Government money should have strings attached

There is a tendency in a crisis to throw out the rulebook: we are 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 are 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 per cent increase in its dividend and a $100m share repurchase in January, only to declare bankruptcy in September. The US government declined to save Lehman.

Citigroup paid $5.9bn 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 under-funded 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 undercapitalised.

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 past 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 is 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 collateralised loans, and facilitate the recapitalisation 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, programmes designed to increase liquidity can easily have the unintended consequence of inhibiting recapitalisation.

Why? Because an undercapitalised 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 recapitalisation 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 is 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 undercapitalised 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 honoured.

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 should not 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 is nothing we can do. But it is 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.  Prof 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.”


Originally published at the Financial Times and reproduced here with the author’s permission.

3 Responses to "Government money should have strings attached"

  1. Maya   January 8, 2009 at 12:31 pm

    Why should government money have strings attached?They printed it, did not work for it and now they have power over th entire financial system based on the unconstitutional and illegal ability to print money without a gold standard. Are we living in a crazy world!

  2. CLS   January 8, 2009 at 3:48 pm

    Without strings shouldn’t the goverment aid rightly be called welfare?

  3. Guest   January 8, 2009 at 6:55 pm

    As you know, I have long advocated a ban on housing evictions in response to this economic collapse. Indeed, I have said that we do not have an economic crisis: we have a rights crisis. Economic activity will only increase if there is an increase in individually enforceable rights. That is the magic key, the secret.The ban on housing evictions is proceeding. Here is a comment I sent to a reporter on the Schumer mortgage modification legislation. Pay attention to the followingHi: I read your article on Citi and mortgage modification. However, I don’t think you understand its legal ramifications. May I step back a few steps and suggest a few questions you might want to ask Schumer? Ever since West Coast Hotel v. Parrish (1937–John Roberts had to sign off on its doctrine IN WRITING: it’s online), the Constitutional regime has been as follows: policy is Constitutional if it is rationally related to a legitimate government purpose. Thus, with a few exceptions (noted below) policy is subject only to “minimum scrutiny.” That is why the current Constitutional regime is called the scrutiny regime. This has meant two things: 1. the political system has nearly absolute control over nearly all facts;2. individuals have virtually no individually enforceable rights over any facts. That is true of housing. The reason homeowners can get foreclosed is because they cannot assert any right against current policy which says: if you can’t pay your mortgage, you get foreclosed. Housing enjoys only minimum scrutiny, as the Court found in Lindsey v. Normet (all these cases listed here are online). OK, what are the exceptions? Certain facts are taken OUT of the political system and virtually absolute power over them is given to the individual. These are known as “important” facts. What are important facts? The test, laid out in West Virginia v. Barnette, is whether a fact is a fact of human experience which does not change no matter what attempt is made to change it. What is an example of an “important” fact? Exercises of religion, which were removed from the political process in West Virginia. It is virtually impossible for government to attempt to change an exercise of religion (such attempts are subject to “strict” scrutiny–which says that government basically has to argue that the government will collapse unless it is allowed to attempt to change an exercise of religion: government never wins this argument). Protected speech is another important fact. So is racial and gender legal equality. Is housing an “important” fact? People have been arguing it for years, but the Court has never found it to be so. Now the question is, if judges can modify mortgages, are we moving toward recognizing that housing is an important fact. For example, the proposal says JUDGES can modify mortgage terms. But where does that request come from? It comes from the homeowner. So, the legislation is giving homeowners power they did not have before. Thus, the legislation RAISES THE LEVEL OF SCRUTINY for housing with respect to home mortgages. The reason you are seeing opposition is that this immediately raises other questions? Are there analogous situations with regard to rental agreements, such that renters would also have the right to ask the Court to alter housing leases? After all, Bair at FDIC doesn’t want to remove renters renting foreclosed houses. So, combining her policy with this new legislation, aren’t we saying that the level of scrutiny for housing is also being raised with respect to renters? And if the level of scrutiny for housing is being raised with respect to mortgage terms and rental agreements, with respect to what other, analogous aspects of housing-related contracts, or housing itself, or health and welfare regulation relating to housing, is the level of scrutiny being raised? So this is why what is going on in housing policy is so momentous. The stakes are high: are we leaving the “scrutiny” regime behind? I think so. You might want to read online an interesting essay about the history of our Constitutional regimes: G. Edward White (University of Virginia Law School), “Historicizing Judicial Scrutiny.” It is VERY important to note that, as individually enforceable rights with respect to facts, are increased, the political system’s control over the MONEY relating to those facts, decreases. Appropriations increasingly are tailored to harmonize with the right. The political system is worried about losing control over government expenditure. Housing is not the only fact with respect to which public opinion is demanding more individually enforceable rights. I studied this phenomenon in connection with the opposition to eminent domain in my book The Eminent Domain Revolt (New York: Algora 2006). So anyway, you should ask Senator Schumer whether the proposed legislation in any way raises the level of scrutiny fo housing, or, does it increase individually enforceable rights in housing. If they strenuously deny that it does any such thing, then ask whether it does not give the homeowner the right to request a change in mortgage terms. Cheers,John Ryskamp