Privatizing Gains and Socializing Losses

Someone asked me yesterday if I was going to do a post on the big bank bailout, and I reviewed my notes from a post I was going to write just two months ago, after the Fannie and Freddie bailouts. At the time, it seemed egregious that those were going to cost $50 billion, or around $170 per person in the US. How naïve and innocent we all were in those days.

Rather than writing about the current bailout per se, other than to say that it’s prima facie an utter Mongolian cluster f**k, I’d like to put it in the broader context of privatizing gains and socializing losses, which has been a special hobby for the current administration but seems to be a general approach in Washington DC.

As regulations were peeled away, leaving hedge funds free to trade opaque securities and mortgage bankers free to write unsustainable loans, members of the financial community made fortunes. These fortunes range from Wall Street titans buying Hamptons estates to Phoenix mortgage brokers buying a new Hummer, but they were all built on a house of cards. And now that the card house has fallen like a Jenga tower at the end of a drunken evening, the fortunes are still there while the taxpayers are picking up the tab.

Just to choose someone at random, let’s look at Michael Perry, the longtime CEO of IndyMac bank, until it was taken over by federal regulators. His total compensation in 2006 was over $4 million. In 2007 it went down to $1 million, but that didn’t include payments to his father ($86,925: independent inspector), his brother ($346,621: loan originator) and his sister-in-law and cousin, both employees making over $200k per year. But most of Mr. Perry’s fortune was made in equity. In May 2005 he netted $6 million from exercising options and in August 2005 he netted another $4 million. He filed SEC forms for many other option exercises, but I got tired of looking them up. You get the point: this guy made tens of millions of dollars while running his bank into the ground. And courtesy of the Bush tax cuts for the wealthy, he got to keep more of his ill gotten gains than he ever would have before.

The FDIC is currently estimating the takeover of IndyMac will cost nearly $9 billion. None of this money is coming from Mr. Perry. He gets to keep his tens of millions of dollars, while we all (anyone who uses a bank, since the FDIC is funded by banks, not taxpayers) pay the cost of his terrible management. This pattern – operator is unburdened by regulation, takes excessive risks, makes fortune, is bailed out by society while keeping fortune – has become almost paradigmatic for the Bush administration. Officials preached deregulation and markets while fortunes were being made, but now that things have soured, suddenly society is expected to bear the costs.

This is clearly a bad idea. Even an old Republican hand like George Schultz recently said “People and institutions behave more responsibly when they have some of their own equity at stake.” George and I are not the only ones who think it’s a bad idea; here are links to some other folks who agree:

• NY Times writer David Carr, who recently described a mortgage broker right out of college: “We ordered three, four bottles of Cristal at $1,000 per bottle.” The taxpayers aren’t getting those bottles of Cristal back.
• Foreign Policy magazine: “What is reprehensible here is that losses have now been socialized to taxpayers.”
• The Financial Times: “Is the reality of the modern, transactions-oriented model of financial capitalism indeed that large private firms make enormous private profits when the going is good and get bailed out and taken into temporary public ownership when the going gets bad, with the tax payer taking the risk and the losses?”
• Nobel Prize winning economist Joseph Stiglitz: “Those on Wall Street may have walked off with billions, but those billions are dwarfed by the costs to be paid by the rest of us.”
• Nobel Prize winning economist Robert Solow: “And once the banking system is involved in a big way–owning, and holding as collateral, assets whose likely value is hard to understand and impossible to calculate–then we are all at risk.”

Five data points do not make reality, but let’s just say, for fun, that most people would agree to my proposition: it is bad to keep gains private while taxpayers cover the losses. So why does it keep happening? Here are some ideas:

• Bankers are wealthy while taxpayers aren’t, and Republican policies generally benefit the wealthy
• Banks and financial firms hire lobbyists and make campaign contributions, while taxpayers don’t
• Republicans think that markets are self correcting, but they aren’t (there will be an entire post on that philosophical faux pas soon)

But another reason it keeps happening is because the voters let it happen. When Phil Gramm was jamming though poorly designed deregulation laws, none of his constituents voted him out.  Maybe Texas voters bought his “big government is bad” argument. Or maybe they didn’t realize the possible implications of unregulated trading in financial derivatives. Or maybe they simply weren’t paying attention. Whatever the reason, if voters don’t punish politicians for acting stupidly, then voters (ie. taxpayers) are going to end up paying the costs, all the way up to (and beyond) $700 billion.