Borrowers, lenders, and others--beware trusting the government

by Philip Brewer on 28 May 2009 9 comments
Photo: Philip Brewer

Having a prosperous country (as opposed to having merely a prosperous elite) depends fundamentally on the rule of law. The system can work adequately well with various sets of rules, as long as they're known in advance and fairly applied. During hard times, though, there's a strong temptation to ignore the rules in a search for a less-bad result. Both borrowers and lenders need to watch out.

There has always been a fault line between creditors and debtors. There are usually many more debtors, which tends to give that side a certain amount of power--especially in a democracy. On the other hand, the creditors usually have a lot more money, which gives that side a kind of power as well. These divisions play out over time, changing the rules to favor one side or the other.

Changing and fudging

As I said, you can achieve prosperity under a broad range of different sets of rules. (Respect for private property is important, but you can be prosperous even with zoning, taxes, and eminent domain. Free markets are important, but it is probably better yet to have the government enforcing accurate weights and measures.) You can even change the rules, as long as the changes are done carefully, with a due respect for deals struck under the old rules. What really hurts prosperity is ignoring the rules--playing fast-and-loose with the rules so as to get an appealing outcome.

Right now we're definitely seeing the rules being changed--and possibly seeing them being fudged as well.

One example of rule changing is the new credit-card law. Generally, I think the changes are good changes. (The key test is: does the change bring the rules closer to what they should have already been? I think the restrictions on how banks can raise rates on already-existing debt fall solidly into that category, as do rules requiring that banks send bills well before they're due and apply payments promptly.) Of course, when the rules are being changed in your favor, it can be tempting to see only the upside.

Rule fudging, on the other hand, is almost always bad. Just now there's some possible fudging going on in the government-led efforts to reorganize Chrysler and GM.

Now, I'm not even sure that the rules are being fudged. The long-standing rules for chapter 11 bankruptcy already included a bias in favor of preserving the enterprise--even secured creditors could be made to accept equity instead of getting to grab their collateral, if the judge decided that keeping the company going could eventually provide as much total return to creditors. I'm not a lawyer, and I'm not knowledgeable enough about bankruptcy law to know if those rules are being followed or not. (Legally, the issue seems to have to do with whether the employee trust created to take over the costs of retiree health care amounts to a separate entity that should have to stand in line with other creditors, or if money owed to it should be treated like other employee compensation. I can certainly seem both sides of that issue.)

Be aware

But whether the rules are being fudged in that case or not, it's important to be aware of several things:

  • First, there's always more rule-fudging during hard times. During good times there's a tendency to just go with the flow, even when the results seem to drop an especially heavy load on one person or another. People can rationalize that, "Yeah, he got the short end of the stick, but he'll just have to pick himself up and carry on." During bad times, though--when maybe he can't just carry on--there's a greater temptation to bend the rules to produce a less cruel outcome.
  • Second, don't assume that the rule changes will all go one way. Both sides have political power and any particular rule change can have complex effects. As recently as 2005 the creditor class had enough power to push through punitive changes to the bankruptcy law. Now the debtor class has enough power to push through changes to the credit card law. (But not, so far, enough power to push through bankruptcy law changes that would allow a bankruptcy judge to reduce the amount owed on a mortgage.)
  • Third, although it's good when changing the rules produces better rules, just getting the rules changed in your favor is no cause for celebration. Rule changing does harm in several ways, one of which is that greater uncertainty makes everyone a little more cautious--which means that loans are harder to get and interest rates are higher. Everyone guessing what sorts of fudging are likely acts to change things even if the rule fudging doesn't even happen. (For example, because the action around the automakers favors unionized workers, the market seems to be pushing up the interest rates for broad swath of other companies with unionized workers, in anticipation that their workers and lenders might get similar treatment.)

Rule changes don't have to involve creditors and debtors. Anybody whose success depends on government policies is at risk. As just one example, a few years ago, when everyone was in a tizzy about a shortage of landfill space, Illinois created a package of tax breaks for people who built incinerators for solid waste. The political winds quickly changed, though, and solid waste incinerators began seeming like a bad idea. So the state repealed the tax break, leaving many companies with half-built incinerators in the lurch.

Diversification

Analyze how you would be affected if the government changed any rules that you depend on. If one or a few simple rule changes could cost you big bucks, the safe thing to do is to change your position so that you're not so dependent on those specific rules.

Note that this is not the same as the most profitable choice! If you align your finances to take maximum advantage of some special rules, you can often make a bunch of money--it's just that you're screwed if the rules change faster than you can adjust.

Sometimes, that's a risk worth taking. After all, you can often get a feel for whether the rule is vulnerable to change by looking at how many voters depend on it. But it's just plain safer to spread things around, so that any one rule change won't affect you too drastically.

For example, although it makes good sense to tax-shelter some of your income in 401(k)s and IRAs, I advise saving some money outside these plans as well. Yes, you're paying taxes that you could have deferred, but those big pots of tax-deferred money are a perpetual temptation for the government. (There has been more than one proposal for a "one-time" tax on retirement accounts to fund some spending priority or another.)

A little diversification--together with a healthy distrust of the government--will do a lot to keep you safe.
 

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Guest's picture
Kelja

Philip, I agree with you that a healthy distrust of government is necessary but I'm sensing you personally put too much trust in government.

I didn't trust the former administration and trust the present one even less. They are making a shambles of law. For example - the bankruptcy of both GM and Chrysler.

You state, "secured creditors could be made to accept equity instead of getting to grab their collateral, if the judge decided that keeping the company going could eventually provide as much total return to creditors."

