Commentary Magazine


The Big Bailout

This memo, by an experienced New York financial hand, offers an important and sobering perspective on the market events of the past week:

The government is working to “solve” the current financial crisis. From current information, it appears that the proposal taking shape is a large mistake as a matter of policy, politics and fairness.

A massive fund into which assets can be stuffed by companies, at prices that they make up and which are not tested by the marketplace, is inappropriate and unnecessary.

The recent AIG deal, involving a fully-secured lending facility and warrants for a controlling interest in the company, is the model of the deals that should be effectuated with problematic companies. That model would save the financial institutions, keep the system afloat, protect the taxpayers’ money, allocate losses to those who assumed them by contract, enable the government to toss out the managements responsible for the irresponsible behavior of the institutions, and give the institutions time to sell the troubled assets and de-lever down to sustainable levels of risk.

Of course, if the troubled assets make the institution insolvent, it will have to go through a restructuring several years down the road. But the government’s money will have been protected and losses will be properly allocated, and the company will be open for business throughout the period. The key point is that both the company’s equity and its unsecured debt must serve as a “cushion” to absorb losses before the taxpayer takes a hit.

The adequate security point is essential. That is the mechanism by which the government’s money is protected and losses are allocated properly. It also is the mechanism by which new private investors may be interested in investing alongside the government, reducing the government’s outlay and leaving room for future crises that require additional government loans.

The pure structure based on the model of the Resolution Trust Corporation would be the wrong choice. To enable troubled institutions to sell assets to the New RTC at prices that they make up and which are not tested by the marketplace leaves the government vulnerable to losing hundreds of billions of dollars that should be lost instead by the unsecured bondholders of the afflicted institutions. The pure RTC structure is a plan that rewards the wrongdoers, the careless risktakers, the greedy, all at the expense of the taxpayers.

It would generate one of the largest and most opaque political patronage operations in world history.

The issues are what assets we taxpayers buy and at what price. The answer is likely to be the mother of all earmarks, with lobbyists enriched beyond their wildest dreams. The original RTC did not have this problem because the transaction was very simple: the government took over the thrifts, paid off the depositors, and gathered the assets to be auctioned off. The “purchase price” was the deposit insurance.

If the afflicted institutions are solvent, the secured loans I recommend will enable the companies to liquidate the bad assets and remain viable during the liquidity squeeze period. If the institutions are not solvent, and are placing unrealistic values on the troubled assets, then my plan will demonstrate that and allocate the losses properly. In contrast, the RTC version will leave the taxpayer massively hanging, while the companies, their overpaid managements, and their stockholders and bondholders reap windfalls that they do not deserve.

Yes, it is a large crisis, and yes, strong steps must be taken to keep the system afloat. But taxpayers will be unforgiving (understandably so) if the solution imposes losses on them rather than those who have contractually assumed those losses. The system can be saved with much less cost and risk by secured loans which give the afflicted institutions time to sell down the assets which have overleveraged their balance sheets and made them subject to these runs.

It is that widespread failure of risk management, not abusive short-selling, which has brought these institutions to (and in some case beyond) the brink of failure. The institutions have needed to deleverage for a long time, but have refused to do so. They claim they cannot sell assets, that markets are illiquid, and that there are no bids. This is not true. There are investors and traders who wish to buy discounted debt securities and derivatives, but who find that the sellers are steeped in denial. The sellers simply do not like the prices that prevail in the marketplace, and wish that those prices didn’t exist. But those are the prices, and only wishful thinking imagines that they are going back to par.

The taxpayer should not fill in this gap that should be plugged by the existing stockholders and bondholders of the afflicted institutions.

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