Over at Momocrats, I am urging all Americans to call or write their Representative or Senators and tell them that the $700 billion bailout plan being proposed by Paulson is unacceptable. It's lack of transparency or accountability is astounding, even by the standards set by recent Fed/Treasury actions. Here, I present some (far better) alternatives that have been presented by some of the best economic minds in our country. I suggest that the current administration gets over its hubris in believing there is a single solution to this problem and that we should lay our trust, unquestioned, in a man who, as the one-time head of Goldman Sachs, has a very personal stake in the outcome of this bailout.
From Nouriel Roubini (subscription only link), who talks about another way we could have handled the AIG bailout (which is also a strategy applicable to the current bailout being discussed).
It is likely that AIG’s shareholders (both preferred and common) may be substantially wiped out; but then why does the government take only a 80% equity share in AIG? Why not 100% as it should? [Although Roubini does not mention it here, he knows, as most economist do, that the reason that the government took just under 80% of AIG is because this allows it to keep its ownership stake in AIG off the Treasury books, which keeps the entire transaction, and by implication, how bad it is for the American public, from being transparent. -ed] So, if by miracle, AIG is not liquidated, such private shareholders instead of being fully wiped out get any upside benefit from this government action.
...In the case of AIG it appears that the US “loan” has as collateral all of the assets of AIG; if this were to be the case (a point to be clarified as the Fed statement was not clear about the seniority of a loan that has equity-like characteristics) the creditors of AIG would not be scot free as the government claim would have priority over any other secured and unsecured creditors of AIG, including possibly the insurance policy holders of AIG.
If this is truly the case (and I say “if” because the Fed has not been fully clear on the nature of its claims in the pecking order of the capital structure of AIG) the objective of the Fed in its intervention on AIG (i.e. avoiding the systemic effects of a collapse of a large and too big to fail institution) may not be achieved: i.e. if the claims of the government are senior to those of all creditors of AIG then AIG bondholders and also other creditors of AIG get whacked if AIG is insolvent (i.e. if in the effective liquidation of AIG the assets of the firm are lower than its liabilities).
But if the action of the Fed are aimed at facilitating an orderly selling of AIG’s assets how does the Fed ensure that its investment in AIG is safe? In a formal bankruptcy (Chapter 7 and 11) there is a stay on the claims of a firm’ creditors; thus a roll-off of their claims cannot occur. But in this government takeover of AIG how does one ensure that such roll-off of claims does not occur?
The only way to avoid such risk is to impose a stay - like in a formal Chapter 7 or 11 – on such claims. But if the objective of the government was to avoid a disorderly workout that a formal bankruptcy would have entailed how does one ensure – short of an effective stay on all creditors claims – that the public money provided to AIG (the $85 billion “loan”) is not used by the unsecured creditors of AIG to roll off their exposure and run out of AIG scot free? Short of such a stay the apparent seniority of the government claims implies that any short term creditor of AIG should cut off its exposure and run. And if instead (“if” because again the Fed has not given any details on this crucial issue) the government claims are ensured by an effective stay on such creditors’ roll off then why did the government intervene in AIG rather than letting it go into Chapter 7 or Chapter 11 bankruptcy court?
So this is the conundrum of the government intervention in AIG: it was made to avoid a disorderly collapse of AIG with the provision of short term liquidity; but in order to avoid short term creditors of AIG to run and be full on their claims you need to impose an effective stay on such claims; otherwise some creditors are bailed out (those with short term claims who can run) and some creditors are whacked even more (those with longer term claims that are junior to the government) and such short term creditors become effectively senior to the government. But if the government has to be truly senior relative to all of the creditors of AIG you need to impose a stay on all creditors. And if you impose such a stay you whack all creditors, you impose losses on all the AIG debt holders and you risk the systemic panic and disaster that you wanted to avoid in the first place.
If this is the case it would have been better to push formally AIG in Chapter 11 or 7 bankruptcy court and then provide the government financial support in the form of traditional debtor-in-possession (DIP) financing. If this had been done such DIP financing would be formally – as provision of new money – senior to all of the other claims on the firm. So the government decision to avoid formal Chapter 11 (or 7) is puzzling: either the government loan is truly senior to all of the claims of AIG – in which case you need a formal stay to avoid short term creditors to run away (but such stay will impose the same potential systemic risks of a formal bankruptcy) – or if such a stay is not imposed then the government claims are junior to those of the short term creditors of AIG and the objective of avoiding a run on the claims of AIG cannot be avoided.
...[I]n the case of AIG we have a problem of solvency and the need for an orderly wind down of AIG so as to prevent a global systemic crisis. So it is rational for short term claimants of AIG to run if their claims are junior to those of the government. And if instead those claims were not junior (i.e. a stay is formally imposed) the systemic effects of such a stay will cause massive losses to all of the creditors of AIG and will thus not prevent the systemic crisis that the government intervention was meant to avoid.
