So, you don't want to nationalize all the bad banks, and neither does Megan McCardle. After all, America is not Sweden, we're heterogeneous and fractious and really gosh-darn big. American politics are nasty, brutish, and interminable — no way to run a lemonade stand let alone a bank. Okay.

Unfortunately, the private sector approach to reorganizing and recapitalizing banks, forced debt-to-equity conversions, is too harsh on creditors. Yes, it is the free-market solution, and it's what we normally do (via the bankruptcy process) when firms are viable but undercapitalized. But, we are afraid of hurting lenders at a moment where credit markets are wobbly and a strike by lenders could be catastrophic. Okay.

Maybe these are two great tastes that taste great together. What if both the state and junior creditors could took equity stakes in reorganized firms, fifty-fifty. The former creditors would run the place without government interference, isolating management from politics and diminishing concerns of creeping socialism. Taxpayers would enjoy the upside as passive investors in ordinary, profit-maximizing businesses, and would buy shares at a bargain price (book value after very aggressive write-downs have been taken). Some creditors would still have to endure the indignity of being converted to equity, but the amount of debt that would have to convert would be cut in half (approximately), giving converted debtors a lot of capitalization bang for their buck. Junior creditors would go from owning very dodgy debt to relatively safe shares, and more senior creditors would see the value of their positions spike and stabilize as solvency concerns abate.

Here's how this would work:

  1. Regulators would go over bank balance sheets, and come up with a very conservative account of their assets. Nothing would be carried at more than market, in-quantity bids. That's a fire sale price? Too bad. There's no market bid at all? That's a zero then.

  2. Any bank that is undercapitalized on this basis, that is beneath the regulatory thresholds for an adequately capitalized bank, is insolvent. Equityholders, common and preferred, are wiped out. Sorry, Charlie. You levered up, you bought crap, you lost. That's how it goes. I love the smell of capitalism in the morning.

  3. We choose a "well capitalized" leverage ratio, and that will tell us how much debt we'll need to convert to equity. Here are the formulas, if I've got my algebra right:

    government_equity = converted_equity =
       (total_assets / (2 * target_leverage - 1))
    reqired_conversion = converted_equity - old_book_equity

    ...where old_book_equity is the book value (a negative number) of the now wiped old equity.

  4. We define two classes of stock, one voting and one nonvoting but convertible to the voting shares, each with a par value of $1. The government puchases its share, by purchasing government_equity shares of the nonvoting stock at par. The government is forbidden from exercising the conversion option.

    The required amount of debt is converted to converted_equity shares of voting stock, which is distributed to creditors pro rata based on the amount of equity converted. (Equivalently, a conversion rate of required_conversion / converted_equity is established.)

  5. The firm would have the option of paying unsecured contingent liabilities that arise from contracts entered into prior to the reorganization in stock at the conversion rate established for other creditors. This has the effect of placing undercollateralized derivative counterparties where they belong, in the same boat as the most junior creditors of the firm. It's also good from a "moral hazard" perspective — we really, really want people to take counterparty risk seriously in whatever OTC derivaties market survives this episode, but we don't want to wipe out existing counterparties and set-off a cascade or meltdown. Counterparties to reorganized firms would take a haircut, and salutary uncertainty would be introduced in valuation schemes that too often begin by assuming away counterparty risk.

  6. If a firm is so profoundly insolvent that, even with the government capital infusion, the required debt-to-equity conversions would have to hit depositors (at banks) or claims on assets held on behalf of clients (e.g. stocks held for clients by brokerages), then the firms should be liquidated, with the government honoring FDIC and SIPC guarantees. If any such firms are systemically important, they'd have to be nationalized outright, like AIG. Half-measures can't save such firms. (Thanks to Winterspeak for pointing out this issue.)

The aggressiveness of the writedowns in Step 1 is the core protection for taxpayers in this plan. If that's watered down, this could become a taxpayer subsidy to converted creditors. Also, to protect taxpayers, creditors should never be able to purchase shares more cheaply than the government. Under the formulas above, that would happen when the book equity of the reorganized firm is positive, but less than regulatory capitalization thresholds. In this case, the new owners effectively get a subsidy, a wealth transfer from old equityholders, during the reorganization. This subsidy should be shared by converted creditors and the government. The formulas above allocate old book equity to converted creditors, to ensure that creditors rather than taxpayers bear prereorganization losses, and would have to be modified when old book equity is positive:

government_cash_infusion =
   (total_assets - (old_equity * target_leverage)) /
   (2 * target_leverage - 1)
government_equity = converted_equity =
   (total_assets + government_cash_infusion) /
   (target_leverage * 2)
reqired_conversion = converted_equity - (0.5) * old_book_equity

...and the government would buy shares at the same conversion rate paid by creditors, rather than at par.

