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  • Why Paulson is Wrong

    Why Paulson is Wrong

    The time has come to save capitalism from the capitalists


    by Luigi Zingales (iTulip)

    Luigi Zingales, Robert C. Mc Cormack Professor of Entrepreneurship and Finance, University of Chicago - GSB

    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 cut down 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 sector's current problems?

    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. If left to the negotiations of the parties involved this process will 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 recapitalize (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 debt holders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson 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: to cram down 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 debt holder 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. Secondly, 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 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. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while 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.

    The decisions that will be made this weekend matter not just to the prospects of the U.S. 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 socialized? 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 penalized 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.

    Luigi Zingales

    Robert C. Mc Cormack Professor of Entrepreneurship and Finance
    University of Chicago - GSB


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    Last edited by FRED; 09-21-08, 11:51 AM.
    Ed.

  • #2
    Re: Why Paulson is Wrong

    Fred
    As I understand it, since much of the debt is held by SWF's, swapping debt for equity would result in the transfer of ownership of most of the US key financial institutions to China Japan the Middle East et al at liquidation prices?

    Comment


    • #3
      Re: Why Paulson is Wrong

      Originally posted by FRED of Luigi Zingales View Post
      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.

      Luigi Zingales
      It strikes me that LUIGI is like those who all complain about the weather while noting no one does anything about it.

      Someone needs to contact LUIGI, and say, "Hey, dude, how?
      Last edited by Jim Nickerson; 09-21-08, 01:17 AM.
      Jim 69 y/o

      "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

      Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

      Good judgement comes from experience; experience comes from bad judgement. Unknown.

      Comment


      • #4
        Re: Why Paulson is Wrong

        Apology Fred...sometimes I forget what is a post and what is your opinion.

        Comment


        • #5
          Re: Why Paulson is Wrong

          Originally posted by FRED View Post

          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.
          I still believed that market were somewhat free (included cheating and stealing etc. by players).

          But now, having the house acting like this is simply too much. No, it is repulsive, unfair, unjust, childish, foolish, stupid and plain dumb.

          I am burning my finance textbooks as we speak. Where can I find some good central planning books?

          Comment


          • #6
            Re: Why Paulson is Wrong

            Rejoice: Paulson spanked the BRIC's and GCC.

            Comment


            • #7
              Re: Why Paulson is Wrong

              maybe be a bit of cliche but

              "We have four boxes with which to defend our freedom: the soap box, the ballot box, the jury box, and the cartridge box."Sen. Larry McDonald

              Comment


              • #8
                Re: Why Paulson is Wrong

                Originally posted by sn1p3r View Post
                maybe be a bit of cliche but

                "We have four boxes with which to defend our freedom: the soap box, the ballot box, the jury box, and the cartridge box."Sen. Larry McDonald
                The "jury box" is a scam, as are two of the others at this time. Only one box is a "sure fire" defense of freedom.
                Jim 69 y/o

                "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

                Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

                Good judgement comes from experience; experience comes from bad judgement. Unknown.

                Comment


                • #9
                  Re: Why Paulson is Wrong

                  Originally posted by Jim Nickerson View Post
                  Only one box is a "sure fire" defense of freedom.
                  Get'em while you can, seriously. You think the gold and silver prices have gone up, check out rifle caliber ammo (esp 5.56 NATO, 7.62x39 and .762 NATO). Should have invested in that!

                  Comment


                  • #10
                    Re: Why Paulson is Wrong

                    Originally posted by jtabeb View Post
                    Get'em while you can, seriously. You think the gold and silver prices have gone up, check out rifle caliber ammo (esp 5.56 NATO, 7.62x39 and .762 NATO). Should have invested in that!
                    Hi, Joker.
                    Are those.... live rounds?
                    Seven-six-two millimeter. Full. Metal. Jacket.

                    Comment


                    • #11
                      Re: Why Paulson is Wrong

                      Problems not adequately addressed by pseudo-Chapter 11 solution:

                      1. Our credit with foreigners.
                      2. Derivatives tangle.
                      3. Domestic credit creation.

                      Comment


                      • #12
                        Re: Why Paulson is Wrong

                        I agree in the affirmative with your final question: "Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?"

                        The long-term solution is to transform corporate law such that it reinstates individual liability to the law for corporate directors and shareholders alike.

                        Comment


                        • #13
                          Contingent Shares

                          What was Paulson's reasons for not asking for those?

                          "Messy" are they?

                          Say GM went to the government and said: "We are going bust trying to compete with the more efficient Japansese; us with our old machines.

                          "You can't let us go bust, we are strategic."

                          Would the government say: "Let's buy those machines off of them, so that they can buy new machines with the money."

                          I don't think it would be considered "messy" instead for the government to buy new machines for them in return for an equity stake in the new, competitive business.

                          Ok, time is of the essence with the financial crisis, but I always sense a shake-down when a salesman tells me there's an urgency to the deal.

                          Especially when the salesman has a recent record of selling people lemons.

                          Comment


                          • #14
                            Re: Contingent Shares

                            I think it's a no win game either way. Door number one, we try this all or nothing fix (which is Bernanke's plan to just provide all money needed so the game doesn't grind to a halt); Door number two, we follow more the Great Depression route of moral indignation, try to punish the guilty (but this stops the game and innocent people still get crushed), etc. I don't agree with the lack of justice we'll see but this thing is a cycle of human affairs (K-Wave) and debts must be paid in suffering or cash. Add some oversight to Paulson and move on. When the Jubilee year idea was used didn't all the debts just get wiped out? What we really need is a plan for the next wave.
                            "The issue ... which will have to be fought sooner or later is the People versus the Banks." Acton

                            Comment


                            • #15
                              Re: Contingent Shares

                              Originally posted by orion View Post
                              I think it's a no win game either way. Door number one, we try this all or nothing fix (which is Bernanke's plan to just provide all money needed so the game doesn't grind to a halt); Door number two, we follow more the Great Depression route of moral indignation, try to punish the guilty (but this stops the game and innocent people still get crushed), etc. I don't agree with the lack of justice we'll see but this thing is a cycle of human affairs (K-Wave) and debts must be paid in suffering or cash. Add some oversight to Paulson and move on. When the Jubilee year idea was used didn't all the debts just get wiped out? What we really need is a plan for the next wave.
                              Pile on the debt, start a war, and force the GCC to buy it or else.

                              Comment

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