Subprime Bailouts and the Predator State

Abstract

Recent bailouts in response to the subprime crisis evince an ad hoc government response that benefited general unsecured creditors and managers within the financial sector, while inflicting great loss upon taxpayers. The bailouts violated notions of the rule of law and sound macroeconomic science. In fact, the bailouts were followed by restricted lending and capital hoarding. This paper argues that such bailouts should be powerfully discouraged by imposing a legal framework including civil, criminal and administrative sanctions designed to discourage CEOs and other senior managers from flirting with too-big-to-fail status. Specifically, such managers would face near-automatic termination, discharge of employment agreements, the loss of protections under the Private Securities Litigation Reform Act, civil fines for causing losses to TBTF firms through unsafe and unsound practices, criminal sanctions for recklessly causing a loss to TBTF firms, and the prospect of administratively ordered prudential divestitures of operating units when a regulator identifies a firm as being TBTF. The goal is to eliminate the attractiveness of TBTF and thereby avert the huge costs implicit in TBTF. This should assure that bailouts are not a function of political power rather than sound economic policy.