Why Paulson is Wrong

Saving capitalism from the capitalists

Luigi Zingales | September 29, 2008

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 debt holders can agree to trim 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?

No time for bankruptcy procedures

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. The negotiations would 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 recapitalise (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.

An Alternative to Paulson's 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. They force 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 equity holders, but also the debt holders.

Comments

Naga Sadow|9.29.08 @ 3:17PM|#

Huzzah!!!

Phelps|9.29.08 @ 3:27PM|#

Good article. What bothers me most about how this slush fund is being advertized, is that it is designed to save the "financial system", by disallowing the failure of firms that are "too big to fail". This demonstrates to me that those involved don't really know what threatens the financial system over the long term. Sure, several massive bank failures followed by a few years of recession is hard to stomach. This country's economy would recover though, and it would be stronger for it. This bailout removes risk from a very important economic decision, or set of decisions, and that my friends is what really threatens our financial system.

Of course it wouldn't be the first time...

Don the libertarian Democrat|9.29.08 @ 4:03PM|#

It's a great post. I'm sure it will be ignored! By the way, this sums up why I'm a libertarian Democrat:

"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."

J.D. Casten|9.29.08 @ 4:35PM|#

Someone please correct me if I'm "wrong" in the following-I'm not for socializing risk, but how privatized is profit, when we have (in theory) taxes?

I think some should seriously question the Republican plan to help in the current financial market crisis-they want to establish something like a financial institutional FDIC, and lower capital gains taxes to import foreign tax-trapped capital. With most entitlements and the defense budget off the table (i.e. most of the federal budget) this tax cut would cause further borrowing for government expenses-but with the "bail out" plan, at least the government gets something in return ("troubled assets"), for a 100% certain and more efficient infusion of liquid assets into the financial system.

Why are these assets needed? A run on all those credit-default-swaps would be like a whole world of defaulting 30-year mortgages coming due in a day for financial institutions that hedged their investments with those credit-default-swaps. The point is not to have the government "bail out" all this potential inter-institutional debt, but to install confidence in the market (and give banks money to lend both from the government, and from confident investor influx of funds)-so that there isn't an institutional run on all the hedged investment bets. (NB Derivatives have a notational value beyond current world assets: they are a reflection of the future value of all world assets-to put a run on them all today would be a financial apocalyptic event).

Look, GOOD regulation is needed, not NO regulation. The SEC raised the debt ratio ceiling to 30-1-Lehman Bros. leveraged to that point and went under; and the Federal Reserve has fueled two bubbles in a row (internet & housing) by encouraging too much credit with its rates. A credit correction is necessary, but who here thinks society needs no BUFFERS to financial meltdown? Does anyone think that the lessons of failure can be learned in a decentralized, non-regulated fashion?

Sarah Palin|9.29.08 @ 4:44PM|#

I'll just have to get back to ya' on this.

|9.29.08 @ 5:12PM|#

Great article!

|9.29.08 @ 5:56PM|#

Does anyone think that the lessons of failure can be learned in a decentralized, non-regulated fashion?

[Looks around, slowly raises hand.]

Generalizing hugely, regulation produces barriers to entry, which encourages concentration of an industry into a few big firms, which makes the failure of any one firm catastrophic. Decentralization is the cure, not the cause, for catastrophic systems failure. Regulation produces centralization and monocultures, which are much more prone to catastrophic failure.

Paul|9.29.08 @ 6:09PM|#

[Clears throat, raises hand]

What RC Dean said.

J.D. Casten|9.29.08 @ 6:21PM|#

R C Dean-thanks for the "correction" (I'm here to get educated)-and I generalized hugely too. I personally would like to see regulation encourage smaller initiatives (and governments that outsource their necessary projects to smaller firms). My beef would be with pure anarcho-capitalists

Am I incorrect that the "robber-barons" were able to create rather large firms under less regulation? We still have JP Morgan. Don't some libertarians celebrate monopolies? (I'm a sustainability libertarian) And also, without the traffic lights and stop signs of at least minimal regulation, couldn't a race to exploit faddish quick-money makers create large-scale problems as well?

