"How do you attack that agency problem? You give control to a government-appointed conservator"

Excellent post by Justin Fox:

"Why hasn't the government nationalized Citigroup? Hank Paulson's sort of answer

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Roger Ehrenberg thinks it's long past time for Treasury to bite the bullet on Citi:

What if, just what if, Treasury (together with the SEC) had said four months ago - game over, guys. Employ FAS 157 across your asset portfolios, show us exactly how broke you are, hand us the keys, we'll settle accounts with those who are owed money and say too bad to those who aren't (common stockholders and unsecured debtholders), sell of the good assets and warehouse the bad at marked-down levels. The Government could have worked out illiquid derivatives positions over time without causing a market cataclysm. Oh, and Management and the Board, don't let the doorknob hit you in the butt on your way out. You'll be hearing from a few lawyers any day now. These decisive actions would have saved taxpayers tens if not hundreds of billions of dollars, yet we still have the good ol' Citi management at the helm steering the ship.( I AGREE )

I actually asked Hank Paulson in early December why Treasury hadn't done this, although I did in far more mealy-mouthed language than Ehrenberg. Here's the excerpt from the transcript:

Q: A thought experiment that I've seen a lot of people making with AIG and with Citi … the conservatorship route, there's this cleanless to it: “Okay it's over, you guys are out. We'll take it public again in a few years.”

A: Every criticism I agree with in terms of the problem. The question is, I ask myself what would I have done differently. With Fannie and Freddie we had conservatorship because it was in the law. People just sort of accept that right now. That was such a stretch, and so heroic as far as I'm concerned to get there a couple weeks ahead of the Lehman earnings, which we knew were coming.

AIG, there was essentially no regulator at the federal level. The New York Fed learned about this the same time I did, that there was pending failure. They were told that New York state's got it under control, the insurance regulator. It was the weekend we were dealing with Lehman Brothers, there was no TARP at that time. Fortunately the Fed was able to make determination that there were the hard assets to do the loan against. So that was done that way. I still believe that the government owning the vast majority of that was warranted by the circumstances. So remember, this is a breakup strategy in terms of selling off pieces that is totally different than Citi, which is a very systemically important bank and we were dealing with severe stress in the markets. But clearly it's important that private capital be welcomed, be encouraged, that government doesn't have the capability to run a business like that for a long period of time.( TRUE )

I think he's sort of missing the point there, and I wish I had pressed him further. Nobody thinks the government is brilliant at running banks( I AGREE. BUT NEITHER ARE BANKERS. ). But right now you have situation where taxpayers have put a lot of money into Citi (and other banks), but the people running those banks are still answerable not to taxpayers but to the shareholders at large. The taxpayers are shareholders too, but they're minority shareholders, and they're stuck with liabilities if the bank fails that other shareholders don't have to worry about.( YEP )

If everything works out for the best and the bank quickly recovers, it's smiles all around. But if the troubles continue you've got a bank management looking out for the interests( THE PROBLEM WITH HYBRIDS ) of limited-liability shareholders (not to mention its own interests), who are generally going to be much less risk-averse than the taxpayers (because they won't be stuck with the bill if all goes pear shaped). It's an agency problem."

"Also sometimes referred to as the principal-agent problem. The difficult but extremely important and recurrent organizational design problem of how organizations can structure incentives so that people (“agents”)( THIS IS WHAT I MEAN BY HUMAN AGENCY. I JUST THINK THAT MY TERM IS EASIER TO UNDERSTAND. ) who are placed in control over resources that are not their own with a contractual obligation to use these resources in the interests of some other person or group of people actually will perform this obligation as promised — instead of using their delegated authority over other people's resources to feather their own nests at the expense of those whose interests they are supposed to be serving (their “principals”). Enforcing such contracts will involve transaction costs (often referred to as agency costs), and these costs may sometimes be very high indeed."

