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 permalink
Benign Brodwicz (mail):
I propose the following:

The problems are (1) frozen inter-bank lending, the big TED spread and slow-down of the commercial paper market, and (2) inadequate bank capitalization.

Recapitalize the banks by lowering the reserve requirements and make it clear it's not a trick. Give the banks direction to mark and unload bad assets at their discretion. This will provide liquidity to the bad debt markets. I used to trade this stuff--there is a market, and the stuff will trade quickly once the market is lubricated.

Do I trust a Republican football player from Dartmouth to do right by anyone but his Wall Street associates (note I avoided saying "cronies").

No. The putative neo-fascist provisions that put Paulsen above the law must not stand. But I'm willing to be surprised.

And then regulate the financials like they need to be regulated. Anyone who hasn't cleaned up their act in a few years is a rotten egg.

Paul Krugman, if you're reading this, put it in your damn column, please.
9.21.2008 10:01pm
Nick Rowe (mail):
I don't see why your proposal would raise the cost of capital for such firms. In the event of bankruptcy, the creditors would get much the same outcome as under chapter 11, just more quickly and with lower legal costs.

Not that this is a problem with the proposal.

The requirement that it have no more than 4X leverage, and be certified as conservatively solvent and liquid by independent auditors, however, would slow down and complicate the process. This detracts in part from the main advantage, the streamlining.
9.21.2008 11:02pm
Steve Randy Waldman (mail) (www):
Nick — The auditors maybe, but the deleveraging is mechanical. Suppose the true value of equity is now precisely zero. We wipe out the equity, and convert 1/4 of the debt to new equity, and voila, we have four to one leverage. If the firm's losses are steeper than 100% of equity, we'd have to convert a greater fraction od debt to equity. But, for any balance sheet (after a conservative estimate of the losses), we can calculate 3/4 of the asset value, and leave that as the remaining value of the debt. The rest gets converted to equity, and voila! 4x leverage.
9.21.2008 11:46pm
Steve Randy Waldman (mail) (www):
Benign — I'm not sure reserve requirements would do the trick. They are already effectively zero for many banks with sweeps programs, but banks have to maintain deposits at the Fed anyway for clearing and settlement purposes. The amount needed for that can't easily be legislated away. Still, if liquidity were sufficient, the Fed could always just inject more reserves, with the same effect. I guess I'm not really getting what you're suggesting. How would reducing reserve requirements recapitalize anyone, even if they were still a binding constraint on banks?
9.21.2008 11:49pm
Independent Accountant (mail) (www):
Auditors? Hahahahaha. If the Big 87654 firms were doing their jobs properly, Freddie and Fannie, among other firms, would have been exposed as insolvent years ago. Hahahahaha.
9.22.2008 8:42am
Steve Randy Waldman (mail) (www):
Nick — Thinking more about your first point, I think another way of looking at it would be that firms wouldn't have the option of issuing asset-secured debt. Seniority of debt would map to likelihood of conversion to equity, and that's all. So there'd be some loss of ability to raise cheap capital, though maybe not as much as I suggest.

IA — I've no argument with your (very well informed) cynicism. The audit thing was (and always is) a "for whatever it's worth" kind of exercise... at least maybe there's someone else who has to fear losing a livelihood or going to jail if things go spectacularly out of kilter... if we're too cynical, even the leverage ratios don't mean anything ('cuz we have to rely on accounts to compute them). And of course in a world with leverage embedded in derivatives / complex contingent liabilities, we reall can't exactly "know" leverage ratios. The best we can do is do our best, but at least for a while until players learn the regulatory arbs designed to lever up 1000x while having 4x on the book, imperfect structural rules seem worth a try (with attention to the already well-known means of hiding leverage).
9.22.2008 10:32am
Peter Principle (mail):
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

I think you are ignoring the unintended (but highly predictable) consequences of a forced bankruptcy scheme on the rest of the debt markets.

Having just seen a whole class of companies declared "systemically important" and their outstanding obligations converted to quasi-equity instruments by government fiat, why would the creditors of OTHER firms stick around to see if their paper, too, will be similiarly expropriated? Is the auto industry systemically important? What about GE? Exxon?

Change the rules in such a fundamental way, and the entire universe of corporate debt is going to have to be repriced -- not just the banks. Under the circumstances, it could collapse the entire system.
9.22.2008 11:04am
Steve Randy Waldman (mail) (www):
Yeah. I do know that too. There'd be a terrible scare among creditors, and the Fed would probably have to replace the private credit market for a while. Let markets throw their little hissy fit, let creditors to sound firms take their losses by panic selling, and find a new equilibrium in which creditors take responsibility for the enterprises in which they invest.

"Collapse the entire system?" No... to dramatic. Slap it back into reality, while letting making Uncle Ben print as much money as necessary to hold it back from the abyss.

They just did change the system in a fundamental way, BTW. Banning shorts? Prices are meaningless, all equilibrium/arbitrage relationships are out the window, but it helps the financials who got us here, so hey. I'm losing patience.
9.22.2008 12:02pm
Benign Brodwicz (mail):
Meant to say lower capital requirements. Capital is entirely notional in our system when you get right down to it. Let the buggers who screwed up have to work their way back out of the hole, rather than bailing them out and putting them on the same footing as good banks that didn't go overboard. This moral hazard aspect of the bailout has been commented on widely, see for example Motley Fool's recent comments.

The Fed controls capital requirements, right? This whole system is a joke.
9.22.2008 10:14pm
Jorge (mail):
Peter, Steve:

I like the proposal. I think Peter's concerns are misguided. In a liquidation bankruptcy, debt is turned into equity.

With the Bear Stearns failure, JP Morgan and the Fed wiped out Bear's equity holders, but kept Bear's credit holders whole. Bear was deemed "too big to fail" at the time.

When Lehman failed, it was allowed to go bankrupt. Not only does this wipe out Lehman's equity, but it effectively turns Lehman's debt into equity. The Fed allowed Lehman to fail, and the markets panicked (as Steve said, creditors "threw a hissy fit") and repriced Morgan and Goldman's debt accordingly, driving up their credit default swaps and making it very expensive for them to finance their short-term credit needs.

Effectively, an ARISE Act would be a government promise that no firm is too big to fail, all firms are subject to bankruptcy (debt turning into equity). Firms that are deemed "too big" just get streamlined treatment.

I like that alternative better than the implicit government guarantee of debt of firms deemed "too big too fail". That implicit guarantee is what drove Fannie/Freddie to get us into this whole mess in the first place.
9.24.2008 9:17pm
Note: You don't have to register to comment! Just use the pull-down menu to comment as "Guest".

Post as: [Register] [Log In]

Remember info?