Risky Business: Conjectural Guarantees and PPIP

Thursday, 06/25/2009 - 10:52 am by Robert Johnson | 6 Comments

Robert Johnson, Director in the Economic Policy Initiative of the Roosevelt Institute, asks large scale bank bondholders like Bill Gross a simple question: Why the sudden interest in the integrity of public finances? Where was your concern in September/October of 2007?

Questionaire, What did U stand 4?
Questionaire, Who did U save?
When it gets right down to-wait a minute
When it gets right down to the nitty of the gritty
When it gets right down to it U take more than U gave

–From “The Truth” by Prince

The Slippery Slope of Conjectural Guarantees

In finance, there’s something called moral hazard, and it occurs when people have an incentive to take big risks because they feel they are going to be protected from the consequences of their actions. For example, if you’re behind the wheel and you have insurance, then you might just turn up the Metallica, put the pedal to the metal, and drive yourself right off a slippery slope. Your insurance company is then going to get over-sized claims that are hard to pay for. Nice for you. Not so nice for the insurance company and the other insurees.

On Wall Street, moral hazard happens when a company has an implied guarantee (not explicitly in the contract) - known as a ‘conjectural guarantee’ - that it’s going to get bailed out by the government if it screws up. So, Mr. Investor tells himself, why not just invest in those who take huge risks with other people’s money? The government will be there with the bailout. Nice for Mr. Investor. Not so nice for the government and the taxpayers.

The recent New York Times puff piece on PIMCO’s William Gross gave a lot of detail about the financier’s yoga practice and the way he brings a lawyer with him to say “Merry Christmas.” But what it fails to explore, somehow, is the elephant in the room: that Gross’ entire career is one long dance of reading the probabilities of the implied guarantees, and at times, using the size and the power of his fund, to change the probabilities and induce the realization of non-contractural guarantees. It is in this respect that he is both skillful and at odds with the U.S. taxpayer. He is an investor who fosters the system of anesthetizing creditors of banks from the consequences of bad bets by those financial institutions. He is, in essence, and in fact, an enabler of moral hazard.

It is somewhat difficult to digest the fact that for rendering these sophisticated and anti-social services, he is rewarded by the government who chose involve him in the proposed Public Private Investment Partnership (PPIP) program which give guarantees to investors, at public expense, to buy toxic assets from those financial institutions who made the mess.

Bubble Deflated, Bubble Reflated: Is this a Crisis Gone to Waste?

Over the years, as economic policy makers stretched themselves to great lengths to ensure that finance experienced as little downside as possible, markets responded by blowing up an ever-larger bubble on the belief that the government would always come to the rescue if trouble unfolded. This dance of moral hazard between government and the markets spiraled higher and higher, until finance eventually created a bubble so big the officials could not support it. This was evident near the end of 2007.

That bubble of expectations and blanket guarantees was slowly deflating at the time of Bear Stearns’ failure, but it violently burst with the Lehman Brothers failure and WAMU’s downfall in a largely unanticipated shock to investors in bank credit. Clumsily, violently and abruptly, the presumed protection was removed, and real risk was restored to those who invested in the unsecured debt of financial instiutions. By reintroducing risk into the liabilities of Too Big to Fail Institutions (TBTF), the excessive leverage and gambling that financial institutions practiced would be curtailed. The downside,in the short run, was that this accelerated the pace of de-leveraging and spilled over onto the real economy, surely. But unlike Gross’ claims, this was a problem of execution on the part of the Bush Administration, not of policy. In other words, the clumsy execution by former Treasury Secretary Paulson and the Bernanke/Geithner team at the Fed does not negate the benefits of re-introducing risk into the thinking of those who extend credit to financial institutions for the long-term balance of the financial sector and the diminution of risks to the taxpayer who ultimately backstop the financial system.

