Why Paulson is wrong

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.

If debt forgiveness benefits both equity and debt holders, why do debt holders 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.

·     Second, from a debt holder point of view, a government bail-out is better.

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.

But if it is so simple, why has no expert mentioned it?

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.


Originally published at VOXEU and reproduced here with the author’s permission.

16 Responses to "Why Paulson is wrong"

  1. Anonymous   September 22, 2008 at 12:58 pm

    They’re doin’ it because they can do it. It is a very good thing that this comes before the election, otherwise the outcome would be worse.Your analysis is common-sense and looks right.The time has come to save the country and its people from the capitalists.

  2. villager   September 22, 2008 at 3:28 pm

    On the issue of determining a price for the assets which is a central feature of the Paulson plan, what is often overlooked, according to a blogger with finanial experience with these assets, is that securitization involved custom design sometimes with one or few customers/clients in mind. Consequently, the notion that there is a broad-based market and a general price level is faulty. If this assessment of custom design is correct, the taxpayer will suffer a definite financial loss. Paul Krugman is correct: the asset is trash.

    • Anonymous   September 22, 2008 at 6:01 pm

      Finally somebody who gets it – to bad its just a comment buried in a Blog.Why can’t the pundits get this on the front page?

  3. Guest   September 22, 2008 at 4:38 pm

    Everybody look up THE NORTH AMERICAN UNION on the horizon.Whatever they are doing today will be passed on to Mexico and Canada as well. Leave it to the governments and politicians to make the future pretty grim.

  4. Guest   September 22, 2008 at 6:15 pm

    I learned in my first real estate licensing class the definition of fair market value- the price someone is willing to pay for an asset. I am so sick of hearing this crap about the value of these assets being artificially low because of ‘market conditions’. Market conditions have nothing to do with it. If no one wants to buy it, its worthless. Pure and simple.

  5. Angrish   September 22, 2008 at 8:04 pm

    How does this stop the crisis, even if the price is inflated? In fact, if the price is inflated, the crisis is delayed for another 700 billion, and then falls off a cliff.Say the bank has a piece of paper which says it’s a 100 bucks. The market is willing to only buy it at 40. Say the treasury comes in with a 70 buck max outstanding plan (smaller numbers, but probably make the point well enough). Say the treasury over pays, and pays the bank 70 bucks. But now the treasury is stuck and can’t move until it turns around and sells this asset. Where can it go next? only to the market, which is clearly only still willing to pay 40 bucks for this. So the market does pay 40 bucks for this, with 2 results1) Every bank that holds this kind of asset, with mark-to-market rules has to write their assets down to 40 cents on the dollar, which is basically going to force banks with this asset on their balance sheet to mark to market, which is what they’re trying to avoid in the first place2) The fed now has only 40 bucks with which to return to the market and offer the banks. So the next time it buys the asset, it will be at 40 bucks, which is the market price to begin with.So it looks like, all this plan does is, for the first 700 billion worth of assets that are bought, the treasury can pay above market prices and bail them out. After that, a mark to market occurs and the economy falls off the cliff it was driving towards in a hurry.This plan puts a 700 billion dollar buffer between the market and the banks, and that’s it. Anything after that, it’s back to mark to market and back to the precipitous fall.

  6. Guest   September 22, 2008 at 10:23 pm

    Great article that articulated things I couldn’t say.In my gut, the whole thing doesn’t feel right.Did Bush and everyone else just wake up to this surprise in the last couple weeks or did they know it was coming?It seems that incompetence has ruled alongside Bush. How could this solution be any different?

  7. Tom from Ohio   September 22, 2008 at 10:32 pm

    Here is what we need to do.The solution is to give $7000 to each taxpayer but with the followingrestrictions.If you are in default on any debt (auto, home, credit card, student), then the7000 will first go to repaying the loans. This helps keep people in theirhomes and helps liquify the lenders with payments on loans.If you are not in default, the money will be held in a self directed accountfor you by social security number. The money can only be used to invest inNEWLY issued stock (common or preferred) from a list of firms to be determinedby the treasury department. These shares could not be sold for 5 years. Also,up to 3000 dollars could be used for a payment against a current home loanwhich would be deducted from the balance. Again this would help keep peoplein their homes and liquify the lenders.Since everyone is getting the money, there is no moral hazzard in bailing outidiots only. The lending institutions are liquified and most but not allpeople are helped with their home mortgages.Bottom line. We need a bailout. But this would do it in a way that would benefit all taxpayers if it works.

  8. Guest   September 23, 2008 at 12:24 am

    This is an excellent, excellent analysis of the same idea I voiced to my senators and congresswoman. Organize a large tax-free workout, similar to a bankruptcy. Robert Reich posted the same proposal on his blog (but without all the helpful details and analysis). After reading this, I am more convinced that this could be a real, viable (and tax-free) alternative to the bailout.People have to vocalize this. We should not waste $700 billion when there are alternative solutions that are free.

  9. Guest   September 23, 2008 at 1:41 am

    The local/fed governments liked the tax revenues from inflated real estate.The Federal Reserve private bank is trying to take over the country.

  10. Euro   September 23, 2008 at 2:50 am

    Paulson, Bush the OWNERS OF THE FED have the nerve and audacity to call other people fat cats. The FEDERAL RESERVE is the cause of these problems make no mistake about it.

  11. Michael Khor   September 23, 2008 at 11:38 am

    I am fully aligned to the view of Prof. Zingales. Enough is enough. Independent economists and financial experts should express their views more explicitly to save the US taxpayers in general from the impending bailout burden that was created by a few financiers. The system where profits are private and losses are socialized have to stop to reduce further adverse impact on the economy. It is high time that the public and lawmakers not be influenced by the myths that a corporation is too big to fail. Probably, lawmakers should not rush to support proposals that always required immediate decision. It is extremely astonishing that Treasury is asking for a blank check without any oversight and accountabilities for their actions, which I believe violates the principle of capitalism. A statement that I find difficult to comprehend is that each time there was a bailout, part of policymaker’s justification was that it was done to save the global financial system. How far is this true?

  12. Guest   September 24, 2008 at 2:26 pm

    Why not asking the wall street’s fat cats to pay their 96 billions bonuses back ? Perhaps they will agree if they love their country…

  13. Bluehawk   September 24, 2008 at 2:27 pm

    Read Sections 2(b) and 8 of the proposed draft legislation. That is all anyone needs to know about how and why “Paulson is wrong.” It is impossible to have “price discovery” when so much as publicizing a “bailout” of this magnitude has already had the effect of artificially increasing the eventual purchase price of an admittedly amorphous set of bailees. The proposal is asking trust where trust has been irrevocably broken long ago.