Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Bailouts and thanksgiving

I wrote a column in Wednesday’s Financial Express arguing that bailout recipients seem to regard the bailout as an entitlement and are therefore unwilling to say ‘thank you’ let alone ‘sorry.’ This sense of entitlement aggravates the risk of moral hazard.

Warren Buffet’s open letter last week (NYT, November 17, 2010) thanking ‘Uncle Sam’ for bailing him out in 2008 serves to remind us that very few corporate leaders in the US or in India have been willing to say ‘thank you’ let alone ‘sorry’ after the global financial crisis and the ensuing bailout. Warren Buffet proudly says that “My own company, Berkshire Hathaway, might have been the last to fall,” but at least he admits that he too needed help.

By contrast, many corporate leaders around the world are busy creating a revisionist history of the crisis in which they can pretend that there was no serious problem with their companies at all. I do not think of the willingness to say ‘thank you’ or ‘sorry’ as a matter of politeness and courtesy. I view it instead as a measure of whether the recipient thinks of the bailout as an entitlement that he can look forward to in future or as a piece of good fortune that may or may not be repeated in future.

Warren Buffet’s letter describes the bailout as a correct policy but makes it clear that the bailout required a confluence of ideological disposition and technical competence in key decision makers. When recipients have this perspective, the moral hazard created by the bailout is attenuated.

While I disagree with the pro-bailout ideology of the Indian government (including RBI and other regulators) at the time, there is little doubt that the Indian crisis response was well thought-out, coordinated and implemented smoothly. Key recipients of this government bailout should be thankful to the government for this but, unfortunately, they seem to see the bailout as their right. Let us look at some examples of how this is leading to moral hazard.

Many debt-oriented mutual funds in India would have had to suspend redemptions but for the support provided by the government through the banking system. More than the mutual funds themselves, the corporate sector that had parked cash surpluses with these funds owe a big thank you to the government. For years, the corporate sector used these mutual funds as a tax sheltered vehicle to earn a high post-tax return on their cash surpluses.

Without the government bailout, these cash surpluses would have become illiquid and inaccessible at the time of the corporate sector’s greatest need. Moreover, the corporate sector would have taken large losses on their investments as the mutual funds tried to liquidate troubled assets into a risk-averse market.

This bailout encouraged moral hazard and within months corporate investors were pouring money back into liquid mutual funds believing that they would be protected if things go wrong. It is very disappointing that the government did not take the opportunity provided by the crisis to end the tax sheltered status of short-term mutual fund investments. Similarly, it is very unfortunate that the government did not impose a hair cut on impatient investors trying to redeem out of these funds at the height of the liquidity crisis.

Many Indian banks benefited from foreign exchange swaps extended by RBI during the crisis. When they were unable to roll over the foreign borrowing after the Lehman failure, and when their credit default swap spreads were trading at around 10% per annum, the RBI swaps were very attractively priced. Indian banks have therefore been in no hurry to subsidiarise their foreign branches.

Non-bank financial companies (NBFCs) owe a large debt of gratitude to the government for the lender of last resort (LOLR) support that they received at the peak of the crisis. Despite the fig leaf of providing the LOLR support through the banking system, the dividing line between banks and NBFCs was largely obliterated in those months.

The entire real estate sector owes a big thank you to the government for encouraging the banking system to restructure real estate loans during the crisis. More importantly, the sector benefited from the bailout of mutual funds and NBFCs, which were important sources of finance for them. Again the moral hazard engendered by this bailout is the main reason we have to worry about a real estate bubble so soon after the crisis.

The Indian corporate sector should also be grateful to the US Fed for unleashing a flood of dollar liquidity into the world after the Lehman failure. The resulting revival of capital flows into India in mid-2009 was instrumental in repairing damaged corporate balance sheets. There is no guarantee that conditions would be the same in the next crisis.

All these bailouts contributed to the relative mildness of the 2008 crisis in India, which has made the Indian private sector complacent. As a result, Indian managers are behaving less prudently than they ought to. That itself is a source of systemic risk. It would be far better if Indian corporate leaders emulated Buffet’s sense of humility and gratitude.

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