BTW-I think Zingales' solution should be a part of the approach-e.g. re-negotiating derivatives should be on the table-but isn't, sadly, time of the essence?

|9.29.08 @ 6:23PM|#

So the govt is just supposed to convert debt holders into equity holders when they so choose? If so, then that would seem to me to cause even more pressure for investors to sell not only the equity of potentially troubled companies but also the debt (why do I want to hold the debt if I think there's increase risk that the government wipes me out?). Seems likely to only make things worse.

|9.29.08 @ 6:33PM|#

Here's another way to look at this...

Credit markets will be screwed (which has lots of bad implications for "main street") so long as investors manifest extreme risk aversion, as they have been doing for several weeks, buying little but gold and T-Bills.

Well, Bill Gross who is head of Pimco, which is a huge, mostly fixed income investment firm with over $800 billion in assets under management was on CNBC a few hrs ago, just after the bill did not pass. When asked what he will be doing with money his firm manages, he said he will advise all his clients to be extremely liquid, putting money into nothing but very short term US Government and US Government Agency paper, so long as those in congress refuse to do something systematic to fix the credit markets. Basically, he's telling us that, without something like Paulson's plan, he's going to do nothing but stick money under mattresses. In contrast, he was quoted in Barron's this weekend as saying how much money would likely be earned for the government should the Paulson Plan get implemented.

If Pimco and others stay risk averse because they don't like the political response to problems they perceive, then they will in effect ensure that the credit crisis remains, and probably gets worse. In contrast, if they decide that the politics are moving in the right direction, they will invest once again more broadly, and in so doing cause credit to ease and liquidity to increase.

Like it or not, guys like Bill Gross are determining the outcome of the credit situation. And, they're telling us that they don't like what they're seeing, and as a result, will remain away from most markets.

dfd|9.29.08 @ 7:42PM|#

Gee bornskeptic, imagine that, someone from the financial industry telling us that he thinks the tax payers should bail out Wall Street? You don't say. What's next, a quote from a car salesmen telling us his is the best price or from a barber telling me I need a haircut?

Perhaps you might apply some of that innate skepticism to the pronouncements of the very people who stand to benefit most from the bailout.

Other-Brand.com|9.29.08 @ 8:05PM|#

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Ebeneezer Scrooge|9.29.08 @ 8:34PM|#

Like it or not, guys like Bill Gross are determining the outcome of the credit situation. And, they're telling us that they don't like what they're seeing, and as a result, will remain away from most markets.

Yeah sure. And the car dealer is telling you he'll go out of biz if you don't pay his asking price, too.

Sooner or later Gross is going to wake up. Because if he imposes conditions that result in a massive economic slow down -- just because he didn't get to have his cake and eat it too -- then in the long run, the slow down is going to hurt his wallet as much as everybody else's.

Sooner or later Gross is going to change his tune. Or maybe he won't, and his boat will sink too. Then somebody with (we hope) better brains will take his place.

Between now and then, it might hurt. But in the long run, letting him have his cake and eat it too is going to hurt us all a lot more.

LarryA|9.29.08 @ 8:52PM|#

Look, GOOD regulation is needed, not NO regulation. The SEC raised the debt ratio ceiling to 30-1-Lehman Bros. leveraged to that point and went under; and the Federal Reserve has fueled two bubbles in a row (internet & housing) by encouraging too much credit with its rates.

History: Failure-to-learn-from Department.

Every time government messes with the market things get more screwed up. But there's always someone saying, "If they just pass the right regulation, everything will be fine."

J.D. Casten|9.29.08 @ 9:16PM|#

LarryA - Which regulations screwed things up this time? Many in the public seem to agree that lack of regulation was to blame for the current abuses… I imagine you think we haven't deregulated enough; but where is the empirical evidence to back up theory? Most of what I see are ad hoc examples that don't add up to systematic evidence (for example the excellent "More About the Lending Crisis…" post by Nick Gillespie in Reason's Hit & Run section).

