Wednesday, September 30, 2009

How to "loot" a corporation

In 1994, George Akerlof and Paul Romer showed us how to loot a corporation by borrowing with other people's money:
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.
Ben Bernanke has apparently read their paper:
On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.”
I like the NY Time's characterization of the current crisis as an example of looting 
Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.
What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.
There are two ways to address this problem. Get rid of the "too big to fail" guarantees that allow banks to gamble with other people's money (heads I win, tails the government loses) or impose more regulation on the banks to prevent them from taking risk. You can probably guess which path they will take.


  1. Given that society won’t do what it should (get rid of explicit and even implicit gov’t guarantees), could not a rational person then back more rather than less regulation of financial companies? Even if this rational person would otherwise rather leave this matter to the markets? As long as regulation is somewhat effective (which it sometimes isn't).

  2. You might want to take a look a William Black's control fraud theory.

  3. Dinosaurs - "Too Big to Fail" ?