Luigi Zingales on the Paulson bailout — Kazow!

He doesn’t like it.  And he has another idea:

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.

And now come the real zingers:

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.

Addendum: Here is further comment.


I have a few questions about the bailout:

1. What's the pound of flesh?

With AIG, the government got 80%. Lehman went bankrupt. Bear Stearns shareholders got hosed. Do shareholders and management get a free pass?

Personally, I wouldn't suggest a pound of flesh. I'd suggest $10 billion a finger. Any CEO who wants to foist $10 billion face value of junk paper on the government should be willing to part with a finger. Maybe there are other suggestions, but this one's handy.

2. What's the price?

The talking heads on TV are saying nobody wants to buy this stuff because nobody knows what it's worth [either now or on a discounted cash flow basis after mortgage repayment]. But the financial firms have had years to study this stuff, and have detail on each mortgage.

The suspicion is that they know what it's worth (22 cents on the dollar, according to a recent Merrill Lynch sale), and it's not much. But they aren't saying what it's worth. How's the government to know?

3. Will it work?

The talking heads really don't know.

4. Exactly how is this really like the RTC?

The Resolution Trust Company took assets the government ALREADY OWNED, because the ALREADY INSURED savings and loans had ALREADY FAILED. They then disposed of them and lost $billions.

We don't own the bad mortgages YET. We DIDN'T insure them. The main thing this has in common is that we'll likely lose $billions. (given the banks are the only ones that have the repayment information and it's the government that's selling)

I've also posted this here:

so if you want to comment on this, rather than commenting on Tyler's post, it's probably done there.

I'm just really mad, like my pocket's being picked.

How exactly would a mandatory debt-for-equity swap change the fact that people are pulling cash out of money markets, which in turn is destroying the market for commercial paper? Or, put more simply, how would a mandatory swap prevent a run on a bank?

Luigi writes: "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."

As I understand it a problem here has been created by so called "fair
value" accounting regulations that force companies to mark assests
to the market. In a thin market this can create a negative self
reinforcing cycle as firms mark thinly traded assets down and then
have to raise new capital in thin markets.

Jim: if a firm marks down a security and can't find any buyers at that price, isn't it likely that they haven't marked it down enough? While there was liquidity for these things, banks were happy to mark to market, but now that no one wants to touch them they're forced to mark "to model."

As Zingales says, there's no way that the government is going to get a good deal buying CDOs and RMBS and CMBS from banks. The information asymmetry problem is enormous. Absent some forced punitive measure (equity warrants, forced debt to equity swap, etc) this is going to be a bloodbath for the taxpayer. Unfortunately, I think it's a done deal - Barney Frank will be able to sell it as 'helping homebuyers.'

Yeah, this is ridiculous.

I'm surprised I haven't heard more of an uproar from Republicans on libertarian grounds.

This whole ordeal has shown us one thing: high ranking Republicans couldn't care less about the principals of libertarianism.

Thomas: "Would Zingales be happy to have the Feds owning a significant stake in half the banks in the country?"

I can't speak for Zingales, but I know I would -- relative to the give-away alternative we seem headed for.

1. This need not be an active stake.
2. It need not be permanent.
3. It creates the possibility that this may be taxpayer neutral, or even positive.
4. We just took over 80% of AIG earlier in the week. Now banks want a better deal.

The bill that Congress received today (it fits on one piece of paper) is a blank check. is Where are the incentives that create the desired behavior?

Reverse auctions for something like a promise to pay from a government work far better than auctions for bundles of loans (CDOs) that are of very different quality. A loan to one troubled borrower is not a loan to another.

Combining a reverse auction and a cram down might be possible. For example, terms might be: "to participate in the reverse auction, this is the equity cram down price you will pay" for loses not reflected in the price. For example, the government would have rights to an equity cram down, if returns were not greater than x on the assets bought at auction. The seller gets cash, but remains significantly on the hook for asset quality. This aligns incentives. Letting bankers get away with fully transferring risk destroys the incentives for the behavior you want. The risk of equity cram down would be discounted in the auction price. The banks get cash but remain on the hook as they should so the incentives are right.