I'm against governmental internalized imperialism as much as the next libertarian-but where is the promised trickling down of economic prosperity that Reagan era deregulation was supposed to bring? I really think one-note libertarians (freedom from government) need to expand their reasoning a bit, to include responsible intervention, to address e.g. irresponsible concentrations of capital.

No matter what the deregulation… there will be rules to the game… and many will game those rules. Excesses need to be regulated and buffered against-there are also explosive positive feedback loops in real world economics, as well as the many stabilizing negative feedback loops.

|9.29.08 @ 9:35PM|#

Hey, ideologues:

1) Bill Gross already has more money than God,

2) Whether or not he benefits, if he and other lesser impressions of him decide to step up and take a little more risk, this credit crunch will be over.

Those are facts. Yet, many seem seem to not care about facts, and are only concerned with ideology. I wonder if they'll reconsider after they're bankrupt?

It seems that those with zero experience with capital markets are not at all deterred from having extra-high confidence opinions on all this. God hep us if their stupidity prevails, as it did today.

Finally, what is the soooooooo bad consequence of something like Paulson's plan, assuming (for the sake of argument) it caused investors to come back and buy securities other than T-Bills? How am I harmed so terribly by that state of the world?

|9.29.08 @ 9:40PM|#

"in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured."

This is incorrect. The FSLIC had to pay the depositors, but they had no obligation at all to preserve the institutions that had failed.

-jcr

|9.29.08 @ 9:42PM|#

The time has come to save capitalism from the capitalists.

The capitalists aren't the problem. The mercantilists are the problem.

-jcr

Ebeneezer Scrooge|9.29.08 @ 9:42PM|#

1) Bill Gross already has more money than God,

Uh huh. Agreed.

Those are facts. Yet, many seem seem to not care about facts, and are only concerned with ideology.

Uh, no, not ideology. Or at least not The Straight and Narrow Capitalist Ideology.

What you're basically telling us is that Bill Gross is threatening to hold the US economy for ransom. "GIVE me this bailout OR ELSE."

If that's his attitude -- and if in fact he has so much power that he controls the fate of the whole freaking US economy -- then right now is the time for us to go to war with God Himself.

Giving him his ransom demand and waiting to fight it out later, we will only be in a worse position.

However, a) I do not believe Bill Gross really has that much power, and b) even if he does, sooner or later greed will get the better of him too.

Do you have experience negotiating ransoms? Because you're essentially telling us that you think we should have paid up.

I don't think very many Americans are going to agree with you. God Gross Hisself can go to hell.

Ebeneezer Scrooge|9.29.08 @ 9:47PM|#

Finally, what is the soooooooo bad consequence of something like Paulson's plan, assuming (for the sake of argument) it caused investors to come back and buy securities other than T-Bills? How am I harmed so terribly by that state of the world?

Because more gods like Bill Gross will come along and hold us for ransom again. Just for starters.

Then there's the fact that we're making the treasury secretary de facto dictator. You think this deal wasn't going to make him able to hold us for ransom?

There's lots more bad about the deal they didn't pass today, but these are big moral points that come to mind.

J.D. Casten|9.29.08 @ 10:17PM|#

I think Sec. Paulson's history with Goldman Sachs and the current proposed solution to the financial crisis should raise as many eyebrows as VP Cheney's history with Halliburton and the Iraq war.

That said… why are so many other investors (larger and smaller) now putting their money in gold, etc? Quite a few people (and many government employees) have their retirements tied up in pensions, 401Ks, etc. A tumbling market would punish not only those CEOs (who cares), but people on the verge of or already retiring. That's the outcome that requires "buffers," governmental, or otherwise.