Update History:
  • 30-Sept-2008, 2:20 p.m. EDT: Replaced an "and" with "as", 'cuz that's what i meant.
  • 30-Sept-2008, 2:45 p.m. EDT: "abated" to "abate"
Steve Randy Waldman — Tuesday September 30, 2008 at 12:27pm [ 11 comments | 0 Trackbacks ] permalink

I've written about the Federal Reserve a good deal, and I've been critical of its willingness to take private sector risk onto its balance sheet by swapping Treasuries for the increasingly dodgy securities produced during the credit bubble.

The (hopefully defunct) Paulson Plan has provided a come to Jesus moment. Having the Fed lend money against overpriced collateral valuations is infinitely superior having the Treasury purchase those securities outright at inflated prices. While the taxpayer is on the hook in either case, at least when the Fed lends, the taxpayer loses only if the borrower first fails. If the Treasury Secretary overpays for an asset, the original owner books the profit and the taxpayer eats the loss directly. A "quiet bailout" from Dr. Bernanke strikes me as much more equitable than a sellers' market fashioned by Secretary Paulson.

Lending from the Fed even against worthless collateral cannot address undercapitalization of the banking sector. Neither could the Paulson Plan, unless the Secretary were to overpay for bank assets. Removing the ability and incentive to overpay on a permanent sale strikes me as a good thing. Recapitalizing the banking system will require more than easy money from the Fed. But easy money, combined with a bit of temporary forbearance on capital requirements, would help blunt the current panic, while leaving bank stockholders and creditors on the hook before any losses would be taken by taxpayers.

The big hazard of this approach is as it has always been, how to wean the banking system from the mother's milk of Fed largesse. Many banks are insolvent, and those banks need to be identified, reorganized and recapitalized (or else liquidated). That should happen quickly — not zombie style over the course of a decade — but it needn't happen instantaneously and simultaneously. In order to even get started, we need to have a fair endgame, a good approach to reorganizing and recapitalizing banks. I'm already on record as supporting either temporary nationalization (a la the Scandinavian model or AIG), or internal recapitalizations via debt to equity conversions. It's possible that a combination of these two approaches, one that doesn't give government direct control over reorganized banks and includes both internal and public sector capital injections, might be more palatable than either choice alone. That will be the subject of my next post.

In the meantime, I would support a standalone act authorizing the Fed to pay interest on deposits immediately. I would prefer that Congress impose limits on the quantity of deposits on which interest can be paid, to limit the risk and interests cost to taxpayers, but that limit could be quite loose for the moment. This approach has the advantage of getting liquidity into the banking system far more quickly than the Paulson Plan ever could have, and drawing a clear line between the liquidity and capitalization aspects of the plan. It could be implemented immediately by passing the one sentence Section 128 of the Paulson Plan in isolation (although again, I'd prefer to muck it up with a limit on the quantity of paid deposits).

Freed of its balance sheet constraint, the Fed might consider injecting funds into the banking system by purchasing a diversified portfolio of holdings in money market funds that trade in commercial rather than government paper. This would help relieve the stresses in the commercial paper market very directly, and reduce the likelihood of a disorderly adjustment in nonfinancial commercial credit markets.

Steve Randy Waldman — Monday September 29, 2008 at 7:40pm [ 13 comments | 0 Trackbacks ] permalink

I remain adamantly opposed to the "Emergency Economic Stabilization Act of 2008". And I'm astonished that so many who opposed the bare-bones Paulson Plan have, however begrudgingly, risen to support this proposal. Yves Smith is right that "turning Hank Paulson's three pager into a 110 page draft made for a nice fig leaf but made virtually no substantive difference." There is a bit more accountability and transparency. But, there are also huge new powers for the Federal Reserve and the SEC that weren't in the original, and were inserted with no public debate. All the rest, the equity sharing, the "installment plan", the compensation limitations are weak, and the act specifically authorizes the Treasury to overpay for assets (that is, "at the lowest price that the Secretary determines to be consistent with the purposes of this Act").

