Onion Eater

When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices: the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity: the old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debtholders can agree to cut down the face value of debt, in exchange for some warrants. Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. So why is this well-established approach not used to solve the financial sectors current problems?

The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. If left to the negotiations of the parties involved this process will take months and we do not have this luxury. However, we are in extraordinary times and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector. But, at what price?

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC.

Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration
declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision. My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices, but bond prices as well, soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equityholders, but also the debtholders.

If debt forgiveness benefits both equity and debtholders, why do debtholders not voluntarily agree to it? First of all, there is a coordination problem. Even if each individual debtholder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay. Secondly, from a debtholder point of view, a government bail-out is better. Thus, any talk of a government bail-out reduces the debtholders’ incentives to act, making the government bail-out more necessary.

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

Source: http://faculty.chicagogsb.edu/luigi....n_is_wrong.pdf

Any comments?

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Onion Eater

No comments?

I'm not saying that I'm 100% behind Mr. Zingales' suggestion, but I do find it an intriguing alternative to Paulson's plan.

The forum is crowded with denounciations of Henry Paulson, Chris Cox, et al. But I'd like to hear from some of you regarding Mr. Zingales' ideas.

MC.no.spin

Makes a good case. I think without some knowledge of the balance sheets of these financials, the anticipated liquidity challenges, the economic growth forecasts if this plan is not implemented, the unemployment, the less tax revenue from the lowered GDP, etc. it's hard to really fault Paulson's plan in its essence from my point of view. Bernanke is a historian on these things, and what I get from him is that the macro-economic concerns were this full plan not to be done, would be quite staggering to the economy. Lowered GDP, lower employment, stagflation, deep recessions, depression, more foreclosures, more lowered home values, etc.

The key is liquidity. The above post doesn't show enough evidence it would solve the liquidity crisis. And that doesn't mean to infer Paulson has given evidence his is the only way out of this crisis without too many bruises.

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ADK_Forever

Too tired to read all that. Paulson was bragging about how strong the economy was not too long ago. He is fighting against limits on compensation. I get the feel he, and the administration, is in bed with the bankers. I don't trust him or any one person or group to do what is right for this country!

donsutherland1

My quick response to some of the points raised in Professor Zingales' commentary:

Chapter 11 proceedings can take an extended period of time. Last week saw the money markets in turmoil as overnight lending began drying up, equities markets were plunging, and the financial system was perhaps 1 or 2 new events away from a meltdown. The "near panic" was averted only after Secretary Paulson announced that the Treasury was working on the rescue plan that is now before the Congress. Time was of the essence. It is difficult to imagine how an announcement of a Chapter 11-type proceeding, with its inherent uncertainty, would have calmed markets to the extent that Secretary Paulson's announcement that the federal government would purchase some of the financial system's toxic paper did.

On account of sentiment/psychology, market prices can diverge wildly from a entity's/security's underlying value. During periods in which fear is predominant, securities can trade well below realistic prices (those justified by fundamentals). In those environments, firms can find it difficult to impossible to obtain financing from extremely risk-averse financial institutions/capital markets.

Two points:

1. The objective of the Treasury plan is to ensure that the financial system gains some liquidity from the sale of its toxic paper. The goal is not to strip the financial system of liquidity by forcing a "fire sale" that leaves banks to realize even greater losses on those securities and the difficult task of raising new capital in an extremely risk averse environment.

2. Stabilizing the financial system is vitally important to the entire macroeconomy. It is not "welfare to the rich" by any stretch of the imagination.

Congress may well add a provision that allows the federal government to gain some equity via warrants or preferred stock in the firms from which it purchases the toxic paper.

Once the financial system is stabilized, the necessary task of addressing regulatory gaps/deficiencies (public sector responsibility) and the absence of adequate risk management practices (private sector responsibility, particularly in areas that are not regulated) can be pursued. However, if the financial system is not shored up from the risk of systemic failure, the nation would be confronted with a macroeconomic disaster that would command far greater priority than the design of regulations/risk management practices concerning leverage, etc.

Avoiding systemic failure benefits all Americans. To the extent that the Paulson solution (modified by the Congress, as is highly likely, or not) reduces the risk of systemic failure, it benefits all Americans.

Mach

I heard that some of it will be buying up company shares/equity. Hopefully it is. What sense would it make for me to invest in something and have no upside...it's absurd.

I agree to that capitalism unregulated is designed to destroy itself, and routinely tries to. Enforcing a marketplace that benefits the sytstem of capitalism/free-market is the best solution, and people need to get over the fact that a free-market is free INSIDE the market, and the market itself necessarily is, and must be, well planned and constantly updated to keep the virtuous aspects of capitalism working for the market, and not just the few with the most concentrated power.

-Mach

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Onion Eater

I received the following PM from someone who declines to join Debate Politics but consented to my posting his comments here:

"I like the 'Why Paulson is Wrong' paper. It seems to me that the crux of the problem is that capital has been re-assigned to unproductive uses as you explain in ATE, so that what people consider to be 'assets' are not assets at all. Debt forgiveness is one way of 'solving' the problem - force people to admit that their assets are worthless, and once the 'toxic debt' is out of the system, firms will be able to lend to each other once again, being better able to judge sound and unsound businesses. Of course, firms will always prefer the 'bailout' option, having their worthless assets exchanged for worthy ones (government debt, which is always 'good' as long as the government can raise enough taxes, or cold, hard cash).

"In a way, this seems like an analog of the case where a country wishes to go back on the gold-standard after an inflationary war; with a return to gold exchangability at the pre-war parity being analogous to 'debt-forgiveness', where the debts to be forgiven are the debts of the bank to those depositors at the back of the queue for redemption; and a new, lower parity being analogous to a bailout (gold cannot be printed, but its value can be reduced by fiat). As you point out in ATE, the bailout must have costs to ensure it is not done too frequently. This is probably enough of an argument against the bailout, as governments will use it whenever they can from now on. This will only delay the re-assignment of capital to productive uses. The argument against debt-forgiveness/pre-war parity was that the ensuing depression could prove fatal to the free-market system, but such a massive bailout would be enough of a move towards socialism that this is hardly a knockout argument any more."

SFLRN

Couldn't the same be said if we handed out aid to individual "troubled" homeowners? If the market is currently driven by sentiment then doesn't it stand to reason that American's belief in the bailout "plan" is a variable that will significantly affect the end results of the plan?

Anjire

I keep seeing the following term(s) thrown around:

Toxic Paper, Toxic Assest

What exactly does this entail?

Why use this verbage to describe what I can only infer to mean HIGH RISK greed (read: extremely bad investment/mortgage decision that more then likely screwed over a middle class american)?

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