The Unheard Case Against the Bailout Plan

The bailout package is worse than wrong; it is unnecessary

As you well know, our government is about to spend a whopping $700 billion of taxpayer money to bail out the major financial institutions. The obvious objections you have surely encountered already. Why should we have to spend anything, much less a gigantic sum like this, to save a bunch of failed financiers who lost a ton of money making risky bets? More importantly, do we really want to create a state-sponsored financial system where private banks reap the rewards from their risk-taking while all losses are shoved onto the taxpayer?

Our Treasury Secretary and Fed Chairman feel our pain. Yes, it is a shame we have come to this. However, they exhort, without it we will descend into the abyss. The financial system will collapse and take the rest of the economy with it. The bailout plan, they claim, is like having your hemorrhoids removed - painful but necessary. (And the parallels between the financial crisis and proctology do not end there; see my previous post, "Financial Market Chaos Explained.")

I am currently overseas in Estonia, a real market economy as opposed to the one in which you apparently reside. But I would imagine that in the last few days you have heard this line about painful-yet-necessary medicine plenty of times.

What you have not heard is that there is a far cheaper and less damaging solution than the one currently under discussion. Its author is Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago. Writing in the new issue of The Economists’ Voice, he sets forth in simple terms a plan which would resolve the banks’ problems while punishing those responsible for them. Best of all, it would not cost the taxpayers a single dime.

To understand it, however, requires some background in corporate finance. So here is a primer. You can thank me later by wiring to my bank account a portion of the tax dollars you will save in the happy circumstance that the bailout package fails to pass. Those already familiar with these basics can feel free to skip down to the meat of Zingales’ plan.

A corporation receives financing from two sources: debt and equity. Debt refers to any loans from a bank. It can also consist of bonds the business issues to investors in return for cash. Similarly to a loan, the bonds have to be redeemed at a later date – that is, the money must be repaid. Until that point, the bondholders receive a stream of interest payments as their reward for helping finance the business.

The other source of financing is the “equity holders,” meaning the shareholders. No bank or bondholder will offer you all the money you need to start your business. They rather demand that you put up a portion of the money yourself. The money you and your partners personally invest represents the equity, and it is divided into shares you now own. By paying for these shares, you are offering the company money it can use to finance its operations. In return, you are entitled to the profits.

If the business flourishes, the equity holders reap the rewards. But they also take a big risk. If the business fails, they get nothing. Any assets that are left over go instead to the bondholders and the banks that provided the loans. In bankruptcy law, this is called a Chapter 7 liquidation. In a Chapter 7, the business is dissolved entirely and its assets sold. The cash raised from the sale of the assets is then distributed to the bondholders and the banks.

But there is another type of bankruptcy called a Chapter 11. It is reserved for situations where the core business remains solid yet the company does not have the cash to pay all its debts. A bankruptcy judge oversees a reorganization in which some of the debts are forgiven and the company gets a fresh start.

In some Chapter 11 bankruptcies, however, the business is not merely short of cash. The value of all its “assets” – plant equipment, intellectual property and, of course, mortgage-backed securities – falls below the value of its “liabilities,” or the total value of everything it owes to creditors. In these bankruptcies, the shareholders lose everything while the debtholders are given new shares in the business in return for forgiving the debts they are owed. The debtholders are thereby exchanging debt for equity, or the right to share in the company’s future profits.

This is the situation many Wall Street financial institutions currently find themselves in; at least part of their underlying business remains profitable, but the value of their liabilities exceeds that of their assets. So why not put them into Chapter 11? The obvious answer is that conventional Chapter 11 proceedings take a long time to sort out – creditors have to negotiate with one another over the remaining spoils, and this can take months. Currently, our financial system is teetering on the brink. It has not months, but days.

That is where Professor Zingales comes in. These are extraordinary times and, as the absurd “rescue package” attests, our Fed and Treasury officials are already in the mood for extraordinary solutions. So, he asks, why not set up a special committee of bankruptcy judges that will force a quick solution down the creditors’ throats? This is typically what a bankruptcy judge does when negotiations among the creditors have become too drawn out. There is no apparent reason why it cannot be done now as well.

Under his proposal, existing shareholders in the failed financial institutions will get nothing, and the debtholders will become the new shareholders. That is, in exchange for relinquishing their rights to most of the debt, they will now be entitled to the future profits of the business instead. The debtholders should be happy with this outcome, since the bank’s core business remains sound and its future profitability is relatively assured.

American history offers up a precedent for a massive Chapter 11. In the Great Depression, Roosevelt forced through a similar arrangement after the end of dollar convertibility into gold put extreme burdens on companies’ abilities to service their debts. The Supreme Court later upheld it, and so it should have no problem with a similar solution now.

If it is that easy, then why have we not heard it proposed? “The major players in the financial sector do not like it,” replies Zingales. For they have large shareholdings in these companies, and such an arrangement would wipe out the value of their equity. They would rather the taxpayers be wiped out instead.

The solution we adopt right now will shape our financial system for decades to come. Zingales states the dilemma most articulately: “Do we want to live in a system where profits are private, but losses 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?”

We cannot stand by and let a few Wall Street executives undermine the basic underpinnings of our capitalist system. “The time has come,” Zingales writes, “to save capitalism from the capitalists.”