3/19/2009

Move Along, Folks, No Expropriation Risk Here.

Without joining those who seek Tim Geithner's head on pike or burning AIG CEO Ed Liddy in effigy and without arguing the legality or propriety of the so-called bonuses dispensed by the company allow me to wax a bit on the implications of expropriation risk. I understand the politics, optics and emotion. As a trader, little makes me angrier in business than a trader's failure rewarded. But as a trader, I also believe only two things separate humans from lower mammals: the sanctity of contracts and opposable thumbs.

However, now that the House has decided to tax some bonuses at some TARP recipients at 90%, we ought to consider the ripple effects. Actually, the House should have considered them before voting, but this is Congress after all where E Pluribus Unum translates not as "Out of Many, One" but "Ready, Fire, Aim!"

When firms invest, among the many things they consider is the prospect of ex post confiscation by government. Want to build a cellphone tower in the Democratic Republic of the Congo? No problem, but if the investor believes, even incorrectly, there's a 50% chance the profit will be extricated without due process, the NPV calculation must factor in this probability. If the assumption is incorrect, over time less pessimistic investors will step in and profit. Provided the less pessimistic assumption stays true, the return requirements will come down, which is good for investors, customers, employees, taxpayers and so on (of course bubbles can form if return requirements come down too much, but that's a different matter and expropriation isn't a good solution).

A simplified explanation for all non-MBA geeks (i.e., those w/MBAs are geeks, author included): Hypothetically, Mr. Cellphone won't invest in any project returning less than 10% net of tax. The tower costs $100.00 and will generate earnings for six years. Given those constraints, the project must produce $142 over those six years or Mr. Cellphone will build elsewhere. As the perception of expropriation risk goes up, up goes required return and down goes the likelihood of investing, down goes employment, down go tax receipts and so on. Rational investors with sunk costs adjust to expropriation risk, too. If Mr. Cellphone has already built his tower and the perception of expropriation risk increases, Mr. Cellphone must decide if it's worthwhile to stay in business or just bailout mid-project (please don't interpret this as a defense of supply side economics. I'm just riffing on expropriation).

Our Constitution's prohibition of ex post facto legislation is a key protection for all kinds of behavior, financial and otherwise. Weakening it, or appearing to weaken it comes at an extraordinary, but often invisible, cost. So, while we pat ourselves on the back for sticking it to AIG's scumbags, consider if investors will bother to determine that a rational Congress meted out a rational response to those who deserved it, or if Congress just makes up the rules as it goes along.

1 comment:

Frank said...

Good post and well explained. As a lib (and perhaps even a DFH) I agree with you.

Surprised?

This is a bad solution to a problem (giving out our tax money as bonuses) that shouldn't have been allowed to happen in the first place. Now I can talk all day about how this tax is a response to the the righteous anger of the common folk to how the Rich and Powerful play the heads I win tails you lose game. But I won't. If this law passes and the Supreme Court doesn't strike it down, there will be all sorts of bad unintended consequences.

I think it's a smokescreen anyway.

For one thing, how did Dodd's original bill/amendment limiting pay and bonuses get removed from the TARP legislation? Harry Reid knows and he isn't talking. See here and here.

Reid is one reason why "my" party is ineffective. I believe you will see the left blogosphere go after him on this. And we need to replace Geitner (and fill those 17 vacancies) with better people.

Sorry, I'm ranting.