Bailouts should be no fun

If everybody wants a bailout, that’s a good indication that we’re making some mistakes.

Let’s start with first principles– why are we talking about huge potential transfers from the government to private companies in the first place? My starting point would be the observation that U.S. output is falling significantly below what America is capable of producing. The problem is not that labor and capital are physically incapable of producing more, but instead that certain key institutions have existing legal commitments that they are unable to fulfill. Foremost among these would be in the financial sector, where liabilities threaten to exceed the market value of assets, preventing the entire sector from functioning properly. But also prominent are other crucial industries, such as the domestic auto manufacturers with a very significant burden of debt and obligations to current and retired workers. We need an unambiguous resolution of this problem, allowing these institutions to return to productivity. The sooner those unpayable commitments can be resolved, the better off we’re going to be.

How do you solve the problem of unpayable existing obligations of institutions that otherwise have the resources to make a productive contribution to total economic surplus? That of course is the function that our bankruptcy system is intended to provide. In a typical bankruptcy, the company’s owners and senior management get wiped out, some crumbs are left for creditors and workers, and hopefully the most valuable underlying assets get reallocated to alternative productive use. But bankruptcy is a very clunky process with lots of deadweight costs in and of itself. We should have significant concerns in the present environment about the possibility of such costs leading to spillover effects, forcing other institutions into bankruptcy that otherwise might have remained solvent. There is a good case to be made for bringing the taxpayers in as a fifth player at the negotiating table along with owners, creditors, management, and workers. There are likely going to be instances in which a modest taxpayer contribution, in conjunction with substantial concessions from the other four parties, could end up preventing a much larger economic loss. I could easily believe that a judicious expenditure would leave the taxpayers as a group significantly better off than if we’d simply allowed the bankruptcy process to run its course.

The representative of the taxpayers in such negotiations would seem to have by far the strongest hand at the table. The threat point is to let the company go into bankruptcy, and the limit on what the taxpayers are willing to contribute should be the direct benefit to taxpayers (as opposed to benefits to the other four parties). If your company doesn’t like our terms, fine, go your own way, and we’ll prop up the next domino in line instead. If properly implemented, the taxpayers should leave the negotiating table pleased with the deal they achieved, and everybody else should leave battered, comforted only by the knowledge that, had they not made those concessions, things would have been even worse.

On the other hand, if everybody and their grandmother is lining up for a bailout, and pulling political strings
([1], [2])
to make sure they get it, I read that as prima facie evidence that the taxpayers’ interests are not being properly represented.



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35 thoughts on “Bailouts should be no fun

  1. David Pearson

    Bravo. Given your comments, however, is it possible that the prevailing wisdom on Lehman is wrong? Everyone seems to think we should have saved Lehman. Even Geithner implies he would have liked to have done so, but couldn’t. You seem to argue that we should have let it fail.
    I think its important to single Lehman out as a real-world example of your thesis. That’s because we made a hash out of bailing out “the next domino”, which, of course, was AIG.
    One could argue that in the post-Lehman market panic, we made a hash out of our negotiation with the next domino. The tax payer was not well-represented because the markets were melting down, and the government was in crisis-prevention mode. Its like we have an EMT handbook that says, “first, stabilize the patient (market).” Of course, using that handbook, the negotiating power of the “fifth party” flies out the window. Its not so much that we treated the AIG shareholders well, its just that we wholesale bailed out the counterparty to AIG’s CDS contracts: namely one Goldman Sachs.
    Policy makers need to look ahead and not worry about the crisis-of-the-moment. Can they? Only if they toss out the handbook and stop using “the market” as a barometer of policy effectiveness.

  2. Elwood Anderson

    The problem is our overhanging public and private debt is just too big to save all the bankrupt companies and individuals. If the government continues its open spigot policy it will likely bankrupt the country to save private businesses and individuals. This effectively spreads the losses over everyone instead of just the irresponsible investors who caused the mess. It will ultimately lead to a devaluation of the currency to allow payoff of the debt with cheaper dollars. Then we will all have a lower standard of living. Check it out at:
    http://docs.google.com/View?docid=df6scsw7_83djxtmxd6

  3. JDH

    David Pearson: Implicit in my proposal is also the suggestion that we need a more powerful legal authority in order to conduct such negotiations successfully, namely, authority to allow partial default on certain debt or derivative instruments as well as to obtain compensation concessions from management and labor.

