Zingales is a Hero; Paulson is a Lout

Luigi Zingales offers a plan far superior to that which Secretary of the Treasury Henry Paulson announced on October 14, 2008. The latter is an unconsionable bailout of firms that made extremely bad choices. That a public bailout should be offered without detriment to shareholders in financial firms--they of the absurd business models and catastrophic miscalculations--is a scandal. It is especially obnoxious because Paulson has a personal stake in the outcome and perpetrated himself while at Goldman Sachs many of the abuses now coming acropper.

The intellectual failure to offer rebuttals to competing plans or to give them serious consideration is a pathetic commentary on the quality of US economic leadership. Scare-mongering and threats of economic terrorism just about exhaust their arsenal of argumentation.

Congress ought not to have given Paulson what is essentially a blank check. It is their failure, too.

As compared with the Paulson plan, Zingales's proposal is a much better deal for the public, more respectful of basic principles of free enterprise, and more efficient in returning to a more normal credit environment.

The essence of the Zingales approach is to facilitate a process whereby insolvent firms are recapitalized in a two step process: existing shareholders are wiped out, as is the basic rule in treating with insolvent firms, and bondholder claims are converted from debt to equity. That constitutes an immediate recapitalization, addresses the fundamental problem of the debt overhang, and would allow a faster return to credit market stability than the approach the US government has favored. It is also far more consistent with elementary principles of justice and law. It is only a sort of “money grows on trees” attitude, and the ability of policymakers to confuse the public with a shell game in which true costs are minimized, that allows this to proceed. It has enormous opportunity costs.

The following extract from Zingales describes how governmental action could facilitate this recapitalization. His approach is a terrific example of the contribution that professional economists can make to public policy, combining an intricate knowledge of market incentives with shrewd legislative proposals that both facilitate the public good and affirm fundamental principles of law and justice. In light of the abuse that economists have received, even from within the breed itself, it remains important to remember that we depend upon the various geniuses resident within the profession to help us find a way out.

You should read the whole thing, but here is an extract from Luigi Zingales on how to recapitalize the banks.

"The core idea is to have Congress pass a law that sets up a new form of prepackaged bankruptcy that would allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are pre-specified and banks could come out of it overnight. All that would be required is a signature from a federal judge. In the private sector the terms are generally agreed among the parties involved, the innovation here would be to have all the terms pre-set by the government, thereby speeding up the process. Firms who enter into this special bankruptcy would have their old equity-holders wiped out and their existing debt (commercial paper and bonds) transformed into equity. This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. In other words, they are close to being insolvent. By transforming all banks’ debt into equity this special Chapter 11 would make banks solvent and ready to lend again to their customers.

Certainly, some current shareholders might disagree that their bank is insolvent and would feel expropriated by a proceeding that wipes them out. This is where the Bebchuk mechanism comes in handy. After the filing of the special bankruptcy, we give these shareholders one week to buy out the old debtholders by paying them the face value of the debt. Each shareholder can decide individually. If he thinks that the company is solvent, he pays his share of debt and regains his share of equity. Otherwise, he lets it go.

My plan would exempt individual depositors, which are federally ensured. I would also exempt credit default swaps and repo contracts to avoid potential ripple effect through the system (what happened by not directing Lehman Brothers through a similar procedure). It would suffice to write in this special bankruptcy code that banks who enter it would not be considered in default as far as their contracts are concerned.

How would the government induce insolvent banks (and only those) to voluntarily initiate these special bankruptcy proceedings? One way is to harness the power of short-term debt. By involving the short-term debt in the restructuring, this special bankruptcy will engender fear in short-term creditors. If they think the institution might be insolvent, they will pull their money out as soon as they can for fear of being involved in this restructuring. In so doing, they will generate a liquidity crisis that will force these institutions into this special bankruptcy.

An alternative mechanism is to have the Fed limit access to liquidity. Both banks and investment banks currently can go to the Federal Reserve’s discount window, meaning that they can, by posting collateral, receive cash at a reasonable rate of interest. Under my plan, for the next two years only banks that underwent this special form of bankruptcy would get access to the discount window. In this way, solid financial institutions that do not need liquidity are not forced to undergo through this restructuring, while insolvent ones would rush into it to avoid a government takeover.

Another problem could be that the institutions owning the debt, which will end up owning the equity after the restructuring, might be restricted by regulation or contract to holding equity. To prevent a dumping of shares that would have a negative effect on market prices, it is enough to include a norm that allows these institutions two years to comply with the norm. This was the standard practice in the old days when banks, who could not own equity, were forced to take some in a restructuring.

The beauty of this approach is threefold. First, it recapitalizes the banking sector at no cost to taxpayers. Second, it keeps the government out of the difficult business of establishing the price of distressed assets. If debt is converted into equity, its total value would not change, only the legal nature of the claim would. Third, this plan removes the possibility of the government playing God, deciding which banks are allowed to live and which should die; the market will make those decisions."

That's actually the second part of the Zingales plan. The first part addresses how to deal with the housing bust, which finds so many homeowners "underwater,” that is, owing more on their homes than they are worth. In the old days, renegotiation could take place between a bank and a mortgage holder, but that is not possible today because of “securitization.”

Here's the key element in the plan: “Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property.”

Utilizing the Case-Shiller index measuring house price changes at the zip code level, “the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property.”

In exchange, “the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.”

“The reason for this sharing of the benefits is twofold. On the one hand, it makes the renegotiation less appealing to the homeowners, making it unattractive to those not in need of it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up 50% of the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

Since the option to renegotiate (offered by the American Housing Rescue & Foreclosure Prevention Act) does not seem to have been stimulus enough, this re­contracting will be forced on lenders, but it will be given as an option to homeowners, who will have to announce their intention in a relatively brief period of time.

The great benefit of this program is that provides relief to distressed homeowners at no cost to the Federal government and at the minimum possible cost for the mortgage holders. The other great benefit is that it will stop defaults on mortgages, eliminating the flood of houses on the market and thus reducing the downside pressure on real estate prices. By stabilizing the real estate market, this plan can help prevent further deterioration of financial institutions’ balance sheets.”

My comment: I have a child-like enthusiasm for Zingales' plan to recapitalize the banks. About his plan to re-negotiate mortgages I am not so sure. I am thinking it could probably be improved, but am sure I am not the fellow to improve it.

Some questions for students to consider for a tutorial paper: what is the impact of the plan if we assume differing levels of house depreciation? Taking, say, a 20%, 30%, and 40% decline in housing values, what would be the implications for the economy of this workout? What are the major alternatives to this plan? How does it differ from the government's approach and from that of Obama and McCain? What are strengths and weaknesses? Assess this not only in relation to "efficiency"--how to get the economy moving again--but in relation to traditional principles of law and justice.

11/01/08