What happened to Senator Chuck Schumer's idea of stepping into this mess with smaller chunks (starting at $150 billion)? Why was $700 billion needed for "confidence?"

|9.29.08 @ 10:36PM|#

So the bankers are bumming out because they need money really bad, but no one likes lending money to people who need it really bad. Now, if they didn't need any money, lots of people would lend them money. You can't get any more ironic than that.

|9.29.08 @ 11:50PM|#

www.billionairebailout.com

They wanted congressman to vote yes for 100 pages of legislation when they haven't had time to read it. Haven't we learned some importnat lessons about not voting for legislation if you haven't read it yet?! isn't notreading the legislation a good reason not to vote "yes"?!


Paulson wanted unreviewable ability to buy and sell whatever he wanted.

Trying to push through that sort of legislation by lying to the people and saying the world would collapse if it wasn't done by LAST THURSDAY...is a good sign that the man is a piece of shi*. so they are right to demand time to reda the new legislation

|9.30.08 @ 12:00AM|#

The article misses the whole point of why this crisis is so much worse than what the president let on when he sugar-coated it in the attempt to scare us into supporting the Enron-style Wall Street bailout. He could have said how bad things really are for the big financial players, but he didn't want to start a national panic.

The problem isn't that some assets have gone bad and it's hard to sell them right now, it's that so many of the major financial companies linked themselves to each other's fortunes, through credit default swaps, and have become so highly leveraged that the slightest drop in their true asset values threatens to wipe out all their equity.

J.D. Casten|9.30.08 @ 1:04AM|#

I think Craig's right on the money.

A question posed to Republicans (and possibly not to libertarian purists) would be how well their "free-market" solution (Insure Banks, and Lower Capital Gains Taxes to draw in foreign capital) - would compare to a modified Paulson solution; each of which would cause more government borrowing (much of the ever growing US budget is basically untouchable in pragmatic terms) but the latter solution offers more efficiency and certainty, and should get some return when the "troubled assets" are sold; while the former may not draw in that much capital while raising debt due to lower tax revenues.

I think the state of New York has established new credit-default-swap regulation (changing the rules of the "game," and all the consequences thereof). Some (like its former CEO) think the US government got a good deal taking on AIG… my hopes are that IF the government takes on these "troubled assets"-it gets them at the lowest price possible. I'd have a hard time being an ideological purist at this point, but people needing time to think this through is understandable (to understate a problem).

|9.30.08 @ 1:54AM|#

Who says we don't have time to do this right? Buffet got his deal done in less than a week, without going into chapter 11, and ended up exactly where this article leads.

Like it or not, I believe the taxpayer is going to insist on equity preference. Why not? There's plenty of turnaround companies we can hire to make that work.

But the last thing we want to see is the Managers and shareholders walk; and Hank is one of them, and undoubtedly 80% of the politicians who for years will see their donations as a pittance of what it was.

|9.30.08 @ 10:43AM|#

Ebeneezer Scrooge: just curious what is your experience in/with/around capital markets?

For any plan to work, it needs to cause investors confidence to change in such a way so as to cause investors to become less risk averse. Paulson's plan would very likely have done that. I'm more skeptical about the republican insurance alternative.

|9.30.08 @ 1:15PM|#

Saw the article a few days ago - what is outrageous is the portrayal of the populace by the MSM as anyone against the Paulson bailout in a neanderthal.

What you have to ask yourself is this: Did Paulson know how Goldman Sachs was making money when he worked there? What is most frightening is that the man may be honest - he really doesn't know what caused this or how to alleviate it.

|9.30.08 @ 1:19PM|#

How about this?

Instead of buying the troubled assets, we loan out money for, say, one year, taking them as collatoral, but loaning much less than the banks claim they are worth - sort of like a pawn shop.

During the year, we disassemble these things and figure out how much they are actually worth. At the end of the year, if they are worth less than what we loaned out, the banks pay zero interest. If they are worth more, they pay interest to get them back, and if they default, we sell them for whatever we can get.

Call it the Pawn Shop alternative.

|9.30.08 @ 1:33PM|#

Theresa,
Don't argue with me slave Your plan defeats the purpose. How am I gonna make my friends some big money out of your plan?