Creditors grabbing their equity is not the issue here. The creditors in question are secured investors who invested in the bonds of both companies when risk was running very high. In return for their money (to keep the businesses running) they received an interest payment and a guarantee that they would be 1st in line in the event of a default.

You do understand that without such a trade-off, money would NOT been available to the companies?

Now, Obama has thrown Bankruptcy law out the window to award his constituents, the unions, a bigger share of the pie than the investors. Lest you think the investor class as the big greedy hedge funds and banks, most of the bonds are owned by pensions - fireman, teachers, policemen and the like.

It's clear the government is in the business of deciding winners and losers. It's not the market anymore.

GM will be 'Government Motors' now that the state will own 72% of the company. As an individual, I'd never invest in that stinking corpse of a company but as a taxpayer, well, I have no choice, do I?

Interestingly, what's not even discussed about this debacle is how the government will completely destroy GM. I mean, who the hell will now buy a car from GM now that team Obama calls the shots? The cars they produce will rival Yugos.

Sorry about ranting about this one example. I live in California, I'm 55 and I will never have any trust or respect for government anymore. The institutions of government have been taken over by the lunatic class.

I guess you can perceive I have more than a healthy distrust of our government. Maybe you can class it more as a healthy disgust.

Guest's picture
Jim

"most of the bonds are owned by pensions"

Do you have a source for that? Article I found said that 4 banks owned 70% of the secured debt for Chrysler.

Another source says that an Indiana Pension fund paid 43 cents on the dollar for Chrysler bonds in August 2008. Would you have bought Chrysler 8 months ago and considered it anything other than speculation? Looks like the Indiana funds probably only owned around $25M of bonds which is very little of the $6B total.
If pensions were heavily invested in Chrysler/GM bonds then I'd have to wonder why they were buying JUNK bonds at 43cents on the dollar when the company was already in very poor health.

Guest's picture
Kelja

Large Pension Funds typically hold lots of corporate and government bonds - what used to be thought of as 'safe' investments. Individuals own as much as 20% of the GM bonds ---- see: http://online.wsj.com/article/SB123940497568709785.html

They are royally screwed by government coming in and changing the rules.

Yes, some big banks do own the bonds as well. But they purchased the bonds with the legal understanding the bondholders would be 1st in line in the event of a bankruptcy.

The real question is why is the government reshuffling the deck in favor of the unions now. (The answer is obvious.)

Anyone who has any trust in our government is either doesn't pay attention or is a fool.

Guest's picture

Your post is well said. While we see these necessary to some knee jerk reactions to supposedly resolve a crucial immediate issue, we need to keep the long view and hope that our lawmakers do as well. Changes to laws have long term ramifications and we should be wary of that fact.

For example you cite the continued inability of bankrupcy judges to change mortgage contracts. If this change was implimented I suspect that the cost of borrowing for all could rise significantly as the risk to the lenders increased.

Diversification truly is the best path for us as individuals.

Philip Brewer's picture

@Kelja:

As to the situtation with GM:  As I said, I simply don't know whether the rules are being followed or not.  I've seen on-line discussions among people who know a lot more about bankruptcy law than I do, and it seems to be an open question.

So, my point is one step more abstract than that:  Rules do get changed.  They also get fudged, ignored, and outright broken. 

As citizens, we should all stand against breaking or ignoring the rules.  We should do what we can to see that changes, when they occur, are changes for the better.

As individual economic actors, though, we need to act in our own self-interest.  And I want to make the point that it's always dangerous to trust the government--even when the rules favor you.  In fact, that's when it's especially dangerous--because the more the rules favor you, the more likely it is that the next change will be for the worse rather than for the better.

Guest's picture
Olivia

This may be a bit of a tangent, but as usual Philip your posts are thought provoking. Rule changing does something else. It makes us think there are no absolute rights or wrongs. As a democratic republic should the government even own private businesses? In a socialistic society that's the norm. Why should an individual pay taxes on something they already own and lose it if they can't? Like property taxes. Should the government be involved in mandating prices paid for healthcare? Is it fair for individuals to pay for the overall costs of actual medical services (or more than actual cost) to cover the deeply discounted amounts Medicare or Medicaid covers? Should the government decide to print money with nothing to back it? Isn't that lying? But we live in the "new grey" and nothing is considered right or wrong, we decide by what's expedient. The big guy wins and squashes the little guy every time. Even though the ball is tossed back and forth between government and debtors and bankers and unions we all get hurt in the end. Bonhoffer said something like (correct me if I'm wrong), "First it was the Jews and we said nothing, then the Catholics and we said nothing, now it's us, and it's too late."

Guest's picture
Kevin

This is a very thought provoking article. I agree that we have to act in our own best interests, which includes some distrust of the government(and I tend to agree with the thoughts posted by Kelja about the current goings-on).

One problem can be the idea of "making sure the changes in the law are for the better". Better is completely subjective, and opinions on legal changes can vary-for instance your example about bankruptcy judges. I would be against giving judges the power to modify mortgage contracts.

I guess at the end of the day, Diversify and Distrust.

Guest's picture

I just wanted to make one additional comment concerning the comments of another over who actually owns auto company bonds. I don't see what it matters who owns the bonds. The corporate bonds were offered by the company which means they were available on the primary market and now sell on the secondary market. Anyone, be they individual or institutional investors, can buy and sell these bonds on the open market.

The point is that bondholders have inherent rights per the rule of law and I find it troubling that some are saying it is okay for the present administration to change the rules now.

Guest's picture

Great post!

We are on the edge here . . . we could be in for big trouble if "they" kepping making poor choices.

Hell, we have a treasurer who doesn't pay his taxes . . .