There has been so much talk of catastrophic consequences if we do not support this bail-out. What happens if we do pass the act — over the clear objections of the vast majority of Americans — and the depression still comes?

I think people are severely underestimating the depths of the crisis we are in. This is not a financial crisis about banks and commercial paper. It is not about the housing market. We are in an economic crisis, because America's productive capacity is deeply out of kilter with our habits of consumption. No amount of financial legerdemain can fix that. We have to actually produce the goods and services we want to consume, or else produce current goods and services that we can trade for what we consume. Relying on the mysteries of finance to square the circle has brought us low. At best, the proposed bail-out might buy us some time to fix the underlying economics before the pain kicks in. At worst, the pain will kick in anyway, but we'll have even less flexibility than we have now to address the real problems.

Suppose we pass the "Emergency Economic Stabilization Act of 2008", and a depression comes anyway, and we cannot raise taxes (blood, turnips, all of that), and we cannot borrow from abroad (because our paymasters have tired of us). Sure, the Federal Reserve will print money, because the debt must be paid and the government must continue, and in a depression many prices will fall regardless, but commodities and imports will grow dear. We will know then that we want to build factories, for all the televisions and computers that used to be cheap from Asia, but that can no longer be bought with debauched greenbacks. But we won't have the capital.

What will we say, in those dark days, when someone comes along and blames the bankers? It was the bankers, after all, who "intermediated" our vast current account deficit, who found ways of accepting goods and producing debt despite our incapacity to repay, and who enriched themselves by doing so. And then these self-same bankers threatened us with armageddon unless we paid them hundreds of billions of dollars, back when dollars could still buy steel and cement and machinery. We paid the ransom, but the hostage died anyway. How will Secretary Paulson answer their charge?

Suddenly we will realize the cost of putting expedience before even the thinnest veneer of justice. Because in the end, Secretary Paulson will answer these charges with a locked gate and an exception to the Posse Comitatus Act. An economic depression will bring temptations to violence and radicalism. And a lot of people will look back on this decade, right up to and through the "Emergency Economic Stabilization Act of 2008", and feel with some justice that they were royally screwed.

Now, in a deep downturn, scapegoats will be found no matter what. Maybe we really have nothing to lose by passing this badly flawed proposal, since it might prevent a depression and if not we're all toast anyway. But, you know what? While we still can borrow valuable dollars, we could use that 700B to build infrastructure that might make the economic facts of a depression less severe. And, if we insisted that the mighty bankers actually fall now, actually take the hit that their own ideology demands of them, that just might blunt the sense that we are "us" and "them", rather than a nation with a common struggle, when it all hits the fan. Maybe the choice we are really making here is not about financial and monetary arcana, but a choice between civic peace and civil war.

Obviously this is speculative, and alarmist, while the crises in the credit markets are acute, real, and tangible. But we really could nationalize failing banks before they take down the credit markets, while bailing out senior creditors. It has been done. The Federal Reserve or the Treasury could buy high quality commercial paper if the money markets go on strike. (That's much less risky than buying frozen mortgage assets.) We really could invest in productive infrastructure, rather than in claims on already built subdivisions. We do have other choices, besides starting the depression tomorrow or giving Secretary Paulson what he wants.

The Paulson Plan is now the easy out. It has a lot of momentum behind it. It feels safe. But it is not guaranteed to work even in the short run, and does not address the substance of our economic problems at all. Much of the public perceives the plan as at best a kind of ransom and at worst a kind of theft. The plan might buy us enough time to put our economic house in order, in which case it would have been well worth the cost. But if it doesn't work out that way, if the public is forced to swallow a bail-out that seems flamboyantly unjust and everything falls to pieces anyway, we will have painted ourselves into a very dark corner. In a genuine catastrophe, social cohesion matters more than anything. Surely, by now, we should have learned not to underestimate tail risk.

Steve Randy Waldman — Monday September 29, 2008 at 7:04am [ 6 comments | 0 Trackbacks ] permalink

So, I'm not a lawyer, I've gone through this very, very quickly, and I've got to run.

On the whole, I think this is basically last weekend's Paulson Plan with much better oversight, more transparency, and a lot more words. Also, the Federal Reserve is given authority to pay interest on deposits, and thereby implement a "channel" or even a "floor" system of monetary policy (ht commenter RueTheDay). And, the SEC can suspend mark-to-market accounting requirments. Those are big things to slip in under the radar.

