Recapitalization

Paul Krugman:

Uneasy feelings, by Paul Krugman: Details are scarce on the big buyout; but as a few dribble out, I’m getting uneasy.

Here’s the source of my uneasiness: the underlying premise behind the buyout seems, still, to be that this is mainly a liquidity problem. So if the government stands ready to buy securities at “fair value”, all will be well.

But it’s by no means clear that this is right. On one side, the government could all too easily end up paying more than the securities are worth — and if there isn’t some kind of mechanism for capturing windfalls, this could turn into a bailout of the stockholders at taxpayer expense.

On the other side, what if large parts of the financial sector are still underwater even if the assets are sold at “fair value”? Is there a provision for recapitalizing firms so they can keep on functioning?

Maybe the plan will look fine once we see the details. But while Paulson and Bernanke are a lot better than the people we might have had in there (thank you, Harriet Meiers!), their track record to date does not lead to the automatic conclusion that they know what they’re doing.

Dean Baker:

Questions on the Bush Bailout Package, by Dean Baker: The NYT missed the obvious questions with the Bush bailout proposal. The most obvious question: is how will paying market price for near worthless assets prevent the collapse of zombie institutions like Bear Stearns, Lehman Brothers and AIG? These institutions needed money. They won't get it from selling mortgage backed securities, that are chock full of bad mortgages, at the market price. We already know this, because they already had the option to do so. ...

The other big question is: how will we get the banks to honestly describe the assets they throw into the auction? ...

Question II is directly related to question I, because a poorly designed auction system will be a fiasco, wasting taxpayers dollars and rewarding the most effective liars. If we have more time to design the auction system, then we can minimize this risk. There would be urgency if the auction system was the mechanism that would prevent the sort of freeze up of the financial system that we saw this week, however if the auction system will not accomplish this goal, then we can take the time necessary to get it right.

Here's a proposal. First, in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years, something like that. Administratively, it could come as an increased tax rate on profits and, if it helps politically, it could be earmarked for a particular cause. The government pays the firm a fair value for the assets plus an additional amount to help with recapitalization, and in return gets a claim on future profits for a period of time (I would also tie executive compensation directly to profits to help prevent gaming).

For additional recapitalization, I would do something similar. Give the firms a zero or very low interest term loan and, in return, taxpayers get a share of future profits for a period of time, say another 25% (or whatever rate is appropriate, the rates could be set so that, even with expected defaults, taxpayers ought to make a profit). The firm pays back the zero interest loan in full and gives up a share of future profits.

The reason for doing it this way rather than through a private sector debt for equity swap is that we need to stop the crisis as soon as we can, sooner is better than later, and it may take too long if left to the usual procedures. Quoting Luigi Zingales with respect to debt for equity swaps (via a link at Marginal Revolution Marginal Revolution, and I should note that he is not in favor of the Paulson plan) :

So why is this well-established approach not used to solve the financial sectors current problems? The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. If left to the negotiations of the parties involved this process will take months and we do not have this luxury.

One of his worries is:

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. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.

Government intervention can make this happen faster and help with his first concern, and wouldn't profit sharing help with his second worry, that inflated prices will cost taxpayers money?

Would you support something like that? Better ideas?