Easterbrook (Gregg, not Frank) Up a Creek

Robert Miller —  5 October 2008

Here’s another reason—as if you needed it—as to why getting a reasonable bailout of the mortgage-backed securities market through Congress was so difficult. Below I reproduce an analysis from Gregg Easterbrook of the Brookings Institute:

Supposing we assume the bailout is required, here is what bothers me about the plan so far: Taxpayers don’t get stock, what they get is warrants that can be exchanged for stock, and nonvoting stock to boot….  Even if the warrants are called [sic, Easterbrook means exercised], taxpayers get no voting positions…. A week ago, Warren Buffett rescued Goldman Sachs by injecting $5 billion in capital. Did Buffett bargain for warrants that can be exchanged at an unknown later date for nonvoting shares? No: He is not a fool. Buffett gave Goldman Sachs $5 billion in return for senior preferred stock, the kind that votes and also is more valuable than ordinary shares…. The United States Congress and the White House should use the public’s $700 billion to buy … senior preferred shares. Why are Congress and George W. Bush not simply following the road map laid out on this problem by the smartest investor of our era?

The problem is that this is factually mistaken from beginning to end. Easterbrook says that Buffett did not get warrants, but in fact he did—indeed, warrants to purchase $5 billion of common stock with a strike price of $115 per share and a five year term. Easterbrook says that the preferred shares Buffett received are “the kind that votes,” but they’re not. Like the six classes of preferred stock Goldman already has outstanding, Buffett’s shares do not vote in the election of directors. Like virtually all preferred shares, they have very limited voting rights that do not allow the holder any ability to control the affairs of the company. This is all set out in the press release Goldman Sachs issued to announce the transaction and in Item 303 of the Interim Report on Form 8-K it subsequently filed with the Securities and Exchange Commission.

More generally, it’s apparent from his blog that Easterbrook simply doesn’t understand what preferred stock is and how it relates to common stock. As most readers of this blog know, preferred stock is “preferred” not because it’s “more valuable than ordinary shares” but because it ranks ahead of common shares in order of payment. That makes it less risky than common shares but not generally more valuable than common stick. Indeed, since return is proportionate to risk, preferred shares generally have a lower expected return than common shares, and since control follows risk, preferred shares generally have less voting rights than common shares. The preferred shares Buffett purchased from Goldman are thus perfectly typical in these respects.

My point here is not that Easterbrook doesn’t understand what he’s talking about (though he clearly doesn’t). My point is that an intelligent person in the opinion-making class trying his honest best to inform the American public about the merits of the bailout can utterly fail to understand the issues at stake. That’s not because people like Easterbrook are fools (they certainly are not) but because the matters are so complex and technical that even informed, intelligent non-specialists can get them very badly wrong.

This is a genuine challenge for democracy. In The Federalist No. 10, Madison argued that representational republicanism is superior to direct democracy because it can “refine and enlarge the public views by passing them through the medium of a chosen body of citizens, whose wisdom may best discern the true interest of their country and whose patriotism and love of justice will be least likely to sacrifice it to temporary or partial considerations.” In other words, democratically elected representatives are on the whole likely to make better decisions than the people themselves, in part because they are better informed than the average voter. History has by and large proved Madison correct in this. Part of the problem in passing the bailout program last week, however, was that our elected representatives were dealing with issues that were often too complex and difficult even for intelligent, informed people who were trying hard to understand them. I do not for a moment suggest that anyone else should get to decide such matters except the elected representatives of the people, but I think we should realize that the world has become so complex that issues like this may begin to appear with increasing frequency.

2 responses to Easterbrook (Gregg, not Frank) Up a Creek

  1. 

    To be fair to Easterbrook, he may be thinking of the kind of Preferred Stock in VC deals that does have control rights, is preferred as to dividends and, depending on the deal, might also participate with the common on liquidation.

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