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U.S. Treasury Secretary Paulson is wrong

by Luigi Zingales

CHICAGO — When a profitable company is hit by a very large liability, the solution is not to have the government buy its assets at inflated prices. The solution, instead, is protection under bankruptcy law, which in the United States means Chapter 11.

Under Chapter 11, companies with a solid underlying business generally swap debt for equity. Old equity holders are wiped out and old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt-holders can agree to reduce the face value of debt, in exchange for some warrants. So why not use this well-established approach to solve the financial sector’s current problems?

The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the current crisis has reached a point where time is of the essence. But we are in extraordinary times, and the government has taken and is prepared to take unprecedented measures. As if rescuing the big insurer AIG and prohibiting all short selling of financial stocks was not enough, now U.S. Treasury Secretary Henry Paulson proposes buying up (with taxpayers’ money) the distressed assets of the financial sector. But at what price?

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity), it is because investors are uncertain about the value of the assets in their portfolios and do not want to overpay. Will government do better at valuing those assets? In a negotiation between government officials and a banker with a bonus at risk, who will have more clout in determining the price? Paulson’s plan would create a charitable institution that provides welfare to the rich — at taxpayers’ expense.

If the government subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? Aside from costing billions of taxpayer dollars, Paulson’s plan violates the fundamental capitalist principle that whoever reaps the gains also bears the losses.

Remember that in America’s Savings and Loan crisis of the late 1980s, the government had to bail out those institutions, because their deposits were federally insured. But in this case, the government does not have to bail out the debt-holders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from Paulson’s plan.

Since we do not have time for Chapter 11 proceedings and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: impose a restructuring plan on creditors, with part of the debt forgiven in exchange for equity or warrants.

There is precedent for such a bold move. During the Great Depression, many debt contracts were indexed to gold. So when the dollar’s convertibility into gold was suspended, the value of that debt soared, threatening many institutions’ survival. The Roosevelt administration declared the clause invalid, forcing debt forgiveness.

My colleague and current Fed Gov. Randall Koszner studied this episode and showed that not only stock prices, but also bond prices, soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for 30 years, having too much debt and too little equity is costly, so reducing the face value of debt can sometimes benefit not only equity-holders, but also debt-holders.

But, while debt forgiveness benefits holders of both equity and debt, debt-holders don’t voluntarily agree to it for two reasons. First, even if each individual debt-holder benefits, he or she will benefit even more if everybody else cuts the face value of their debt and he or she does not. Hence, everybody waits for others to move first, creating obvious delay. Second, from a debt-holder’s point of view, a government bailout is better. Even talk of a government bailout reduces the debt-holders’ incentive to act, making the bailout more necessary.

As during the Depression and in many debt restructurings, it makes sense in the current contingency to mandate partial debt forgiveness or a debt-for-equity swap in the financial sector. It is a well-tested strategy, and it doesn’t involve taxpayers.

Forcing a debt-for-equity swap or debt forgiveness would be no greater a violation of private property rights than a massive bailout. But, for the major players in the financial sector, it is much more appealing to be bailed out by the taxpayers.

Indeed, for the financial industry, the appeal of Paulson’s proposal is precisely that it taxes the many and benefits the few. Since the many (taxpayers) are dispersed, we cannot put up a good fight in Congress, whereas the financial industry is well represented politically. For six of the last 13 years, the Treasury secretary was a Goldman Sachs alumnus.

The decisions that Congress must make now will affect not only the U.S. economy’s short-term prospects, but will shape the type of capitalism that we will have for the next 50 years. Do we want to live in a system where profits are private, but losses are socialized, where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held accountable for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?

The time has come to save capitalism from the capitalists.

Luigi Zingales is a professor of entrepreneurship and finance at the University of Chicago Graduate School of Business. © 2008 Project Syndicate