Some easy changes that would make me feel a little better:

  • Section 114 on transparency: "assets acquired" should be changes to "assets acquired, obligations assumed, or any other use of financial instruments undertaken", so that the Treasury's participation in derivative markets or its assumption of contingent liabilities is made public.

  • While disclosures are required for taking positions in financial instruments other than security purchases in Section 3(9)(b), there should be stronger controls, and those controls should apply regardless of whether the contracts entered into are mortage-related or not.

  • The streamlined contracting described in Sec 107(a) should be toughened. Disclosures should be public, and approval by, not merely notification to, some oversight body should be required. The Bush Administration has a poor record on "streamlined contracting".

  • In general, a required disclosures and reports to committees under TARP should be required to be public.

Some miscellaneous bullets:

  • The House Republican's insurance plan has been added, presumably to salve egos, but that only harms the taxpayer.

  • The equity participation portion is toothless, much less specific or meaningful than in the earlier Dodd proposal. If equity participation is your core criterion, it's unclear to me how one could say "no deal" to last week's plan but "deal" to this one. Yes, some kind of equity participation is broadly mandatory, but aside from general principles, the scale of that participation is wholly at the discretion of the Treasury Secretary.

  • The compensation limitation section is very complex. Tin-foil-hat me thinks that this means there are loopholes by which the Treasury could structure participation in ways that prevent these requirements from biting, but going through the different sections, I wasn't certain that I'd hit upon the scheme. There's a fairly broad section that would create tax penalties for those who participate via auctions, and a much less specific section regarding beneficiaries of direct purchases. Tin-foil hat me thinks that those the Treasury Secretary wants to exempt will participate via direct purchases, and these players will be subject to vague, discretionary restrictions, or will be exempt due to a lack of meaningful equity participation. But overall, this section is too complicated for me to quickly make sense of.

My bottom line:

I still dislike this proposal and hope it does not pass. However, in a way, reading this makes me feel better about Secretary Paulson's original plan. He was at least very honest about the powers he was asking for last weekend. Here he basically gets the same thing — although the added transparency and extra oversight is meaningful! — but all the verbiage blunts the impact.


Below are, unedited and unexpurgated, the notes I took while reading the act. They are very quick and dirty, but I gotta run. My apologies in advance.

Sec. 3 (9) — Defines "troubled assets" to. Section (a) includes not only securities, but "obligations, or other instruments" related to mortgage assets, while Sec. (b) allows

any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress

The word "obligations" in (a) means that Treasury is authorized to assume the liabilities of private parties. The phrase "any other financial instrument" in (b) is very broad, and could include entering into contracts that put taxpayers on the hook for far more than any upfront cost. It's clear that Congress recognized the danger associated with "any other financial instrument", and insisted on some check. I would prefer this check be stronger, at least permitting "appropriate committees" to object, not merely be notified of a trade. In any case, the non-security "obligations, and other instruments" defined in Sec (a) need to be subject to the checks and oversight defined in Section (b). Assuming contingent liabilities can create a hole in the public balance sheet regardless of whether those liabilities are related to mortgages or other assets.

Sec. 101 (d) — Requires publication of

(1) Mechanisms for purchasing troubled assets.
(2) Methods for pricing and valuing troubled assets.
(3) Procedures for selecting asset managers.
(4) Criteria for identifying troubled assets for purchase.


Sec. 102 — Not only authorizes, but requires the Secretary to start a program to provide Federal insurance of troubled assets, if the core TARP program is implemented. I have a great deal of respect for the House Republicans for having slowed down this train, and still harbor some hope that they may stop it. But adding this insurance program is positively harmful. It increases the potential cost to taxpayers, if actuarially estimated premia turn out not to cover the cost of the claims. The "concession" the Republicans have insisted upon ended up creating a new potential hole in the taxpayer balance sheet. Two wrongs don't make a right, and two bad programs don't help the taxpayer. We'd be better off without this section. The insurance program creates a loophole by which taxpayer money can be given away, and th resulting losses blamed on good faith bad estimates. (Justin Fox points out that while the program is mandatory, the actual extension of guarantees is at the Treasury Secretary's discretion. I'm less confident that guarantees won't be offered than Justin is.)