Nope you slaves had your chance, now we are gonna see if we can make the sheep suffer. Next time they'll accept whatever I tell them to accept if they know what is good for them!

|9.30.08 @ 1:36PM|#

I am retiring today. Reason is against the bailout, this ends the joke behind "Cosmotarian Overlord". Maybe "Paulson" or "Fed Supporter" will now take over for me. Any suggestions on more obnoxious/bitter names?

Ebeneezer Scrooge|9.30.08 @ 2:10PM|#

Call it the Pawn Shop alternative.

Now this is the third best idea I've heard yet.

First best: Fed does nothing.

Second best: Fed says "we're going to wait six months and see what's really going on, if between now and then we see a genuine, systemic problem then we'll look at doing the Pawn Shop Deal".

Third best: do the Pawn Shop Deal now, it's at least not giving them much incentive to dump their questionable assets into the "Taxpayers pay for it" pool.

Ebeneezer Scrooge|9.30.08 @ 2:16PM|#

just curious what is your experience in/with/around capital markets?

Enough, that nobody gets to beat me with that soggy noddle called "investor confidence" (you know, it's only a frightening stick if you believe it is).

Enough to know, anybody who claims to "know" what "investor confidence" is really going to do in the long run and the big picture, is lying either to themselves or the people around them.

Yes I hear Wall Street sqealing like a stuck pig. They'd rather not have to take their medicine. But a) I have not yet seen clear evidence that the problem really is systemic, rather than a big hit to certain market segments, and b) if it is systemic, and we waited a few months of *find that out*, we could still do this "deal" with taxpayer money, and put the train back on the tracks.

This train hasn't really derailed itself yet. Call me back when if it does and we'll talk. But don't call back until there's clear evidence, which is not squealing pigs and not a market that's doing what markets always do (jump up and down like a nervous jerk).

And here I thought you were a skeptic of some kind.

I vote for government and taxpayer skepticism.

Ebeneezer Scrooge|9.30.08 @ 2:23PM|#

And btw (un)born skeptic, investor confidence really isn't The Prime Moral Directive here.

If the investors screwed the pooch (you know, small fuzzy ears and all that), then they should get a mouth full of fur. Plus a few other problems.

The scenerio you're setting up here, is that the government should put itself on the line to always "insure investor confidence". This is the same as saying the government should "always insure economic growth, insure the booms always boom and the busts never bust".

Cripe, how much experience do *you* have with capital markets?

And have you ever taken an ethics course? I know it's complicated having to connect those two disparate topics, but it really does have to be done.

You're still advocating the Hold 'Em For Ransom solution. I contend it's wrong for the taxpayers to agree to it, on moral grounds.

Ebeneezer Scrooge|9.30.08 @ 2:27PM|#

The current media spin, that the whole reason the bailout billed failed in the house is just because "people don't have confidence in the government", is really really pissing me off.

The fundamental issue here is moral, not a matter of "confidence".

Somebody should have shot Keynes when he was still just a wee lad. But I suppose if they had, some other idiot may have come up with a worse idea.

J.D. Casten|9.30.08 @ 2:34PM|#

Ebeneezer Scrooge-- Rick Santelli is the center of confidence in Wall street (and other CNBC commentators who often seem to stray into Pro-Wrestling rant territory).

me not you|9.30.08 @ 3:45PM|#

Can someone explain how this debt-for-equity swap would work? Home owners with bad mortgages would have their mortgage debt reduced in exchange for giving mortgage-backed security holders equity in their homes?

|9.30.08 @ 3:50PM|#

The premise of this article is wrong. Chapter 11 bankruptcies work for companies with hard assets. They DO NOT work for financial companies. Financial companies' assets are often intangible and can easily lose value or be withdrawn.

Fundamentally, a financial company's intrinsic value rests on the notion that it WILL NOT GO BANKRUPT. That's why this crisis will not just work itself out.

