Why Paulson is wrong

This weekend’s decisions will shape the type of capitalism we live with for the next fifty years. Here one of the world’s leading financial scholars, Chicago Business School Professor Luigi Zingales, argues that bailing out the financial system with taxpayers’ money is wrong. He discusses an alternative – forced debt-for-equity swap or debt-forgiveness.

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?

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.

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.

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.

If debt forgiveness benefits both equity and debt holders, why do debt holders not voluntarily agree to it?

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.

Thus, any talk of a government bail-out reduces the debt-holders’ 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.

Taxing the many to benefits the few 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. 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.

Profits are private but losses are socialised? The decisions that will be made this weekend matter not just to the prospects of the US 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 socialised? 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 penalised 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.

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“Long term, yes, deflate assets, or inflate money.”

Their stinking baikout will probably do both.

If they print the money, the minute it hits the banks it becomes 7 trillion at a minimum which will bring on wholesale inflatiom.

If they sell the property they bought for what they paid for it we still actually take a 50% loss because if the depreciated dollar rhat they sold it for.

I guess it’s time to turn money into hard assets that will follow the value of the dollar in purchasing power.

But what about the immediate problem of the monetary system that nearly froze last week, and remains at risk of such?

The monetary system is frozen because if someone thinks a potential creditor might end up repaying only pennies on the dollar for its debt, the person isn't going to want to risk having his money pooled with all the other pennies-on-the-dollar debt. If the government were to, as expeditiously as possible, announce that much of the bad debt was simply written off (tough luck to the existing creditors) then new creditors would be able to invest with much more confidence.

From what I understand, the situation is somewhat like personal bankruptcy. Someone who has just declared bankruptcy will hardly be regarded as a good credit risk, but will have a much easier time getting honest credit than someone who is clearly imminently facing bankruptcy.

Pop the bubble and the markets will recover.

“It is also quite possible that a lot of those mortgages could become good and the Feds could sell them for a profit. It is entirely possible to recover the whole $700 billion over time and maybe even a small profit could be had.”

These MBS’s are already full of defaulted mortgages. How can they become good? I wish I could find the charts I have seen somewhere showing the defaults in the actual packages. They are high. Here are some links with information.

http://mrmortgage.ml-implode.com/

Older stuff
http://mrmortgage.typepad.com/blog/

Here is a treasure trove of videos
http://www.tickerforum.org/cgi-ticker/akcs-www?forum=Presentations&page=2
Mr Mortgage is Hedgefundmanip for the videos.
Genesis is Karl Denninger

True enough. This just happens to be the biggest bubble in the history of human civilization; it should be a fun ride.

Unfortunately, I suspect (though I really hope I'm wrong) that Paulson et al. will inflate it to twice its present size before it bursts.

Further, even if the bubble would be the same size when it bursts as it is today, and even if the bail-out magically cost nothing, trying to delay the burst would still be a bad idea. It won't be long before the Social Security bomb hits. If the markets crash now, they may have recovered enough to survive the SSB. If we wait before letting them crash, disaster.

I'm figuring that the Social Security problem can be dealth with by arranging for the monthly checks to be worth perhaps half what they promise to be worth now.

They can do this with a combination of not indexing the increases as rapidly as real inflation (which they are doing now, by stealth suppression of the Consumer Price Index), by delaying the "full retirement age" further, and by other such adjustments. In short -- inflation must increase more, for Social Security and all this other debt, over the next few years.

Medicare is a bigger problem; that is handled by further socializing medical care -- it all becomes "free" and that's about what it's worth (though it costs the taxpayer far more.)

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