Sec. 104 — The members of the newly defined "Financial Stability Oversight Board" are all members of the Executive Branch, with the exception of the Federal Reserve Chair, who is appointed by the President. WTF? There should be significant Congressional representation on this committee. The era of trusting the executive branch to do the right thing is long passed. Having only "reports and recommendations" sent to Congress is insufficient. It let's this committee set the options and determine the range of reasonable debate, just as Paulson and Bernanke did to us last weekend.

Also, it is insufficient that the reports and recommendations of the Oversight Board (which include financial statements, justification of prices paid, etc.) be sent to Congress. They should be made public.

Sec. 106 (d) — Requires that at least 20% of any profits be transferred to specific funds. That's dumb. These assets are being purchased from the General Fund of the Treasury. The General Fund of the Treasury should be made whole. If Congress wants to support the "Housing Trust Fund" or "Capital Magnet Fund" it should do that in separate legislation. Let's try to make the taxpayer whole, and then worry about make use of all our profits.

Sec. 107 (a) — Permits a "streamlined" contracting process under which ordinary checks on Federal contracting can be circumvented, if the justification for the circumvention is submitted to various committees. Given the plum jobs this act could create for financial intermediaries, and the degree to which precedents for extortionate compensation can be found in private sector contracts (2 and 20, anyone?), I am deeply uncomfortable with this. The Bush Administration has not won the public's trust with respect to no-bid contracting. "Streamlined" contracting should require more than notification, but active approval by some third party, and notification that contracts have been awarded through the streamlined process should be public, along with full details of the contracted arrangement.

Sec. 111 — This is the section containing the vaunted restrictions on executive pay. I cannot quicky understand or summarize it, as different rules apply for firms accepting direct purchases, participating in other ways, "golden parachutes", etc. I am suspicious that in all of this complexity there is room for the Treasury and firms to structure their participation in such a way as to evade the restrictions and penalties defined in the act. But I don't have the time or legal experience to think about all of the different what-ifs, and how this very complicated section of the act might apply.

Sec. 112 — Permits the Treasury to take "troubled assets" off the hands of foreign central banks, if the assets were issued by financial institutions that have defaulted. Whoa! What's this all about?

Sec. 113(2)(b) — The Treasury is specifically authorized not to purchase at the lowest price possible, but to purchase "at the lowest price that the Secretary determines to be consistent with the purposes of this Act". That's comforting.

Sec. 113(d) — While in general the Treasury has to acquire warrants or debt from participating firms, this section is much weaker than the "make whole" requirement reported in the Dodd proposal. The Secretary has complete discretion over the terms of these arrangements

(i) to provide for reasonable participa-  
    tion by the Secretary, for the benefit of 
    taxpayers, in equity appreciation in the 
    case of a warrant, or a reasonable interest 
    rate premium, in the case of a debt instru- 
    ment; and 
(ii) to provide additional protection 
    for the taxpayer against losses from sale of 
    assets by the Secretary under this Act and 
    the administrative expenses of the TARP. 

That's it. There are no teeth, nothing that says if a firm fobs an asset off and forces a serious loss on taxpayers, the Treasury will achieve a claim on the firm sufficient to make it whole.

Sec. 114 — Market Transparency. The good part:

To facilitate market transparency, the Secretary shall make available to the public, in electronic form, a description, amounts, and pricing of assets acquired under this Act, within 2 business days of purchase, trade, or other disposition.

The bad part: buying "assets" doesn't begin to cover all that TARP is permitted to do. What about the obligations or contingent liabilities it assumes? Those should be made public as well.

Sec. 115 — This is the part about the size of the TARP's balance sheet, including the celebrated "installment plan". It retains the huge loophole that restrictions apply to the size of TARP's balance sheet "outstanding at any one time". That is, Treasury could spend more money than these limitations seem to imply by purchasing and then reselling assets at a loss, then purchasing more. There are restrictions elsewhere, suggesting that Treasury must either hold-to-maturity or sell when it would be most advantageous to the taxpayer, but that leaves a whole lot of wiggle room. Treasury can always purchase, then claim to have revised its valuation and sell "advantageously" at a loss.

There's a lot of verbiage in this section about the procedure by which Congress could refuse the second $350B installment. The details are beyond my comprehension or interest, but broadly, by default Treasury gets the second installment unless it is specifically blocked by action of Congress.

Sec. 128 — Though there's no indication of what this is about in the plain language of the act, this is a stealthy acceleration of the Fed's ability to pay interest on deposits (ht commenter Rue The Day).