The reality is that it would have been more honest and clean and proper to take AIG to bankruptcy court and then provide the government support (the $85 billion loan) in the form of a formal debtor-in-possession (DIP) financing. Why was this solution not taken? It is not clear. Going to court may imply a credit event that triggers formal default and consequences for creditors and CDS holders and the guarantees made by AG on toxic fixed income securities. But what has happened is effectively a credit event and such triggers should be occurring regardless of whether AIG goes into formal bankruptcy court or not. The Fed and Treasury should immediately clarify on whether their intervention includes or not a formal stay on all the creditors of AIG including the holders of the short term claims against AIG.
Any fuzziness and lack of transparency on this matter would be severely destabilizing for markets and investors. To truly safeguard the government claims such a stay should be imposed; and it is not imposed the government action will allow short term creditors of AIG to run scot free with two consequences: the government claims will be at risk putting taxpayers’ money at risk; and the claims of longer term creditors of AIG will be whacked more down the line as short term creditors were allowed to be bailed out. But in that case why should different creditors of AIG be treated differently with some being bailed out and some not and with the consequence that the bailout of some implies much bigger losses to the longer term creditors of AIG? Again a formal bankruptcy court would have allowed a more fair process for allocating losses between shareholders and short term and long term creditors of the firm.
The Fed statement is also fuzzy on the claims of the insurance policy holders of AIG. Are these insurance contracts junior or senior to the government claims? You may think that holders of standard insurance (life, casualty, etc.) should be treated as senior (in the same way as small depositors of banks are insured from loss)? But should only such policy holders (individuals and non-financial firms) should be bailed out and be senior or should also the holders of AIG insurance of fixed income assets (hundreds of billions of dollars of such insurance) be bailed out? If all of such insurance contracts are safe and made whole by the government why should the government bail out investors that bought insurance of toxic products (MBS, CDOs, etc) from AIG? There is no rationale for that.
...[I]nstead of doing the right thing – pushing AIG into bankruptcy court and providing government DIP financing – the Fed and Treasury have formally nationalized AIG and they have created a legal mess where there will be endless confusion and lack of transparency of the government claims relative to junior and senior creditors of AIG, short term creditors and long term creditors, insurance policy holders of a traditional sort and of a non-traditional sort (life and casualty holders versus bond insurance holders).
...[S]oon enough the transformation the USA into the USSRA (United Socialist State Republic of America) will be complete: we have defeated the USSRR to create a communist economy in the most advanced free market economy in the world. And calling it socialism (even socialism for the rich, the well connected and Wall Street) is giving a bad name even to a failed experiment like socialism; this is more akin to the creation of a corporatist state (like the Italian fascism or the Germany Third Reich) where private sector interest are protected (gains privatized and losses socialized) where the government is taken over by corrupt and reckless private interests.
Roubini apparently gives the plan a thumbs up, though I cannot comprehend the inconsistency between his aforementioned disdain for the AIG bailout compared to the current much larger and much kinder bailout. (Sigh, another fallen hero).
From Steve Waldman over at Interfluidity, who offers a simply, yet elegant alternative:
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.
Waldman is basically suggesting a structure more akin to the original RTC (Resolve Trust Company, formed in the aftermath of the S&L crisis), where all the institutions that need to go bankrupt go bankrupt first, then the government steps in with intervention. The highlight is mine, my favorite part of the plan, beauteous in its simplicity and ultimate reliance on free-market decision making.
From Robert Reich (UC Berkeley):
Paulson is right that it makes sense to allow the big banks to wipe their balance sheets clean of as many bad loans as they can identify, and put them into a special agency that then sells them for as much as possible. The agency would bundle or unbundle the risky loans, slice and dice them as needed, with the goal of getting the most for them on world markets by creating a market for them.
But there's no reason taxpayers need to be involved in this.
Whether you call it a reorganization under bankruptcy or just a hellova fire sale, the process should resemble chapter 11 under bankruptcy. Any big financial institution that wants to clear its books can opt in. But the price for opting in is this: Investors in these institutions lose the value of their equity. Executives lose the value of their options, and their pay (and the pay of their directors) is sharply limited. All the money from the fire sale goes to making creditors as whole as possible.
Meanwhile, policymakers work on a new set of regulations to ensure transparency on Wall Street -- governing disclosures, minimum capital requirements, avoidance of conflicts of interest, and better ensurance against stock manipulation -- so that, once the bad debts are off the books, the new numbers can be trusted.
I repeat: This isn't a crisis of solvency or liquidity; it's a crisis of trust.
From Luigi Zingales (U Chicago):
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 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.
Although these suggestions (and the many others that may be out there) all vary in specifics, they are all very similar in the following ways: all demand greater transparency, all demand that the current equity holders be wiped out first and all have at least taken into account the risk to the taxpayer. Considerations that Paulson is apparently incapable of.
In parting, I leave you with this rather scary reader comment from Naked Capitalism:
I worked at [Wall Street firm you've heard of], but now I handle financial services for [a Congressman], and I was on the conference call that Paulson, Bernanke and the House Democratic Leadership held for all the members yesterday afternoon. It's supposed to be members only, but there's no way to enforce that if it's a conference call, and you may have already heard from other staff who were listening in.
Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.