At the time of the BofA and Citigroup worries in early 2009, Obama policies began to take shape and we might have had government restructuring of Too Big to Fail banks. But also at this time, the price of bank debt and of credit default swaps suggested that government protections for unsecured bank debt were no longer ironclad. That didn’t sit well with Gross. It was at this time that he made his claims that the financial world would melt down a la Lehman if Citi or BofA were restructured. Would it? One can never be certain. But I would argue that the price structure of bank debt and Credit Default Swaps (CDS) suggest that a restructuring of these behemoths would not have been an extreme shock to the system like the Lehman and WAMU episodes were. We had already largely paid that price in September of 2008. We had already digested the disruptive surprise. No one priced Citi or Bof A debt like it was risk free after the inauguration.

In the end, the Obama team did not go the way of restructuring and Administration officials appeared to heed Gross’ advice/threat. The Geithner/Summers team have reinvigorated those old — and dangerous — conjectural guarantees with their capital assistance program and forbearance. They offered protection to creditors that will anesthetize their concerns and subsidize those who engage in risky behavior at the large financial institutions.. Once again, bank debt is overpriced and leverage subsidized.

This scenario is just what the Too Big to Fail financial institutions and their creditors would like: Insurance coverage with no premium. Again. I wonder if Rahm Emanuel thinks the reapplication of anesthetic to unsecured creditors of our TBTF institutions was necessary? From my perch, it looks like they blinked and wasted the financial crisis potential to catalyze meaningful structural change.

PPIP is a Win Win Win: All for PIMCO

In terms of lessons for the future, the most candid and interesting portion of the New York Times article is where Mr. Gross discusses — quite openly — the benefits of PPIP (Public Private Investment Partnership) for his firm. He once said this approach would be a “win-win-win” for the government, taxpayers and investors. Well, it is surely is a “win-win-win” for PIMCO. They make money managing government programs for the Treasury in the ring-fence structures surrounding assets at troubled financial institutions. They make money on PPIP investments in distressed assets, and they make still more money indirectly by vacuuming assets off of the balance sheets of banks at subsidized prices and making sure they won’t be forced in the future to restructure their existing holdings of unsecured bank debt at those troubled institutions. That last side effect should trouble the Treasury: it gives PIMCO a motive to drive prices higher than any fair market value.

Warren Buffett (along with PIMCO and Goldman Sachs) had recommended a PPIP-like structure to the government in 2008. He has said that this financial crisis is the economic equivalent of Pearl Harbor, and that the American people must band together like they did in response to the Japanese attack. What concerns me about PPIP is that it looks like the American people are being asked to band together and use their tax dollars to enrich firms like PIMCO, Goldman Sachs, and Berkshire Hathaway as they rebuild the Japanese bomber fleet — in this case the large banks and investment banks that did the damage.

PPIP is demoralizing for the taxpayers and believers in fairness. The subsidy structure is extreme.  But perhaps the most toxic aspect of the plan to clean up the mega financial institutions toxic balance sheets is that it fortifies the Too Big Too Fail market structure that produced this crisis in the first place. As if that weren’t enough, it invites the moral hazard and regulatory timidity that large institutions are often able to inspire. Again the crisis appears to have been wasted and we have fostered structures that set the stage for the next disaster.

As we look to the future and the long-term consequences of our bailout policies, I anticipate that Mr. Gross will, like most bondholders, be a strong voice for deficit reduction and anything that alleviates fears of potential inflation. Now that bank creditors have taken theirs, we will see them return to their traditional role as disciplinarian deficit hawks who work very hard to see that the full force of “opportunity cost” of the bailouts is visited upon the body politic.
I hope they will be called upon to answer why exactly they took a vacation between September of 2007 and April of 2008, before resuming their defense of the integrity of public finances. They should be forced to explain to the American people why their priorities — like bailing out their bond investments in the reckless and risky behavior of mega finance — were so much more important than the priorities of those who want schools, roads, bridges, hospitals and healthcare.

Braintruster and economist Robert Johnson is former managing director of Soros Fund Management. Dr. Johnson served as Chief Economist of the U.S. Senate Banking Committee under the leadership of Chairman William Proxmire and before that, as Senior Economist of the U.S. Senate Budget Committee, under the leadership of Chairman Pete Domenici.