Begin forwarded message:
From: anita sands <[EMAIL PROTECTED]>
Date: September 25, 2008 1:10:57 AM PDT
To: anita <[EMAIL PROTECTED]>
Subject: ZINGALES WEIGHS IN: PAULSON IS WRONG
Like Nouri Roublini, the foreign economists understand USA best, better
than the CHICAGO TRICKLE DOWN GROUP, MILTON FRIEDMAN et cie.
Luigi Zingales writes on 21 September 2008
This weekend’s decisions will shape the type of capitalism we live
with for
the next fifty years. Here one of the world’s leading financial
scholars,
Chicago Business School Professor Luigi Zingales, argues that bailing
out
the financial system with taxpayers’ money is wrong. He discusses an
alternative – forced debt-for-equity swap or debt-forgiveness.
---
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.
at: http://www.voxeu.org/index.php?q=node/1670
