What was wrong with the AIG model?
I’m feeling unhelpful, because I’ve complained bitterly about the Paulson Plan and been cool towards the Dodd Plan, but my own suggestion was an obvious nonstarter. We mustn’t offend the delicate sensibilities of creditors, or God forbid give them a haircut. So, really, what would I suggest?
I wonder, what was wrong with the AIG / GSE model? The government has already published a pretty exhaustive list that includes the systemically important and potentially vulnerable financials along with many other firms — the “no short” list. Suppose Congress passed a law providing for fast-track reorganizations modeled on AIG. Firms on the “no short” list would be required to consult with the Treasury prior to any bankruptcy filing, and listed firms would be presumptively eligible for an AIG-style bailout. During an insolvency, the government would take warrants on 79.9% of firm stock, in exchange for a loan or preferred equity infusion sufficient to cover obligations to creditors during an orderly wind-down or reorganization. Existing management would be replaced, and government auditors would examine firm accounts to ensure that there were no “fraudulent transfers” precipitating the bail-out. Any such transfers discovered between the listing of the firm and the reorganization would be criminalized, and prosecuted vigorously. Listed firms would have a fiduciary obligation to the government as well as shareholders, such that “gambling for redemption” near insolvency would also place firm managers in criminal jeopardy.
Temporary routinization of AIG-style bailouts would put skittish creditors at ease. Although Treasury would retain the right to opt out and permit a traditional bankruptcy, the default course of action would make creditors whole. Equityholders and management of listed firms would have a strong incentive not to take the government up on the bail-out if they have any prudent means of avoiding it, since they would lose nearly everything. Taxpayers would own the firms they rescue, and would enjoy the upside of successful reorganizations or divestitures.
Like all the bailouts, this scheme rewards the moral hazard of creditors, and I hate that. There is the danger that it would not be temporary, and that promised regulation to restrain leverage would never materialize, leaving only a subsidy to future blackmailers. Still, I think it’s a lot better than silently and opaquely recapitalizing firms without replacing management or forcing at least shareholders to take a hit.
AIG-style bailouts would stigmatize firms that take advantage of them, as any form of bankruptcy does, but many firms do successfully reorganize from bankruptcy, and the stigma would be well deserved. The process would be transparent.
That many firms would not survive their brush with insolvency in anything like their original forms is an positive. I strongly agree with Barry Ritholtz, quoted in a piece by David Leonhardt:
If Chrysler had collapsed, [Ritholtz] argues, vulture investors might have swooped in and reconstituted the company as a smaller automaker less tied to the failed strategies of Detroit’s Big Three and their unions. “If Chrysler goes belly up,” he says, “it also might have forced some deep introspection at Ford and G.M. and might have changed their attitude toward fuel efficiency and manufacturing quality.”
If we do end up with a gentle, behind-closed-door bailout of financials, I’m afraid that in twenty years, we may view lower Manhattan the same way we see Detroit today. What Wall Street needs is what it has delivered to so many other industries, a dose of Schumpterian creative destruction, to make room so that better things may rise up from the ashes.
p.s. I do hope to rise to Dani Rodrik’s challenge and be concrete about what “better things” might look like, but, alas, my bitter obsession with the looming bail-out takes priority.
p.p.s. Since the government has stormed the commanding heights anyway, does anybody else think it’d be a good idea for some bureaucrat to declare a ban on dividend payments for all firms on the “no short” list? This would have the effect of helping troubled firms preserve cash, while softening the hit individual firms would take if they announce dividends cuts. Firms on the list would have no choice, and only a small minority of “no short” firms are in crisis, so there should be no stigma.
Steve – When you suggest making creditors whole, do you include holders of CDS and the variety of derivatives? If so, the cost may be literally prohibitive.
Related to that, do you have any thoughts on the potential cost of your proposal?
Yves Smith has an interesting post citing an advisor to Chinese authorities that is quite sobering. Just about everyone (myself included) has concluded, based on experience rather than logic, I think, that at least the asians and probably the Gulf states would continue to buy treasurys at a torrid pace with the only limitation being their *ability* to do so. A large enough “rescue” package may call into question both their ability *and* their willingness. They do have options. What then?