Sec. 131 — It looks like someone didn't like that the Treasury's guarantee of money market funds made use of the Exchange Stabilization Fund.

Sec. 132 — The SEC can suspend mark-to-market accounting requirements.

Sec. 134 — Recoupment... a ridiculous kick-the-can down the road, after 5 years we'll bill participants in the program for any loss. Right.

Sec. 310 — Looks like some kind of tax relief for losers on Freddie and Fannie preferred.

Steve Randy Waldman — Sunday September 28, 2008 at 8:42pm [ 5 comments | 0 Trackbacks ] permalink

I really hate to disagree with Kevin Drum. He's thoughtful, moderate, level-headed, smart. He's the kind of guy who is, on balance, usually right. So, it makes me nervous to read his recent post, Pass the Effin Bill.

I don't know if the financial universe will blow apart if Asian markets open tomorrow night and there is no bail-out in sight. I do know that the TED spread may not be telling us what we think it is, that the current proposal has almost nothing to do with the stressed out corporate paper market except via the catch-all term "confidence", and that the timing of bank failures is largely at the discretion of the FDIC. I accept the principle that it is worth bearing significant costs to insure against even uncertain catastrophes, but other than cries of inchoate pain from anything labeled financial, I have yet to hear a compelling tale of why we should be confident that this expensive ounce of prevention will actually work. Hope is not a plan, and neither is discomfort.

Of course the people advocating the Paulson Plan have the capacity to create pain that might be perfectly avoidable. Yes that's cynical. But that's honestly where I am. Not only do I not have confidence in the solvency of the banking system, I don't even have confidence that important players in both the public and private sectors wouldn't use the tools at their disposal to create a little pain, until they bully the public into giving what they want. I know, I know, give me my tinfoil hat. But, if you believe the advocates of the Paulson Plan, major financial institutions would be insolvent if they marked their assets to current (um, "fire sale") market bids. That's not what their balance sheets say. If it's true, investors and the public at large have been lied to for months by the leaders of the institutions to which we are expected to trust our life's savings. And they want us to help cover that up. So, I'm cynical.

Anyway, for better or for worse, I was finally moved to do get political and write my representatives in Congress. I hope this was the right thing to do. For whatever it's worth, here's what I wrote:

September 27, 2008

To:	Representative Ben Chandler
	Senator Jim Bunning
	Senator Mitch McConnell

Re:	the “bail-out” (Fax transmission, 3 pages including this page.)

Like many voters, I feel helpless and angry as an astonishing bail-out of our corrupt and obsolete financial industry wends its way through the Congress. I am a new resident of Kentucky, have lived here for just over a year. The three of you are now my voice in Washington.

I am a doctoral student in finance at the University of Kentucky. I am not the world’s foremost expert in anything, but I am making the study of financial markets my vocation.

The legislation submitted by Secretary Paulson last weekend, if passed, would have been an astonishing arrogation of unchecked power. I fear for the United States of America that the proposal was even considered by the Congress, and described as “a good foundation” by Senator Schumer. After his crass attempt to assume near dictatorial power, I have lost my trust in Secretary Paulson. I believe this financial industry insider must be kept on a very tight leash for the few months he has left to help his friends and former colleagues on Wall Street.

I do, however, believe that we face a financial emergency, and that the Congress could play a constructive role in resolving the crisis in a manner that protects taxpayers and the general public and ensures that those responsible for our financial collapse bear most of the costs. I think there are two workable paths, one fully public and one fully private. I am open to both approaches. But I am adamantly opposed to a "public / private hybrid" solution, because frankly, I don’t think even our most well-intentioned public officials can avoid being milked and hoodwinked by the world’s greatest dealmakers. Either the Federal government should take over failing institutions, as it has taken over the insurance giant AIG, or the barrier between the public purse and the private banks should be made impermeable. The first thing that any legislative proposal should do is remove the gun that bankers currently hold to the head of our nation: the threat of disorderly bankruptcies. All systemically important financial firms should be subject to a controlled procedure in the event of insolvency, and should only have access to ordinary Chapter 11 reorganization or Chapter 7 liquidation after regulators have vouchsafed that such a filing would not imperil the nation’s financial system. Similarly, a petition by a creditor for involuntary bankruptcy should trigger the same regulatory review.