In essence, the government buys the loans in a form which has the nature of a bond (which it should) and if things are actually worse than discounted into the price of the bond at auction, then warrants should allow the government to stick the loss to the seller as equity dilution. The bank has the incentive to behave in the desired manner.

As an aside, what we do not want is banks buying paper from hedge funds and others that is particularly odious and then selling it on to the Treasury. No paper bought by a bank after last week should be part of this scheme at a minimum.

Two practical questions about the grand Paulson bail out:

1. It is so vague that it ought to leave room for terms that give the taxpayer an eventual payback for assuming the risks; but has anybody in the Treasury or the Fed begun to think out these terms?

2. Was it necessary to announce the scheme on Friday 19th. September?
Following Thursday when short sellers got their fingers burnt because of the takeover terms for AIG and HBOS, and Morgan Stanley at last signalled that it was willing to pay the Chinese the market price for new capital, it looked like Friday was likely to see the stock markets slowly beginning to turn round (and I suspect that many experienced traders thought that was the most likely sort of Friday). A major sorting out of bad US mortgage debt was still needed, but there was time to work out how to do it. I fear that the grand announcement has had as much efffect in adding short-term instablity to the market as it has in reassuring participants.

What is wrong with the current system that banks can give the government collateral and get cash against that collateral with the risk that if collateral falls apart the banks have a problem not the government? No above market price paid by the government and hence no subsidy? No transfer of risk from the banks to the government?

There is no requirement in any scheme that all risk move to the government-- the banks should continue to have plenty of risk for anything transferred and the government should see the upside of any risk it takes. The way to make sure that the banks behave themselves is with equity warrants that kick in if the debt deteriorates in quality.

I have one [simple] question. Is an "illiquid asset" an established economic term that I just never heard before or is it a new (or newspeak) phrase that has been coined to con the inelite?

nycfund -

Thanks. Do you then mean to surmise that the sum total of these illiquid assets might still be managed back to a degree of liquidity by a deep-pocket entity such as the US government? Or are they in fact the smoke and mirror devices that they seem to be?

Also, I would like to add that the phrase "socialized costs with private benefits" is the stupidest slogan I've heard in a long time, particularly coming from the mouth of liberals who support big government. It's an accurate description of every government spending activity (other than possibly crime protection).

Zingales implies that Paulson bailed out the firms only to save his buddies. But letting the firms fail would have ensnared the man on the street too, leaving him without insurance and source of credit. The resultant recession would have not been politically acceptable. So long as we accept management of Aggregate Demand as a legitimate function of the government, such bail-outs will have to be repeated.


If the cash flow on the mortgage backed securities is so good then I'd expect you'd be out there buying a lot of them? Buffet, China, Hedge funds etc....why are all these folks staying away? I guess they aren't as smart as you? or is it that the uncertainity of future cash flows is bad enough that combined with the uncertainty of the future value of the dollar that the securities are only worth 20 cents on the dollar? will some people be made whole buying these assets at 20% of face value? the uncertainty of the dollar(in the case of massive bailouts and communization) and the uncertainty of future cash flows(in the case of tight montery policy) enough to prevent massive investment by people smart enough to run a some valuation models? clearly yes....if your future income stands to benefit from bailing out Goldman and the Morgan then I'd expect you to make up stupid arguments about why my 5 and 3 year old need to borrow money to save Goldman and the Morgans....nevertheless your argument is ridiculous, my boys would be best served by eliminating the federal reserve and returning to a sound currecy so that business can have more stable conditions for making investment decisions. If this would force the morgans and goldman to go bankrupt it wouldn't hurt me in the least.

The fact that it is kinder to me, the taxpayer, the idea of "cramming it back down the banks" has a certain political appeal that may make it easier to appease taxpayers/voters. The "cram down" repayment would be over a long period of time and so it shouldn't create more than minor ripples at a time.

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