Fixing the Financial System by Reinventing Debt

In his State of the Union address, President Obama did a bit of Wall Street bashing (although less than I would have expected). I don’t really have a problem with Wall Street bashing. The financial sector came to represent an abnormally large share of the U.S. economy over the past decade. It needs to shrink. And bashing makes things smaller, right?

Still, it’s usually more interesting (and definitely more HBRish) to think about reinventing rather than tearing down. My colleague David Champion recently offered up a list of several wonkily interesting financial-system reforms we ought to focus on. They included a Capital Markets Safety Board, central clearing and margin collateral for derivatives markets, and more (not less, as the banks want and have so far gotten) mark-to-market accounting. Well, here’s another idea that’s been making the rounds among economists and finance profs but doesn’t seem to have gotten much traction in the wider world: the reinvention of debt.

The first hint I got of this came in reading Yale economist Robert Shiller’s book The Subprime Solution, which was published just before the “subprime crisis” turned into the Panic of ’08. Shiller had a bunch of wonderfully Shillerian ideas for making the financial world better, but my favorite was what he dubbed the “continuous workout mortgage.” Here’s Shiller’s description:

Such mortgage contracts, when originally signed, would specify a program for steady adjustment of the balance and payment schedule over the life of the mortgage, enabling most homeowners to continue to afford to make payments and maintain some home equity, even in harsh economic circumstances. These contracts might become the standard, with automatic adjustments based on shifts in national housing-cost indexes and futures markets (I’ve been involved in creating both), as well as economic indexes like the unemployment rate.

The idea here was to make the financial system less fragile by making risk-sharing arrangements in advance of a crisis. I filed that away somewhere in my head and promptly forgot it as the financial world started to collapse. But a few months into last year I began hearing things that reminded me of Shiller’s funky mortgage plan. My friend Felix Salmon pontificated about the need to “move in general from a world of debt finance to a world of equity finance.” Philosopher/provocateur/frequent-bather Nassim Nicholas Taleb made similar noises. And then, at a conference this fall, I heard Myron Scholes (whose financial innovations have been pointed to as a possible cause of the financial crisis) make the case that maybe the inflexibility of debt contracts was the main cause of the financial crisis. Ah, the Scholes-Taleb Theory, I thought. (The two really don’t get along.)

It hasn’t stopped there. Lately, a group of finance scholars calling itself the Squam Lake Group has been talking up a kindred proposal for “regulatory hybrid securities”:

The idea is simple: banks should be pressured to issue a new kind of debt that automatically converts into equity if the regulators determine that there is a systemic national financial crisis, and if the bank is simultaneously in violation of capital-adequacy covenants in the hybrid-security contract.

When economist Joe Stiglitz stopped by HBR on my first day on the job (Jan. 25) to promote his new book, Freefall, I couldn’t resist asking him about this whole reinvention-of-debt meme. His response: “Bruce Greenwald and I have been writing about that for a long time.” Stiglitz always says something like that when you ask him an economics question. And he usually has a point. Agree with his policy prescriptions or not, you can’t deny that the man has played at least a cameo role in most of the interesting economic-theory discussions of the past 40 years.

“The reason people like debt contracts is that they’re simple,” Stiglitz went on. “With equity you get a fraction of the profits, but you don’t know what the profits are. Equity is better in risk-sharing, but equity has more problems in enforcement and asymmetric information.” That is, when you lend somebody money, they have to pay it back or there will be trouble. When you put equity into a venture, the people who are hired to run it (the agents) might decide to funnel an inordinate share of the profits to themselves. Or spend it on campaign donations.

So that’s the attraction of hybrids like continuous workout mortgages or regulatory hybrid securities. During normal times they look like debt, with all the disciplining effects thereof. But when the financial world goes haywire, they automatically turn into something more like equity, so risks are better shared. What’s not to like about that? (I don’t mean that as a rhetorical question; I’m really interested in hearing about the holes in this approach.)