Friday :: Mar 6, 2009

The Art of Looting and Tunneling

by eriposte

As the search for AIG's counterparties continues, it's worth remembering what AIG and the rest of the Too Big to FailTM gang did in the last few years. For that we turn to the abstract (emphasis mine) of the 1994 paper by George Akerlof and Paul Romer (h/t Yves at Naked Capitalism):

Looting: The Economic Underworld of Bankruptcy for Profit

During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent - and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and the suffered a dramatic collapse. Also in the United States, the junk bond market, which fueled the takeover wave, had a similar boom and bust. 

In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds. 

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Sounds like a good description of what we've seen play out more recently, although the "underworld" operated quite openly.

Simon Johnson at Baseline Scenario observes that given the current trajectory of the Obama Treasury department, the looting will be followed by tunneling - "borderline legal/illegal smuggling of value out of businesses". He concludes:

Confusion in policy breeds disorder in companies, and disorder leads to the loss of value.  This is the reality of severe crises wherever they unfold; we have not yet reached the worst moment.  And, of course, there are many more shocks heading our way - mostly from Europe, but also potentially from Asia

The course of policy is set.  For at least the next 18 months, we know what to expect on the banking front.  Now Treasury is committed, the leadership in this area will not deviate from a pro-insider policy for large banks; they are not interested in alternative approaches (I’ve asked).  The result will be further destruction of the private credit system and more recourse to relatively nontransparent actions by the Federal Reserve, with all the risks that entails.

The road to economic hell is paved with good intentions and bad banks.

Now tell me the bad news.

eriposte :: 7:43 AM :: Comments (2) :: Digg It!