How Bond Rescues Helped Cause the Financial Crisis

Lenders have gotten too complacent, Russell Roberts, a professor of economics at George Mason University, argues, because of policies over the past 30 years that have tilted the playing field too far in the direction of bondholders. Now we're stuck with too much debt and too much risk in the economy. The solution, the economist says, starts by requiring increased transparency in government bailouts and forcing lenders to feel some pain when they make bad investments.

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Kiplinger's senior editor Bob Frick sat down with Roberts for an interview:

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So, your premise, in a nutshell, is that bondholders haven't paid the price for bad investing decisions and that contributed to the financial crisis?

Right. The amount of debt we've allowed is not the natural amount of debt because we've protected bondholders.

Bondholders only care about one thing. They care about solvency. They just want to get their money out. The risk is relatively small that they won't, and they know it takes a disastrous event for them to be wiped out. But they care a lot about avoiding that disastrous event. And so the way that should work is that bondholders, creditors, and debt holders of various kinds monitor prudence. If I'm going to buy your bonds, I'm going to make sure you're not being imprudent with your risk-taking. If you are imprudent, I'm going to stop lending you money by not buying your bonds.

So when did this natural feature of capitalism go wrong?

This lack of prudence goes back to at least 1984 in the United States. If bondholders are sufficiently large and are lending money through debt to another large financial institution, and that business being financed is wiped out, the bondholders should get wiped out. Instead, they didn't get just 50 cents on the dollar when the business failed, they got 100 cents on the dollar. That makes no sense. No sense whatsoever.

Why not?

Think about it this way. You go to a casino with your dad. And you say, "You know, dad, I have a good feeling about red." And you put your whole stake, $100, on red this one time, but it comes up black.

Your dad says, "Tough luck."

"But dad, I was expecting $200."

"Okay, here's $200."

What does that do to you? What does it do to your investing thoughtfully, wisely and prudently in the future?

What are prime examples of bailouts?

We bailed out Continental Illinois bondholders in 1984 and Bear Stearns bondholders in 2008. They both disappeared. U.S. bondholders of Mexican debt were bailed out in 1995 after the 1994 economic crisis in Mexico.

How did this affect those big firms that buy bonds?

I'm not saying that firms sat around and said, "Hey, we don't have to worry about risk," though some did that. What really happened is that the natural incentives to be cautious were handicapped. We severed the feedback loops and the natural market forces. Now when political push comes to political shove, big institutional bondholders don't worry as much about risk because they expect to be rescued.

How has this been allowed to happen?

First let me just say the standard thing I hear is, "Well, can you blame Wall Street? They have a natural incentive under capitalism to make as much money as possible. It's not their fault, it's bad government." Which is half true.

The part they leave out is that the government takes a lot of advice from Wall Street before it allows those bond bailouts. Also, I use (former Federal Reserve Chairman) Alan Greenspan as an example of how government is half of the problem. Alan Greenspan is considered to be this free-market ideologue. This Ayn Rand protégé. A champion of dog-eat-dog capitalism. And he was, when it was about not restraining Wall Street. When it was about helping Wall Street, he was a socialist.

We have turned Wall Street into the worst of all possible worlds. It allocated capital poorly. In a real capitalist system, we need Wall Street and other parts of the system to allocate capital prudently. We have instead allowed Wall Street to live like a tumor that is swollen out of proportion to the rest of its system. The apologists say, "Oh, well, they allocate capital to its highest use." Is that why we put trillions of dollars into the housing market? That's our precious capital's highest use? Las Vegas needed one more housing development?

So how do we fix this?

My solution is to restrict the power of government to pick winners. How you achieve that is not an easy question. Constitutionally limiting the Federal Reserve would be a great start. I believe the Fed acted illegally. It certainly acted in unprecedented ways in its support of Bear Stearns and AIG. I think that was a mistake. The Fed convinced itself it had to do something when in fact it didn't.

Improving transparency is the second step that's needed. The Fed bought over $1 trillion in Fannie Mae and Freddie Mac bonds. It gave $32 billion to JPMorgan Chase to buy Bear Stearns. How did those investments turn out? I don't know, and I'm in the top 1% of people who pay attention to that. That's absolutely 100% wrong in a democracy. That's grotesque.

The bigger solution is much harder to find. How do you encourage politicians and policymakers to endure short-term pain for long-term benefit? A bailout right now would be hard to execute politically. President Obama rescued many of the creditors of General Motors. That was viewed pretty negatively by the American people, and he paid a price for that in the midterm elections.

The real solution has to be cultural. It has to be an awareness of the long-term price we pay for these bailouts, because the long-run price is fierce. This idea that we had to save Bear Stearns or AIG or that there would be a catastrophe ignores the fact that we're in a catastrophe now -- consistent unemployment of around 9%, for one thing -- because the markets haven't been allowed to work to prevent such financial disasters.

The irony is that this is not a Republican issue or a Democratic issue. It's a systemic issue.

Read Roberts' paper on the subject, "Gambling with Other People's Money: How Perverted Incentives Caused the Financial Crisis."