  4. Junior

    The fact that industry and taxpayer together are pleading for bailouts and stimulus merely reflects the complete and total ignorance of America when it comes to money and its insidious function within this broken system.
    Had they a single clue that it is the stimulus itself which perpetuates the overall malaise, they might instead plead for a sound alternative.
    The system will collapse before them and they will still be crying for stimulus. Fedquarters will continue to feed them with more debased money and later claim “Well, that’s what you wanted.”
    It sickens me.
    You cannot build a system around debt and then believe that somehow the system will discourage the lethal plunge deeper into said debt. God forbid someone kill off the Federal Reserve by suggesting this in lieu of stimulus and FAILouts.

  5. John N. Winn

    A cleaned up re-posting:
    Taxpayer representation is currently needed as you have indicated but it is an inadequate long term response. If a company is “too-big-to-fail” then its insolvency imposes significant hardship on the remaining economy. There is a significant externality. Further it is the private responsibility of capital owners to protect solvency by prudent management. What is needed is recognition of the externality in private decision making.
    This recognition will occur if capital suppliers—shareholders, bond holders, and deferred compensation/bonus pool recipients–are wiped out/crammed down further than they would be by bankruptcy alone. So, e.g., stockholders in TBTF firms should not have limited liability in the eventuality of bankruptcy; instead, they should become debtors to the government. The extent of the potential indebtedness (or additional cram down for bondholders) should ratchet up the greater the externality potential, i.e., the larger the company, and the more likely the insolvency.
    In the event of imminent bankruptcy (Lehman on Sept. 14, e.g.), the TBTF indebtedness note (the stockholder indebtedness or the additional bondholder cram-down) against capital owners is called by the government with immediate wire transfer payment required (like a margin call) so that it has funds for a bail-out should a Chapter 11/7 follow. These funds should be much more than is perceived to be necessary for any bail-out (perceived need times 2 or 3, e.g.) in order to recognize the natural desire firms have to disguise dire financial conditions. With such incentives, firms will avoid becoming so big that they are TBTF and will voluntarily spilt themselves up into “small enough to fail” entities. Or, if they do not, then those benefitting from the presumed economic advantages of TBTF will also bear any associated social clean-up or prevention costs. In any instance, TBTF costs are privatized.
    In effect, a “bail-out” becomes something to be dreaded more than a mere bankruptcy.

  6. Tim C.

    You are quite right that the taxpayer holds the cards. For example, it is idiotic to actually pay banks for their troubled assets. They should be pleased to get rid of them for good and concentrate on making their good assets work. Whatever recapitalisation the banks may need now has nothing whatsoever to do with what those bad assets might be worth. Only time will reveal their value and time is not a luxury left for most banks.

  7. MrM

    It is pretty clear that Treasury can get any legal authority it wants. It just needs to ask Congress.
    The problem is that under the previous administration Treasury did not want to negotiate better terms. All it wanted was to provide banks with as much capital as possible, combined with as little interference in how banks are run as possible and at as little cost to existing shareholders as possible. This is why Treasury was satisfied with worse terms for taxpayers than what Buffett got for his much smaller capital injection.
    It remains to be seen whether the new administration will be as ideologically blindfolded.

  8. Anonymous

    Banks mainly owe money to each other. Bank A owes bank B, B owes C, and C owes A. Each individual bank is “insolvent” because it owes more than it holds, but if we could reconcile all their debts at once, each bank would end up with the same balance sheet except with zero debts.
    Of course the real situation is much more complicated, and the institutions involved are not all strictly “banks”, but the princple is roughly the same. There is lots of “debt” out there, but much of it is money we simply owe to ourselves. We need a grand plan to reconcile debts simultaneously on a large scale. In actuality this won’t eliminate all of the debt problem, but it can put a good dent in it, and leave at least a few clear winners and losers in the financial sector, rather than all losers.
    The bigger problem of course is that the financial crisis has already caused a confidence crisis and therefore a huge slump in demand. Having loans available to businesses won’t necessarily do much good if there’s no demand for that business’s product. Hence the need for a stimulus of some sort.