The Congress should choose either a private sector or public sector approach to managing the failure of systemically important firms. A private sector approach should follow the principles outlined by University of Chicago Professor Luigi Zingales. [See] All of our financial firms are "asset rich" — they have plenty of money, it’s just that they have too much debt. They can be rendered liquid and solvent by requiring some creditors to accept equity in the firms in exchange for their debt claims. This is a perfectly fair outcome: People who lent these highly leveraged companies money knew or ought to have known they were taking a risk, and capitalism requires that lenders every bit as much as stockholders take responsibility for the soundness of the firms in which they invest. Unless these firms are quite profoundly insolvent, most creditors should take only a small haircut on the value of their debt, and could profit over time if the firms recover. Even the thorny issue of derivatives and other contingent liabilities can be addressed in this fashion: Firms that undergo a “fast-track reorganization” would be given the right to pay these obligations in the form of $1 par value preferred stock (the structure of which would have to be defined by Congress). Counterparties to derivatives transactions would undoubtedly prefer cold cash to company stock, but at least these contracts wouldn’t become fully worthless, as they would have under ordinary bankruptcy. Since counterparties would take only a haircut rather than a total loss, debt-to-equity conversions would help minimize the likelihood of cascading defaults on derivative contracts, the dreaded "CDS meltdown".

A public sector approach the problem would be to let the controlled failure of AIG serve as a model for systemically important financial firms. The banks that are today failing took on huge and foolish risks. (That "everyone was doing it" is a schoolboy’s excuse, not acceptable from people entrusted to manage trillions of other people’s money.) If as a consequence of their poor decisions, they now need money from the Federal government, we should demand that the taxpayer take effective ownership of the firm in exchange for the support. Regulators could then ensure a reorganization that promotes systemic stability while minimizing taxpayer costs, following which firms could be reprivatized in small, conservatively financed pieces that would no longer be "too big to fail".

Both the private sector and the public sector approaches presented here are workable, protect taxpayers’ interests, and avoid rewarding malefactors of great wealth with gargantuan public subsidies. The hybrid approach at the core of the Paulson Plan will result either in a serious cost to the taxpayers, or in future inflation as the Federal balance sheet is stretched to the breaking point and people lose confidence in US Treasury securities. (With a high enough rate of inflation, the Treasury can definitely turn a paper profit on any trash it buys from Wall Street, but that paper won’t be worth much. We could avoid a lot of foreclosures if we devalued the dollar by 50%.)

I am an independent voter. At the Presidential level, the Republican Party has already lost my vote. The last eight years have been catastrophic for the country, and accountability demands a change of party in the White House. At the Congressional level, however, my vote is up for grabs. Frankly, your response to the current financial crisis is my litmus test issue.

If there is any way I can be of service as you work through these difficult issues, I would be very honored to help. I thank you for your time and consideration.

/s Steve Waldman
Steve Randy Waldman — Sunday September 28, 2008 at 12:22am [ 11 comments | 0 Trackbacks ] permalink

The following expands on ideas from a previous post, but is similar in spirit to a wonderful essay by Luigi Zingales (ht Tyler Cowen, Arnold Kling). If you have not read that, please do. I think it is the most important document to have arisen from this debate this far.

Rather than a bail-out, Congress should pass an "ARISE act". ARISE would stand for Automatic Reorganization of Insolvent Systemically-important Enterprises. It could be very simple.

The Secretary of the Treasury, in consultation with the Chairman of the Federal Reserve and subject to judicial review, would declare certain firms systemically important according to criteria specified by the act. Those firms would be subject to a streamlined form of bankruptcy rather than ordinary Chapter 11 reorganization or Chapter 7 liquidation. The Treasury would compile a list of all systemically important firms, not just those considered to be imperiled, so inclusion would not signal any sort of distress. Should a systematically important firm find itself unable to meet its obligations, it would be subject to a very simple reorganization procedure: common and preferred equityholders would be wiped out (but would be given deep out-of-the-money warrants on stock of the restructured firm), a new class of $1 par value common equity would be established, which would replace existing debt claims dollar for dollar, until the resulting firm would be no more than 4x leveraged and can be certified as conservatively solvent and liquid by independent auditors. Junior debt would be swapped for equity before senior debt, and secured debt would become unsecured. All creditors would have the option of exchanging their debt for equity in the new firm. Further, reorganized firms would have the right to pay off unsecured contingent liabilities (including, for example, liabilities under derivative contracts) in stock at par value rather than in cash.