J.D. Casten|9.30.08 @ 6:59PM|#

me not you - I'm not an authority on the subject, but I believe many mortgages are packed in securities. These securities can be "swapped" when, e.g. one party wants one type of interest rate (like variable) and another party wants another (like fixed). They basically assess the values of the two respective securities (or bonds, etc.) and the holder of the higher risk investment pays a onetime fee to the investor with the lower risked investment. They trade returns on the investments, but if the investment one party is holding defaults, they must pay the other party the loss on the investment. Basically it's a way to insure, or hedge investments, through heretofore unregulated contracts.

Hence the notational value of all derivatives, including credit-default-swaps, is larger than all current world assets-they're like a "shadow" of, say, the next 30 years worth of investments. What some people are worried about, I believe, is that even a limited run on banks who are involved with these credit-default-swaps could send a cascading avalanche of run after run, as all sorts of financial institutions have to pay each other for the, again-basically insured-failures. "Confidence" is necessary not to "start" these runs. Too late. Lehman bros. etc. went down. Hence the escalated financial "crisis" to prevent runs on banks with more FDIC, $700 billion liquidity for bad debt, etc.

James- Excellent point.

J.D. Casten|9.30.08 @ 7:01PM|#

me not you -- sorry, misread debt-for-equity swap as credit-default-swap... my bad.

|9.30.08 @ 7:08PM|#

Ebeneezer: I have 20+yrs working in capital markets, running various institutionally-sized portfolios including derivatives, corporate bonds, mortgage backed securities, money markets, equities (long/short, long-only, domestic and foreign), have been involved with various kinds of hedge funds, have been involved with issuing a variety of debt and equity securities, and have created various published research applying options pricing ideas to certain types of real assets.

Ebeneezer Scrooge|9.30.08 @ 7:31PM|#

Okay, so you have more experience than I do here. But you've made zero attempt to explain where/why/how I'm wrong.

I understand the idea of investor confidence. I even understand and have some genuine respect for its importance. Because as someone who's out there trying to sell risky technologies to customers every day, I've learned first hand, from the real world, exactly what happens when people don't believe in you.

But this doesn't change my argument. If we prop these people up now, the whole market will have every incentive to best arrange its affairs for a bailout tomorrow, the same way you arrange your affairs for minimum tax liability.

It's the "too big to fail" syndrome. It's a recipe for the whole freaking market to start holding the US taxpayer for ransom. "Fix me up and do it now, or else."

I'm open to rational argument. Why is it better to let this leach grow on us, than to suffer the pain of pulling it loose right now? Because in the long run I see no way to avoid pain.

Oh, and then there's the minor issue of the naked power grab in giving Paulson unlimited powers to do whatever he feels like, without review, recourse, or any accountability whatsoever. Am I just too stupid to know that in fact, I should feel really warm and fuzzy about that part of the deal?

|10.1.08 @ 1:12AM|#

Ebeneezer:

Look, we need for credit markets to function in this economy. Too many companies depend on a consistent ability to refinance debt. The credit markets aren't really working right now. Borrowing costs have gone up to crazy levels having nothing to do with the creditworthiness of the underlying borrowers. Some entire classes of financing vehicles have ceased to exist. This is very bad for any firm that has some debt, and this is a large number of firms (municipalities too). If things don't improve in the credit markets, that will negatively affect economic growth, possibly severely affecting it.

How can this change? Investors need to become more risk seeking. Whatever causes this to happen will help this problem. I believe the Paulson Plan had a better chance of doing this than anything else I've seen to this point, and judging by market reactions I'd say lots of big investors had similar views.

As for the too big to fail issue, doing nothing will surely result in more bank failures. What is one result of this? The few banks judged as solvent will become bigger and bigger. Folks like Citi, BofA, JP Morgan and Wells Fargo are gobbling up all the failing banks. As a result, it seems to me these four have become much more likely to be too big to fail than was the case before all this nonsense, and this will certainly become even more so with increasing numbers of bank failures. That doesn't seem like a good thing to me.

