Subsidies and Bailouts

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Lecture 7 — Subsidies and Bailouts (Risk Subsidies in the 20thDownload

Lecture 7 — Subsidies and Bailouts (Risk Subsidies in the 20th Century)

0) Big Idea

Risk subsidy = a policy that lowers the private cost of taking risk by shifting loss-bearing to the state (e.g., guarantees).

  • Unlike a cash (lump-sum) subsidy, a risk subsidy pays off only if someone takes more risk.
  • Politically attractive because fiscal costs are opaque (often off-budget), yet benefits are salient.

1) Why Governments Use Risk Subsidies

  • Quiet transfers that don’t show up fully in budgets.
  • Fit long-standing government–bank bargains: banks help the state; the state protects bank risk.
  • But: to preserve the subsidy’s value, prudential regulation is kept weak/inexact → more risk-taking → more crises.

2) Deposit Insurance as Risk Subsidy (U.S. states, 1910s–1920s)

Research design: Compare insured state banks vs. uninsured banks in the same state and vs. nearby states (clean identification).

2.1 Hypotheses

1) Insured banks attract deposits away from uninsured banks.
2) Insured banks take more risk, visible in balance-sheet choices:

  • Lower Cash/Assets
  • Lower Equity/Assets
    3) Depositor discipline weakens at insured banks: depositors stop rewarding prudence / punishing risk.

2.2 Findings

  • Deposit flows: +~25–30% deposits and loans at insured banks vs. controls (post-implementation, not mere passage).
  • Risk choice: Insured banks cut cash buffers and capital ratios (economically large drops).
  • Mechanism (discipline test):
  • For uninsured banks:
    • ↑Loans/Assets → deposits leave
    • ↑Equity/Assets → deposits enter
    • ↑REO/Assets (foreclosures) → deposits leave
  • For insured banks: the same risk signals don’t move deposits (effect neutralized).
  • Who drives it most? Young/small entrants in counties tied to WWI crop booms (high-beta opportunities).
  • Outcomes: When WWI price shock reverses, insured systems collapse; uninsured/national banks remain viable.

2.3 Contemporary recognition

  • FDR (1932) opposed federal DI (“laxity in bank management and depositor carelessness”; fiscal drain).
  • Yet FDIC (1934) passed via log-rolling with unit-banking interests; temporary → entrenched.

Takeaway: Deposit insurance reduces market discipline, raises bank risk, and amplifies failure, even when intended to stabilize.

3) Farm Credit System (FCS) & Ag Land Bubble (1970s–1980s)

Institutional setup: Government-backed, cooperative lenders → weak governance & soft budget constraints.

3.1 Economics of ag land value (Mark Carey insight)

  • Commodity prices mean-revert in real terms → warranted land values shouldn’t jump merely from temporary crop price spikes.
  • 1970s: Real farmland prices surge (’72–’82) → unwarranted by fundamentals → classic bubble.

3.2 Who lent into the bubble?

  • Commercial banks with shareholder capital pulled back as prices detached from cash flows.
  • FCS expanded to near 100% of new ag loans by the peak, underwriting on appraisals that simply capitalized rising comps → credit fuels prices → prices justify credit (feedback loop).
  • Collapse in the 1980s; fixes raised capital but core incentive/governance issues largely persisted.

Lesson: Government-subsidized credit + non-shortable asset (land) = strong pro-bubble dynamic.

4) Thrift (S&L) Collapse (1980s)

Policy trilogy (New Deal, 1934):
1) Insured thrifts (S&Ls) mandated into housing → de facto subsidy to 30-yr fixed-rate mortgages.
2) Fannie Mae (secondary market) → further subsidy to conforming mortgages.
3) FHA → guarantees for borrowers who couldn’t qualify conventionally.

4.1 Interest-rate risk at heart

  • Market never produced widespread 30-yr fixed loans unaided: duration risk too large.
  • 1979–81 rate spike → massive mark-to-market losses at S&Ls (assets fixed-rate, funding short).
  • Rule of thumb: +1% long-rate move can wipe ~15% off a 30-yr bond’s value.

4.2 Gambling for resurrection

  • With equity gone, S&Ls lobbied for expanded powers (’82): CRE, junk bonds, etc.
  • Brewer result: Deeply impaired S&Ls took the riskiest bets; well-capitalized S&Ls didn’t.
  • Politics: Resolution delayed until post-1988 election (FIRREA, 1989).
  • Fiscal cost: touted ~$300B; realized ~$150B after asset sales, but true economic burden closer to the higher figure.

Lesson: Subsidizing unhedged long-duration mortgage assets while suppressing discipline creates predictable insolvency and moral hazard.

5) Unifying Mechanisms (Across Cases)

  • Balance-sheet margins:
  • Lower Equity/Assets and Cash/Assets when protected.
  • Market-discipline margin:
  • Guarantees mute deposit flows & rate premia as risk signals.
  • Entry/strategy margin:
  • Guarantees attract new, riskier entrants & incentivize risk-shifting by impaired incumbents.
  • Political economy:
  • Risk subsidies are sticky (constituencies form); prudential rules bend to keep subsidies valuable.

6) Policy Implications

  • If the goal is affordability or access, prefer transparent cash/on-budget subsidies (or income-side tools) over risk guarantees.
  • If guarantees are used:
  • Price them (risk-based premia),
  • Cap exposure (coinsurance, deductibles),
  • Enforce tough, countercyclical capital/liquidity,
  • Resolve zombies early (no gamble-for-resurrection),
  • Preserve information & market signals (disclosure, credibly uninsured funding at the margin).

7) Key Ratios & Terms (quick reference)

  • Equity/Assets (E/A) — solvency buffer (↑ = safer).
  • Cash/Assets (C/A) — liquidity buffer (↑ = safer).
  • Loans/Assets (L/A) — asset risk intensity (↑ = riskier, all else equal).
  • REO/Assets — foreclosure footprint (↑ = distress).
  • Duration/IR risk — value sensitivity to rate changes.

8) Discussion Prompts

1) When (if ever) are risk subsidies superior to cash subsidies?
2) How would you design deposit insurance to preserve discipline?
3) What early-warning metrics would you track to catch “gambling for resurrection”?
4) Should a state ever subsidize 30-year fixed-rate mortgages directly?

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