  9. ReformerRay

    Some negotiated system, as you propose, may be better than bankruptcy, if humans were not invovled in setting the terms. Stakeholders will insist in sitting at the table. Results – a mess.
    Banrkruptcy is better if we assume selfishness by all stakeholders. Bankruptcy does not allow anyone to establish conditions.
    Every day that passes is a lost opportunity to turn the country around.
    Why are we not saying that the Obama led bailout will likely be no more effective than the Paulson led bailout ?
    Bring on Bankruptcy.
    With federal government promise to intervene when X% of the current financial system has collapsed?
    X should be defined before the refusal to provide more federal money is ordered. X will take into account how large the successor financial system should be. X should be defined precisely in numbers that can be collected as the dominos fall. Everybody can see when X is approaching.
    The federal intervention AFTER X is achieved should consist of loans at no interest rate for all financial institutions left standing.

  10. ReformerRay

    The consequences of the Lehman Brothers collapse should be carefully examined, to follow up on a previous suggestion.
    All the credit default swaps that were thought to be so large were settled by an interchange of 5.5 billion dollars among the parties.
    Bankkuptcy looks terrible because we are to some degree operating in the dark. Welcome to the real world. We just think we are not operating in the dark normally.
    Given human nature, Bankruptcy is the only good way to reduce the toxic assets.

  11. Neil C

    If an institution is ‘too big to fail’, then it is in all probability ‘too big to succeed’, be it a private enterprise or a government.
    No matter how brilliant ‘strategies’ might be, if there is a lack of ‘operational control’, you doomed to fail, e.g. what happened to the first $350 billion of TARP money.

  12. Ian Nunn

    Nice and succinctly put. The media and the single neuron individuals that feed them have painted the issue as one in which the automakers seemingly disappear in total. In fact, as you nicely point out, it is the opportunity to remove senior management, unions and untenable contractual pension and Medicare obligations – all issues that have contributed to the current state of affairs – so that a viable company can emerge from the ashes.

  13. Anarchus

    This is a great point: “On the other hand, if everybody and their grandmother is lining up for a bailout, and pulling political strings ([1], [2]) to make sure they get it, I read that as prima facie evidence that the taxpayers’ interests are not being properly represented.”
    Of course, isn’t it obvious that taxpayers’ interests aren’t being represented at all when Merrill Lynch receives $10 billion in TARP funds, loses $15 billion in their 4Q in part because of some bad “bets” on mortgages (or perhaps it was basis risk on CDS exposures put on in 4Q) and yet pays out $4 billion in performance bonuses to employees?

  14. Fazal Majid

    Taxpayers ponying up some money may indeed stave off bankruptcy for a little while. On the other hand they are also giving an unfair competitive advantage to the nearly bankrupt firm over its competitors.
    If thec competitors were not close to bankruptcy, it’s perhaps because they were better managed or made better products, but now they will in turn be exposed to bankruptcy because of that edge subsidized by the government. In essence, staving off bankruptcy at taxpayer’s expense means rewarding failure and punishing virtue in competitors.
    When the turkeys in question are US companies like GM or Ford (Chrysler has pretty much been written off, it seems) and the solid competitors foreign like Toyota, it is protectionism of the worst order or hypocrisy, and we all know how well protectionism works in periods of global economic crisis…

  15. Sackerson

    Re the main post above: nice idea in principle, but in practice in the UK in the 70s it became part of a complex calculation – the “social cost” threat of redundancy, State benefits and lower tax take became an argument to put up with existing inefficiencies in e.g. car manufacturing and coal mining. We ended up with overempowerment of labour unions, and miners trying to bring down the elected government; and when Margaret Thatcher took over, a damaging counterblow that put the miners in their place but also pretty much ruined an extremely valuable energy resource. Better, I’d suggest, to cut down the clunkiness of bankruptcy – a fast bust and re-open unburdened by debt. I have also suggested halving house purchase mortgage accounts, busting the banks and reopening them under new management, too. What we’ve got now is moral hazard on a big scale – again.

