The Major Scandal

Willem Buiter (of the Financial Times and the LSE) nicely diagnoses the major scandal entailed in Paulson's plan to recapitalize the banks.

Buiter argues that the US taxpayer is getting a “terrible return” from Paulson’s promise to supply $250 billion to the banks, “bound to rise to probably around twice that amount.” It is basically a “free gift.” In Paulson’s program, “the injection of capital is through non-voting preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injection into Goldman Sachs).” There are also no attractively valued warrants; the shares “can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks.” Unlike in Belgium, the government gets no vote even as it ponies up the funds. Unlike in Britain, whose preference shares get a 12 percent yield and board members, the US taxpayer gets a 5 percent yield and no say in the running of the firm.

The major scandal, as Buiter notes, is that neither in the latest iteration of the Paulson Plan nor in the bailouts of AIG and Freddie and Fannie did unsecured senior creditors have “to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out” of each bailout whole. “There were no up-front haircuts, charges or mandatory debt-to-equity conversions.”

Buiter emphasizes the “moral hazard” objection to proceeding in this vein, arguing that “we are laying the foundations of the next systemic crisis” by this conduct. That may be—it is indeed a horrible precedent--but the far larger point is simply that the whole proceeding upends and makes a total mockery of basic principles of bankruptcy law. It’s as if the shareholders of an insolvent firm decided that they were going to simply make off with all the excess cash and potted plants, stiff their creditors, and waltz away unimpaired. You can’t do that. There is an order to these things. There are several laws on the books against it. That shareholders must suffer first from insolvency, with the creditors picking up the scraps, is like some sort of first principle, is it not? Yet the US government’s policy violates this principle and allows both shareholders and creditors to gain unfair advantages at the expense of the public.

There is a proper role for the state as the “lender of last resort” in panics; it is not the idea of government intervention that is objectionable. The government should probably be willing to commit public funds and guarantees in a supplementary vein in the aftermath of the bankruptcy and recapitalization procedure that Zingales calls for. To do so in the first instance, however, is a simple fraud on the public, a great crime committed in broad daylight. 10/24/08

David Merkel also makes the key point, though somewhat tentatively: "I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity. This extinguishes debt claims, and accelerates the healing of the economy. This would be true reform." Right. It would have been clearly better! 10/25/08

Buiter continues to hammer away at the absurdity and incompetence of the government's approach, as the AIG price tag rises to $150 billion. 11/11/08

Robert Reich aptly calls it "Lemon Socialism." He rightly wonders why the shareholders of insolvent firms "should not be cleaned out first, and their creditors and executives and directors second -- before taxpayers get stuck with the astonishingly-large bill." The powers that be have crafted an absurd form of political economy in which "taxpayers support the lemons" and "capitalism is reserved for the winners." 1/24/09

Here are some additional links sympatico with this general line of criticism:

Blodget, "Why are We So Afraid to Fix the Banks the Right Way?" 1/19/09

Tilson, "Preventing the Greatest Heist in History," 1/20/09