An intended "unanticipated consequence" of this proposal is that it would make the debt of firms that are potentially "systemically important" much more equity-like, long before any hint of financial distress or reorganization (and even before an explicit listing by the Treasury). That would raise the cost of capital for such firms, serving as a kind of a tax on scale and criticality. Leveraged firms that are "too big or interconnected to fail" create negative externalities for markets, taxpayers, and the public at large. Under the ARISE act, lenders would absorb some costs that the general public would otherwise bear, and would charge appropriately for the insurance. Firms that prefer inexpensive debt financing to the strategic options associated with scale can spin-off independently controlled entities as they grow.

Those who claim this would be a radical abrogation of contract should note that it would only be a change in the bankruptcy code, basically a new form of reorganization. Individuals have been subject to many retrospectively applicable changes in bankruptcy law over the years, and property rights have survived. This change would affect a very small fraction of firms (although a much larger fraction of debt, since it would predominantly affect very large firms).

See also: Mark Thoma, Willem Buiter

Steve Randy Waldman — Sunday September 21, 2008 at 3:54pm [ 10 comments | 0 Trackbacks ] permalink

I am sorry to go all AWOL lately. I'll try to post something substantative over the weekend. My temporal balance sheet looks a great deal like Lehman's financials. Plus, despite the generous antidotes provided by Yves Smith, the events of the past few weeks have me twitchy and disoriented, reading obsessively but barely capable of drooling. I think I speak for a lot of us who've been on the pessimistic side of the financial blogosphere these last few years in saying I wish we had been wrong. (I wish the mighty who are now falling had paid us some mind, too.)

Today's big news is the hint of a bail-out to end all bail-outs. I often have mixed feelings about Robert Reich's commentary, but I commend to you his piece today.

There is no question that we are going to spend a lot of public money to address the current crisis. We have already put a very extraordinary amount at risk. The question we should be asking is not whether or how much, but to whom and for what. The financial crisis we are facing is a symptom of a much larger economic and social crisis. Wall Street is not the source of the pain. On the contrary, the financial sector has been put this decade primarily in the service of hiding, literally of papering over, unsustainable trends in the current account, income distribution, human and physical capital deterioration, and the sectoral composition of the American economy. The conventional wisdom is that this is a financial crisis, and that so far "Main Street" has been largely insulated from the catastrophe. That is rubbish. The cancer is on Main Street, and the tumor has been growing there for years. Wall Street provided drugs to hide the pain and keep us going, palliative but not curative. What is happening now is those drugs are wearing off. The American economy is fundamentally unsound, and has been for some time. We would have noticed sooner, were it not for financial methamphetamine conjured by mad scientists in lower Manhattan from a whirlwind of foreign central bank money.

I think we'll only get one shot to set things right by throwing a ton of money at the problem, so we'd better think carefully before we throw it at symptoms rather than causes. Trying to figure this out in a week before Congress goes off to reelect itself strikes me as ambitious. Broadly, my view is that if we are going to legislate, Congress should empower regulators to declare systemically important firms insolvent, write off existing common and preferred, fire incumbent management and unilaterally convert debt to equity as far up the capital structure as they need to go until the firms are unambiguously well-capitalized, with little or no public money involved. Going forward, investors should understand that firms that are too big to fail are too big to be debt-financed, and government enforcement of debt claims against such firms will be limited. If economies of scale are real, equityholders should be glad to reap them. Otherwise markets function better anyway when populated by small actors who compete rather than by behemoths who dominate. The government should not subsidize the many negative externalities of scale. Members of the Pigou Club might suggest that bigness should be taxed and diversity subsidized.

As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I'd rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let's spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.

There's no such thing as a choice-free bailout. The government's largesse will go to some and not to others, and we have to decide. Don't believe self-styled technocrats who claim that science or the market tells them who deserves the tax- (or inflation-) payers' dollar. In a bail-out, there are winners and losers, and we get to pick. I think we should focus on a simple goal: Restructuring the economy so that the vast majority of Americans can afford a middle-class lifestyle with very little leverage on household or government balance sheets. That may be a radical suggestion in 2008, but our grandparents would have considered it only common sense.

Update History:
  • 19-Sept-2008, 8:30 a.m. EDT: Minor edits, added a missing "is", replaced required with involved re public money.
Steve Randy Waldman — Friday September 19, 2008 at 2:25am [ 16 comments | 0 Trackbacks ] permalink