As for all the moral hazard arguments, I really don't buy the notion that doing something to help unfreeze the credit markets because they are in a one in a hundred year funk will somehow cause investors and bank CEOs to materially change their investment decisions, heretofore thinking that their losses will be nationalized (woo hoo!).

me not you|10.1.08 @ 3:46AM|#

bornskeptic,

Perhaps you can explain how this debt-for-equity swap would work? Seriously, who takes on the debt in exchange for equity as proposed in the article after the bank/whatever goes through bankruptcy?

"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."

It's not the case that the banks are in debt and so bankrupt, but don't have adequate reserves and so need capital after marking mortgage-backed paper to market. I really can't figure out how the Zingale's proposal would work: who gets equity, what happens to the "debt"?

thanks

Ebeneezer Scrooge|10.1.08 @ 6:00AM|#

Look, we need for credit markets to function in this economy.

Hmmm. Okay, I'm hearing you and do see the case you're trying to make. However.....

Tell me why, this problem could not have been solved in a manner very similar to the S&L bailout back in '89 (or was it '87?). No big power grab going one, no One Man Above the Law going on, a vehicle for over sight was built in and so were the mechanisms to return assets back to the government (ie the tax payers).

The S&L bailout was far from ideal. But it was a hell of a lot better than what Bush is trying to jam down our throats.


The underlying reality of this whole situation, is not that nobody knows how to price the bad mortgages. It's that everybody knows, they really aren't worth their face value. Because home values have declined.

And doesn't everybody know that real estate values always go up, not down?

Tell me this isn't the S&L Bailout scenario, just shifted from commercial to residential real estate. It's pretty much the same story all over. Yes? My resume may not look like yours, but I'm not illiterate.

And then, tell me again why a solution much like the S&L bailout wouldn't work just as well this time. As opposed to making Paulson an economic dictator. I contend, that part of the "solution" is very simply unnecessary.

I also contend that the moral argument still stands but -- I also understand that following the straight and narrow of laissez faire economic theory, can hurt a hell of a lot. It may be more efficient in the long run, but the effects are drastic enough that I wonder what other political fall out would come of it.

Back off on the high handed power grab, and I'd have much less (though still not zero) heart burn with a bail out.

Your thoughts?

I appreciate your reply, btw.

|10.1.08 @ 11:13AM|#

me not you:

Say you're a debt holder of a bank. Now, govt comes in and says, mt. debt holder, give us your debt securities. We're taking your debt securities and giving you equity shares in exchange. The old shareholders get told, thanks for playing, but your shares are now worth zero; run along now. So the old equity holders get to see their shares go to zero, and you as a former debt holder get to see your bonds transformed into new equity shares.

The bank is left with more equity, because while it's assets have stayed the same, it's liabilities have decreased, as it's obligations to the debt holders have been zeroed out.

Usually, it takes bankruptcy to force this kind of thing, which would not typically be something debt holders would enjoy (unless they bought the debt at steep discounts with the ultimate intent of getting new equity in the recapitalized company after bankruptcy).

|10.1.08 @ 11:32AM|#

Ebeneezer:

Actually, I don't think you and I are so different in our positions. Yes, residential real estate is at the heart of the current situation, as was commercial in the S&L crisis. The RTC situation was similar, but a bit different in that it was liquidating assets of failed thrifts and S&Ls, where this time, they'd be attempting to buy and then sell assets from entities that have not yet failed. In any case, RTC was a systematic approach to that problem, and that's what I'm in favor of here. You're very offended by the way this plan might be structured. To that I'd say, fine, let's structure it in a way that doesn't seem like such a power grab to you, but that still addresses the problem systematically, which I think is a necessary condition of increasing investor confidence and stopping the downward spiral.

you not me|10.1.08 @ 12:54PM|#

But isn't the problem that the *bank* holds the mortgage-backed securities, not outside investors (ie, *not* mr. debt holder who gets stock in exchange for the debt). The rest of what you write makes sense to me, I'm still stuck on the initial roles in this.

|10.1.08 @ 6:17PM|#

Prof. Zingale's point is interesting but I question whether it would work legally. The analogy to the Roosevelt gold case sounds pretty weak - the legal environment on such things has evolved quite far since those days.