BTW, my emotional reaction and that of many I know was strikingly similar to the one you conveyed. As jaded as I have become, even I was surprised at the lack of restraint in DC. Truly scary. Could you believe that Bernanke even lost his loyal colleague Krugman?
Thanks for helping at least some of us through this.
September 25th, 2008 at 6:19 am PDT
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BSG — Thanks for the nice words.
There’s, um, some “costructive uncertainty”, as John Hempton likes to say, in the AIG model re counterparty liability. The government commits a fixed quantity of funds in exchange for an 80% equity stake, the quantity of funds is sufficient to meet the firm’s immediate and medium-term liabilities, which must include liabilities to counterparties. But it would not be a blank check in case of a Barings-like reckless portfolio or a counterparty meltdown killing offsets. The Treasury would have the ability to review the firm’s obligations prior to committing to the bail-out and setting the funding level, hopefully permitting it to triage firms with outrageous obligations.
Obviously, this may not be “enough”, the market may judge too many firms too exposed for the Treasury to be able to cover their liabilities, and still withhold credit. But, if it is not enough, the 700 billion dollar trust-me bailout is likely not to be enough either. Overpaying for assets to firms not all of which are in finacial distress is likely to be less cost efficient than exacting a pound of flesh, but then only subsidizing firms in need. This proposal includes a kind of “means testing”, since OK firms can’t breezily extract a subsidy.
(One can make a counterargument by nonlinearity, that somehow the diffuse subsidy will keep the aggregate financial system well enough that few firms enter distress, but that’s an argument by faith. In terms of direct impact to firms, paying whatever is necessary only to the needy is cheaper. There could be some vicious-cycle-breaking nonlinearity by which 700B broadly spread prevents distress more cheaply, but that strikes me as far-fetched.)
September 25th, 2008 at 8:35 am PDT
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Steve – Thanks for clarifying. What you suggest makes a lot of sense. My main concern is to put a reasonable upper bound on the exposure for obvious reasons. I’m aware that some have concluded that the cat is out of the bag as far as a hard crash for the USD and I’m not far, but I want to leave some room for hope (and luck!)
Beyond that, I think a major challenge to any program is the integrity of implementation, not to mention competence. If Bernanke stays too long, that may make things difficult – the fantasy world that he seems to have constructed for himself regarding “tricking” market participants into gaining confidence by repeatedly doubling down is truly mind boggling.
September 25th, 2008 at 9:07 am PDT
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You are completely right, from the point of view of an ACTUAL work- out scenario. Why should this situation be any different? It seems to be that the AIG deal merely streamlined the process, and we became the DIP lender, profitable business to be sure.
In general, Chapter 11 has been an effective tool for distressed firms. The problem is that it takes so long and the administration of cases often eats up available cash. In any normal bankruptcy, the debtor can’t pay dividends, and absent stellar rehabilitation efforts, existing equity takes a haircut – maybe gets wiped out, depending on whether there’s enough asset value to make the creditors whole and the type of deal all parties are amenable to. We are all aware of many cases where the equity bounced back better than ever, and creditors made out great on their warrants. And where’s the moral hazard when parties are able to maintain the benefit of their bargains?
But heres what I think is the kicker and I say this from experience. Most bankers AND their counsel don’t understand the derivatives and can’t even begin to figure out how to unwind them. Its hard to even lift the documents, much less read them. Understanding them ? You’re talking bankers here. Often, you can’t even tell who the ultimate obligors are and what the defaults and remedies are. And even then, the terms are generally unclear, thus requiring interpretation within a litigation setting. So valuation being nearly impossible, its better, from the banker’s point of view to just sell the paper to the next fool, the fool in this case being us.
Any case involving swaps and the like? Makes my head hurt to think about it. And I know very few people who actually understand them, despite their claims to the contrary. So maybe thats the point of this — to avoid the bankers having to read the documents before trying to collect on them.
September 25th, 2008 at 1:24 pm PDT
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And also — the issue of fraudulent transfers need never be reached if Uncle Hank gets his way.
September 25th, 2008 at 1:41 pm PDT
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