Back to Justin Fox:

"How do you attack that agency problem? You give control to a government-appointed conservator, who isn't necessarily going to be any smarter than existing bank management, but will have minimizing taxpayer losses as a first priority( THAT'S IT ). After that's taken care of, then you can start thinking about how to get private capital back in."( I AGREE. NATIONALIZE, THEN PRIVATIZE. )

Many of the terms and theories I use have more technical names, but I try and make things easier to understand, especially for myself. In any case, a terrific post.

"The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees."

Arnold Kling has an excellent post on EconLog:

"One topic that came up was the principal-agent problem of financial firms. It was argued that managers took advantage of shareholders by taking undue compensation and excessive risks. I was one of those who believes that managers duped themselves and that they regret how this worked out for them personally. However, had the incentives been radically different (for example, if one could be sent to prison for improper risk-taking at a financial firm), I can imagine that fewer managers would have duped themselves.

My sense is that there is a widespread public perception that financial managers deserve to be punished more than they have been, regardless of whether such punishment is necessary or sufficient to deter excessive risk-taking. I think that if we are going to have government guarantees, then punishment as a deterrent is worth considering. For example, I would like to see those responsible for under-funding defined-benefit pension plans go to prison. Of course, we will not see that happen, since it would mean that every legislator would be behind bars.

Anyway, apply the principal-agent paradigm to government. Think of "we the people" as the principals and government officials as our agents. To me, the principal-agent problem involved with government is much worse, both in theory and in practice, than that involved with financial firms."

I basically agree with this. I find that manager's pay is too high, but I'm more worried about actual fraud, negligence, and fiduciary incompetence. I would rather the shareholders and clients take a more active interest in their investments, and I worry that these rules might lead to more slumbering on their part. However, I can see the point, and I don't believe that they deserve these high salaries, so I'm not going to put up much of a fight. I would simply have wished the clients and shareholders had done this. I actually do believe that there was a lot more misconduct than he seems to.

"Another issue is transparency. In the used car market, if the government knew the true quality of every used car, then I presume it should disclose this information to get rid of the "lemons problem." Next, apply that to banks. If the government knew the true condition of every bank, and disclosed which ones were in trouble....there would be runs on those banks. So, in Megan McArdle's immortal words, "Money is weird. Finance is weird."

I do not think that the FDIC needs to disclose specifically which banks are in trouble. But I do think that there is a lack of transparency about the overall strategy of the Fed and Treasury. In particular, I do not think they are telling us what they don't know. They want us to believe that they know much more than they really do, because they don't want us to doubt their wisdom. In particular, my guess is that in some very important cases they do not know whether institutions face solvency issues or liquidity issues."

Now, I believe that the Fed and Treasury need to be completely clear, especially about implicit and explicit government guarantees, otherwise my Bagehot's Principle Plan won't work.

"An important point is the fact that the financial crisis was not limited to the United States. If you think that the Community Reinvestment Act caused the housing bubble, then explain how it caused the housing bubbles in the UK and Spain.

To put this another way, if policymakers had used the bully pulpit or regulatory policy to stop the bubble in the middle of 2004, does that mean that everything would be fine now? Or would the "global savings glut," as Ben Bernanke famously called it, simply have gone and produced excesses and imbalances somewhere else? In other words, even if you had prevented the housing bubble, would some other bubble have taken its place?"

This one I've talked about many times before and I'll link to them. My basic point, jawboning won't work, and there are other problems as well.

"We got into the question of whether the financial sector had gotten too big in this country. My belief is that it had, in the sense that too many financial institutions and financial instruments are guaranteed by the government, implicitly if not explicitly. Going forward, I think that the plan is to continue to guarantee an immense amount of stuff, but try to regulate more closely. I don't think that's such a good plan. In theory, I like the idea of a finite, guaranteed-and-regulated sector (banks with deposit insurance and tight limitations on activities) alongside a relatively unregulated sector that is more innovative and takes more risk. But in practice we seem to have difficulty both in keeping banks safe and in allowing an unregulated sector where failure is an option. The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees."

This is gold. I agree with it completely. Where the government has a clearly spelled out guarantee, regulate as needed to protect the taxpayers. Otherwise, use minimal and effective regulation, based on general rules, to oversee the free market. The final sentence says it all. Brilliant.