Socializing Corporate Risk-taking: Moral hazard 2.0

Attempting to ameliorate the immediate and adverse economic consequences of the rapidly spreading coronavirus, Congress is engaged in a pell-mell rush to force passage of $2 trillion in fiscal largess. Their actions are not without precedent.

On September 20, 2008, just as the last financial tsunami was cresting, Fed Chairman Ben Bernanke allegedly told colleagues: “There are no atheists in foxholes and no ideologues in financial crises.” The implication was that we must do things we might normally find unpalatable when the situation demands it. We have lived, however, to regret some of the hasty fiscal and monetary decisions made in the heat of that moment. It appears memories are short as we seem destined to repeat those missteps during the panic of 2020.

While difficult to implement, programs that provide immediate financial relief to the half of U.S. households that don’t have $500 in savings should be Congress’ first priority. Accountability is essential, but that’s tomorrow’s challenge. It is right and humane that the cost of “social security,” in the upheaval of a pandemic, should fall on the broad shoulders of all taxpayers.

Corporations are expected to have access to both the credit and capital markets. Government loans, bailouts, or other means of providing public companies with financing is an entirely different matter. Unlike the aforementioned paycheck-to-paycheck households, shareholders have been the prime beneficiaries of the perpetual zero cost money machine at the Federal Reserve. As to who was on the receiving end of its spoils: until the first quarter’s carnage, the total annual return from the S&P 500 averaged over 15% since the 2009 low.

By definition, shareholders have the most junior claim on a corporation’s cash flow or assets. Once suppliers, workers, creditors and others are paid, what’s left over goes to them in the form of dividends or retained earnings. For the last 10 years, at least insofar as share price appreciation is the measure, shareholders have prospered mightily compared to senior claimants.

Contrary to popular belief, the $2 trillion spent by corporations in buybacks over the last several years should not qualify as a return to shareholders. The sellers, perhaps taking advantage of share prices buoyed by buyback programs, were exiting the ranks of the company’s shareholders, in whole or in part. Corporate buybacks only benefit remaining shareholders if the company repurchases at prices below the intrinsic value of the business itself. That rarely happens. Worse yet, many companies have put themselves in peril, having borrowed copious amounts of debt to finance the repurchases.

Now the worm has turned. If there are not enough cash flows or assets to go around to satisfy the senior claimants, shareholders must pick up the tab. Recompense could take many forms: borrowing, assuming it’s possible, at interest rates that reflect the risk to lenders; dilution through the sale of additional equity at distressed prices or disadvantageous terms; sale of the company to another that is stronger financially; or even orderly reorganization of the company under bankruptcy law protection. Emerson’s “Law of Compensation[1]” is impolitely summarized as: “To the victors go the spoils, and woe to the vanquished.” This is the means of corporate accountability in a capitalist economy.

A company’s officers and Board of Directors are “agents”’ of the shareholders. Under law, they are accountable to their shareholder “principals.” The vast majority of shareholders, however, are one long step removed from being practically capable of holding their hired agents’ feet to the fire. They are owners of mutual funds and other securitized pools in which they have no direct voting power regarding individual companies—a point which is practically irrelevant because of the multiplicity of holdings the funds own. The extreme example is the ever more popular automaton index fund, which, for a low fee, mimics an index like the S&P 500. It simply can’t afford to micromanage. In such an arrangement, recklessness on the part of agents goes unchecked until a crisis like the coronavirus inconveniently exposes the company’s managerial fragilities. While shareholders have benefited from the recent bull market, their absence in corporate governance is now yielding the unfortunate fruits of poor corporate management.

Investment editor Jim Grant has observed that there is nothing ever really new in the world of investment and finance, just old principles dressed up in the latest fashion. That’s why the current situation looks so much like the chicanery and sleight-of-hand leading up to the financial crisis.

Moral hazard occurs when one player has an incentive to increase exposure to risk because they don’t bear the full downside cost of those risks. The last crisis resulted from mortgage originators, bankers, and brokers offloading risk to mortgage pools formed by investment banks. Because of the ill-considered AAA-ratings they secured, the investment banks were, in turn, able to further offload the risk to institutional investors. The high ratings were the ticket to the gargantuan institutional markets, which rely heavily on official third-party quality affirmations. Moral hazard 1.0.

The incentives of corporate officers and boards today are moral hazard 2.0. The coronavirus has hastened the inevitable arrival of a global recession in business and commerce. Its abrupt appearance has exposed those who assumed more risk than prudent. In the event of a government bailout, the executive-level managers who occupy the “C-suite” will have avoided culpability. They will have used the asymmetry of information they possess as a tool for personal gain rather than wielding it on behalf of shareholders. For all the havoc wreaked during the financial crisis, the minimal consequences officers and directors have borne speak volumes.

Shareholders, not taxpayers, must bear the brunt of poor decisions or there will be no imperative to involve shareholders again in holding their agents to account.

Congress, please speed thoughtful and compassionate relief to the disenfranchised but insist corporations show their mettle. Let the law of compensation render its judgment. For those zombies that have masqueraded as upstanding corporate citizens, may they muster all the ingenuity they possibly can to minimize the damage to the shareholders they purportedly represent. To paraphrase, billions for the needy but not one cent in tribute to corporate frauds. As for the many who are worthy of the title corporate stalwart, epitomized by Berkshire Hathaway, they will refuse even a penny if proffered.

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[1] Martin, Frank K., A Decade of Delusions (pp. 431-432). Wiley. “Nearly 200 years after Newton, philosopher and essayist Ralph Waldo Emerson appealed to the laws of physics to explain the nature of humanity in a similar action/reaction duality. He called it the law of compensation. Within every cause, Emerson reasoned, grew the seed of its own effect. Even before Newton and Emerson, Buddha identified the central law of our existence as karma, which in Sanskrit means action. For every action there is an effect; this law of cause and effect, Buddha taught, is the central law of both our internal and external world. ‘As you sow, so shall you reap,’ said Jesus several centuries later. The common thread: Actions have consequences—and those consequences, though likely quite different from the actions themselves, tend to be more or less proportional.”