Tuesday, October 9, 2012

Government money should have strings attached - Viral Acharya, David Backus, and Raghu Sundaram

There's a tendency in a crisis to throw out the rulebook: we're in a unique situation, some will say, and that calls for unique measures. In fact, financial crises are recurring events whose history has taught us some clear lessons. One is that policy responses can make things worse if they're not designed carefully. The most important example, we think, is that companies face less pressure to solve their own problems if they think government help is on the way. At best, the cost to taxpayers is higher than it could be. At worst, well-intended policies can aggravate a bad situation.

Consider these examples:

• Lehman Brothers Holdings announced a 13% increase in its dividend and a $100 million share repurchase in January, only to declare bankruptcy in September. CEO Richard Fuld is said to have complained bitterly that the government declined to save Lehman.
• Citigroup paid $5.9 billion in dividends in the first three quarters of the year, only to ask the government for help in November.
• General Motors waited until July to cut its dividend, despite underfunded health-care liabilities and a business with fundamental problems. A public bailout was approved in December.

These are obvious examples, but we can all think of others.
The crux of the problem is that financial institutions as a whole, and even some industrials, seem to be undercapitalized. Until governments invested massive amounts of public money, the world's largest banks had yet to raise even as much new capital as they lost over the last two years. But if the problem is lack of capital, why did these firms (and many others) do the reverse: pay out dividends to investors? It's hard to know their motivation, but easy to imagine that the possibility of government help may have played a role.

So what should governments and central banks do? Consider financial firms. Their lack of capital has generated widespread uncertainty about the solvency of some institutions, which inhibits a broad range of common financial transactions, including interbank loans and commercial paper. Standard policy in such cases is for central banks to supply liquidity to markets, traditionally in the form of collateralized loans, and facilitate the recapitalization of the financial system. Central bank lending traditionally addresses liquidity problems, and new capital, either private or public, addresses solvency problems.

The challenge, of course, is to distinguish illiquidity from shortage of capital or insolvency. The rapid expansion of central bank lending facilities around the world has blurred the line between them. If the two look the same to an outsider, programs designed to increase liquidity can easily have the unintended consequence of inhibiting recapitalization. Why? Because an undercapitalized bank can claim illiquidity to borrow money from a central bank, thereby postponing the necessity of raising more capital. Current shareholders might even prefer this, since recapitalization may come at their expense.

We think private sector arrangements point to improved solutions to both liquidity and solvency problems that governments should consider now. We know it's hard to say that with a straight face right now, but bear with us. Consider liquidity. Many firms sign lines of credit with banks, which give them an option to borrow money at a future date -- under certain conditions. The conditions are important. They typically include restrictions on the use of funds, covenants on financial performance, and a "material adverse change" clause that rules out loans to undercapitalized or insolvent firms. These conditions make it clear that lines of credit are designed to help firms deal with liquidity issues, not solvency issues. An undercapitalized firm can therefore expect that a line of credit will not be honored. These conditions on lending have of course been misunderstood in Illinois, United States where the governor (since arrested and later released) called for a bank to loan money to a bankrupt company so that it could pay severance to its workers!

Central bank lending facilities are, in principle, protected from insolvency by collateral. But the collateral requirements have been loosened so much they have become close to meaningless. There seems to be little in place to stop an insolvent bank from raising cash against shoddy collateral. We think something like a material adverse change clause would be useful here. Central banks should refuse loans to banks, and governments to other firms, that cannot demonstrate their ongoing viability.

Similarly, the private sector has a solution to insolvency; in the US, we call it chapter 11. The government can facilitate this by providing something analogous to "debtor-in-possession" financing, but only in support of a legitimate reorganization of a business that results in a viable company.

Government money shouldn't be a gift to existing investors and management. We think governments need to apply similar terms to the extension of credit: a firm must demonstrate its viability before receiving government money. Without such strings attached, government help is likely to be more expensive and, perversely, reduce the willingness of the private sector to contribute to its own survival. To the extent that firms have already given money away in the form of dividends, there's nothing we can do. But it's in the public interest to establish clear guidelines for the future about the conditions under which private firms can access taxpayer money.

The authors teach at New York University's Stern School of Business. Acharya is also affiliated with the London Business School. Their work is part of the NYU Stern project, “Repairing the US Financial Architecture: An Independent View.”

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