bringing to life a whole economic under-

world with perverse incentives. The looters in the sector covered by the

government guarantees will make trades with unaffiliated firms outside

this sector, causing them to produce in a way that helps maximize the

looters' current extractions with no regard for future losses. Rather than

looking for business partners who will honor their contracts, the looters

look for partners who will sign contracts that appear to have high current

value if fulfilled but that will not-and could not-be honored.

We start with an abstract model that identifies the conditions under

which looting takes place. In subsequent sections, we describe the cir-

cumstances surrounding the financial crisis in Chile and the thrift crisis

in the United States, paying special attention to the regulatory and ac-

counting details that are at the heart of our story. We then turn to an

analysis of the real estate boom in Dallas, the center of activity for Texas

thrifts. We construct a rational expectations model of the market for

land in which investors infer economic fundamentals from market

prices.' We then show how the introduction of even a relatively small

number of looters can have a large effect on market prices.

In the last section, we examine the possible role of looting at savings

and loans and insurance companies in manipulating the prices in the

newly emerging junk bond market during the 1980s. In contrast to the

Dallas land market, where the movements in prices appear to have been

an unintended side effect of individual looting strategies, we argue that

in the junk bond market, outsiders could have-and may have-coordinated the actions of some looters in a deliberate attempt to manipulate prices. Evidence suggests that this opportunity was understood and exploited by market participants. By keeping interest rates on junk bonds artificially low, this strategy could have significantly increased the fraction of firms that could profitably be taken over through a debt-financed acquisition.

Before turning to the theoretical model, we will place this paper

within the context of the large literature that bears on the issues we ad-

dress. The literature on the thrift crisis has two main strands: popular

accounts2 and economists' accounts.3

In contrast to popular accounts, economists' work is typically weak

on details because the incentives economists emphasize cannot explain

much of the behavior that took place. The typical economic analysis is

based on moral hazard, excessive risk-taking, and the absence of risk

sensitivity in the premiums charged for deposit insurance. This strategy

has many colorful descriptions: "heads I win, tails I break even"; "gam-

bling on resurrection"; and "fourth-quarter football"; to namejust a few.

Using an analogy with options pricing, economists developed a nice

theoretical analysis of such excessive risk-taking strategies.4 The prob-

lem with this explanation for events of the 1980s is that someone who is

gambling that his thrift might actually make a profit would never operate

the way many thrifts did, with total disregard for even the most basic

principles of lending: maintaining reasonable documentation about

loans, protecting against external fraud and abuse, verifying information

on loan applications, even bothering to have borrowers fill out loan ap-

plications.5 Examinations of the operation of many such thrifts show

that the owners acted as if future losses were somebody else's problem.

They were right.

Some economists' accounts acknowledge that something besides ex-

cessive risk-taking might have been taking place during the 1980s.6 Ed-

ward Kane's comparison of the behavior at savings and loans (S&Ls)

to a Ponzi scheme comes close to capturing some of the points that we

emphasize.7 Nevertheless, many economists still seem not to under-

stand that a combination of circumstances in the 1980s made it very easy

to loot a financial institution with little risk of prosecution. Once this is

clear, it becomes obvious that high-risk strategies that would pay off

only in some states of the world were only for the timid. Why abuse the

system to pursue a gamble that might pay off when you can exploit a sure

thing with little risk of prosecution?

Our description of a looting strategy amounts to a sophisticated ver-

sion of having a limited liability corporation borrow money, pay it into

the private account of the owner, and then default on its debt. There is,

of course, a large literature in corporate finance that emphasizes the

strategies that equity holders can use to exploit debt-holders when

shareholders have limited liability .8 We have nothing to add to the analy-

sis of this problem in the context of transactions between people or firms

in the private sector. The thrust of this literature is that optimizing indi-

viduals will not repeatedly lend on terms that let them be exploited, so if

lending occurs, some kind of mechanism (such as reputation, collateral,

or debt covenants) that protects the lenders must be at work.

However, this premise may not apply to lending arrangements under-

taken by the government. Governments sometimes do things that opti-

mizing agents would not do, and, because of their power to tax, can per-

sist long after any other person or firm would have been forced to stop

because of a lack of resources.

This is the introduction to the full article.

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HOLA4414

This just confirmed something I long suspected.

I once wrote a post here in which I described how I suspected the elite wilfully engineer bubbles with the intention of shorting the collapse.

I coined the phrase "shorting bubbles" - or tried to. :(

Essentially the financial system is massively vulnerable to manipulation and until something is done to prevent it you will have every right to wonder why you bother paying your taxes.

Crooks are attracted to the markets like flies are to shit.

Edited by Dave Spart
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HOLA4415

Full introduction to this article is at the further down.

http://www.nytimes.com/2009/03/11/business...ml?ref=business

Damning article.

the thing about the actions of "investors" has to be systemic and from the top with a Policy made at the top.

otherwise, lenders have a tickbox lending criteria....it is the tickbox they tighten or loosen. and middle management wont have the power to change the central policy the tickbox reflects. Loosening was therefore Policy from the top.

Edited by Bloo Loo
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HOLA4416

the thing about the actions of "investors" has to be systemic and from the top with a Policy made at the top.

otherwise, lenders have a tickbox lending criteria....it is the tickbox they tighten or loosen. and middle management wont have the power to change the central policy the tickbox reflects. Loosening was therefore Policy from the top.

You've been thinking about this for a long time! :D:P

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HOLA4417
  • 5 months later...
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HOLA4418

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