paulwilkinson.com

Debt, Equity, and Credit: Equity Scores a Home Victory

Judge Posner’s Wall Street Journal op-ed on Thursday got me thinking.

Equity spun out of control in the 1920s, crashed, severely damaged the economy, and was controlled not only by forcing equity to be more transparent, but also, strangely enough, by regulation to control banks.

Twenty years ago, I participated in a mini policy boomlet on Capitol Hill based on concerns that federal policy favored debt over equity: Interest was deductible by corporations and individuals (if paid for the “right” reason); gains were taxable and dividends were double taxed. Perhaps there was an excuse for some of that back then — banks had to live in a highly regulated environment, while equity market participants had much more flexibility as long as they disclosed all material information. Maybe there was a reason for some marginal economic bias in favor of debt over equity — but not the huge bias it enjoyed then and still enjoys today.

A decade ago, I was working mostly on other things on the Hill when the 1933 legislation that was the basis for much of the regulation that controlled banks was repealed. But even though slightly less onerous tax treatment for investment compared to regular income taxes on work was enacted in 1997 and modified in 2001, debt remained hugely favored, and remains so today. (Taxing work instead of consumption also creates rather curious incentives and magnifies the bias toward debt and away from investment.)

Consumer debt got out of control the past few years, was resold as if it carried risk comparable to typical debt (not equity), crashed, severely damaged the economy, and is being controlled (heard today that the half million newly unemployed in April included 14,000 loan officers). Er, well, maybe we’re not trying to control consumer debt — just “risky” banking practices. Ok, whatever.

Anyway, strangely enough, the latest tactic around debt is borrowed from the equity regulation that made U.S. capital markets extraordinarily successful in the second half of the 20th century. Instead of typical “prudential” bank regulation, where each bank’s regulator cordially and privately talks to his or her bank about whether it has enough capital or needs more, the results of the stress tests are being publicly disclosed. This could be spun a hundred different ways, but how’s this:

Imitation is the sincerest form of flattery, and it’s nice to see the long-secretive bank debt markets become more like the long-transparent equity markets.

As my favorite securities regulator was fond of saying, score one for the home team.