University of Chicago Finance Professor Luigi Zingales explained clearly the political obstacles that are blocking efficient resolution of the financial crisis:
“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.
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.
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?”
My design for a cram down and recapitalization is somewhat different, but in the same spirit. I would add a push for tax reform, a new mechanism for automatic equity issues to prevent bankruptcy, and better incentives in executive compensation.
To achieve all these remedies and reforms, we need to counteract the private-public collusion that undermines taxpayer and shareowner interests. That will require fundamental governance reform in democracies and corporations. So I’ll get back to working on that.
It looks like Canada is wasting taxpayers’ money on a misdirected bailout — see this article reporting it and this blog post for why it’s a bad idea.
OK, this is a naive idea. Somebody please tell me what’s wrong with it. And/or has it been proposed before?
It’s well known that bankruptcy is a socially costly process. If it were only a matter of occasional negative outcomes in risky business enterprises, followed by transfer of ownership and control from equity holders to debt holders, then it wouldn’t be so bad. But the costly legal proceedings for determining and settling various debt claims, the interruption of business during this process, the lower value of dismembered assets compared to an ongoing business, and the loss of employment, all compound the financial calamity. Can’t we avoid this somehow?
Here’s my proposal for a better way to recapitalize troubled financial firms. For a first illustration, I’ll use numbers based on Lehman Brothers’ recent bankruptcy. In a way, it’s easier to restructure a bankrupt firm, because the old shareholders and management have already lost the battle and lost power. That gives the bankruptcy administrator more freedom to restructure claims on the firm. Later I’ll extend the idea to apply to firms that are not (yet) bankrupt.
This proposal is based on my 1998 paper “How To Transform a Failed Japanese Bank”, and has a lot in common with Zingales’ paper “Why Paulson Is Wrong”. The numbers are a very simplified version based on Lehman’s bankruptcy filing as reported by MarketWatch 2008-09-15.
With $700 billion of U.S. government funds approved for stabilizing financial firms, there has been much debate on how best to use it. The original Paulson proposal called for buying distressed assets. Many have pointed out that if the government pays fair market prices for these assets, then it won’t make financial firms any more solvent. If more than fair market is paid, then it’s a giveaway of taxpayer funds to poorly managed firms. See for example Diamond et al; and Krugman 45 minutes into the Princeton panel discussion.
There are more effective and fairer ways to strengthen balance sheets. The Treasury plan has now shifted toward a growing consensus view (shared by Diamond, Krugman, the UK government and many others) that the U.S. government should buy preferred stock in troubled firms. $250 billion has now been allocated to that strategy.
I agree that buying preferred stock is better than buying distressed assets. But I think we can do much better yet. Here are three problems with buying preferred stock:
Does the double taxation of equity push financial firms toward excessive leverage? I think so, but then why don’t I see anyone writing about that? Maybe because I don’t read enough. Please let me know if you are aware of some recent insights on this topic. I plan to research it later, but first would like to share some thoughts on several other issues. Meanwhile, if taxes are a significant factor, it affects the whole discussion so should be recognized at the outset.
Without tax effects and net costs of bankruptcy, the standard Modigliani-Miller analysis says that it doesn’t matter what proportions of debt and equity a firm uses — e.g. see lecture notes from MIT Sloan School course 15.414.
Thanks to my interest in Japan, I’ve already spent some time thinking and writing about how a leveraged financial system can overcome the dislocations caused by falling real estate prices. Japan went through that in the 1990s, and took more than 10 years to recover. In 1998 I started writing a paper entitled “How To Transform a Failed Japanese Bank”. I only wrote 4 pages and never published it, but in 2000 I published a summary in section 6 of “Corporate Governance in Japan: A Future Scenario”. Both papers are available at http://votermedia.org/publications.
Rereading those ideas, I think they can be usefully adapted as proposals for resolving the current U.S. crisis. So I plan to post some updated proposals in this blog, on these topics:
- Tax reform
- Recapitalizing a financial firm
- Automatic incentive to issue equity
- Corporate governance reform
- Government guarantees of risky debt
- Democratic governance reform
Here are some links to expert analyses that I have found helpful for thinking about the crisis – history, causes, and proposed policy responses. (Please let me know about other sources.)
1. Paul Krugman’s blog at the New York Times
2. Zingales – Why Paulson Is Wrong
3. Douglas Diamond et al – Fixing the Paulson Plan
4. U Chicago B-School: Comparing Alternatives to the Paulson Plan
5. RGE Monitor group blog by various economists
6. 2008-09-23 Princeton economists panel
(Hyun Shin, Markus Brennermeier, Harrison Hong, Paul Krugman, Alan Blinder)
To me, the highlight was Paul Krugman’s explanation (45 minutes into this video) of why the idea that “we need to take the troubled assets off the financial system’s balance sheets” misses the point.
7. 2008-09-25 Harvard law econ finance panel
(Jay Light, Robert Kaplan, Elizabeth Warren, Greg Mankiw, Ken Rogoff, Robert C. Merton)
8. 2008-09-24 ProxyDemocracy Blog post on corporate governance reforms
Background about me (Mark Latham) and the scope and reasons for this blog are on the “about” page.
In the next few months I plan to post mainly discussions on how to resolve the U.S. financial crisis.