  16. Jeff

    Of course, isn’t it obvious that taxpayers’ interests aren’t being represented at all when Merrill Lynch receives $10 billion in TARP funds, loses $15 billion in their 4Q in part because of some bad “bets” on mortgages (or perhaps it was basis risk on CDS exposures put on in 4Q) and yet pays out $4 billion in performance bonuses to employees?

    Anyone who is the least bit surprised by the Merill bonuses, Thain’s office renovation, or Citigroup’s new private jet simply has not been paying attention. All of this was utterly predictable at the time the TARP was being voted on.

    Bankruptcy is clunky precisely because of the safeguards against further ripoffs built into the process. If politicians and political appointees could be expected to adjudicate financial claims fairly, no one would have ever established bankruptcy codes and courts in the first place. Have we all forgotten what the rule of law means?

  17. Jeff

    When Lehman Brothers filed for bankruptcy, they claimed to have assets worth $639 billion and debts of $613 billion. In other words, their claim was that they were not insolvent at all, just illiquid. But the October 10′th auction to settle outstanding credit default swaps priced Lehman’s $155 billion of bond debt at only 8.625 cents on the dollar, meaning the bondholders got only $13.4 billion. Even if all other debts were paid off at face value, this would still imply that Lehman’s assets could not be worth more than $371 billion, rather than the $639 billion they claim.

    Is it really credible that on October 10′th Lehman’s assets were worth 40 percent less than Lehman thought less than a month before? Before you answer, perhaps you should consider this news story: Ex-Lehman chief sold $13m home to wife for $100

    Shouldn’t some of these people be in jail?

  18. Andrea

    Totally agree and about time someone made that point. However, in practice asymmetries in information (not to say incompetence from the tax payer representative) defuse the actual threat posed by the tax payer and the roles are quickly reversed once the tax payer is sufficiently scared. The tax-payer is so because he has a job/wealth etc. If firms are able to force the perception (does not need to be real!) of systemic meltdown upon the tax-payer than the tables are turned completely.
    The ?scaring? mechanism is enforced thanks to the tax-payer ignorance about the true state of the firms asking for bailout money. In fact it will not be inconceivable that tax-payers proxy the probability of systemic meltdown through imperfect signals such as the number of firms asking for bail-out money.
    This is basically a repeated game where the probability of losing everything through meltdown makes the tax-payer threat of not-paying up not-credible if firms can collectively and credibly show deep signs of trouble!
    This is why I disagree in practice (not in principle) with Prof. Hamilton statement that quantitative easing and looser fiscal policy are equivalent. Giving the Fed the ability to hand out bail-out money (and authority over its unwinding!) actually socialises the cost of the bail out plan through future inflation/currency movements which, unlike tax, is lobby proof and partially shields more productive companies. However the tax-payer will not regain its bargaining strength until the incentive to collude is decreased. This implies tackling the asymmetries through the appointment of seriously competent negotiators or somehow buying the information from within the firms (lots of incentive problems here too!).

  19. ReformerRay

    Jeff – Thanks for info on Lehmans.
    Will better information on the consequences of the Lehman bankruptcy have any impact on the question of more bandruptcies as the solution?

  20. dave

    I think you seriously need to question the premise that we are underutilizing productive capacity. It seems to me a society with a giant CA deficit is consuming far more then it produces. We are utilizing other peoples production on top of our own.
    I think you’ll also find that a great deal of damage was done to our capital structure when it was shifted from production to housing, finance, and other goods of now dubious value.
    We are in fact not as productive as we were in the recent past, we squandered a great deal of productive capital that is now gone.

  21. don

    OK. So Eugene Fama, Paul Krugman, our host, and many others decry the current structure of the bailout. I only wish the press would properly represent the issues, so the electorate would be properly informed and steamed up.
    Paulson should return much of his wealth.

  22. DickF

    And just who will be the one to represent the taxpayer?
    I nominate me.
    Certainly not the ethically challenged Tim Geithner.

  23. Anonymous

    This excerpt from the Arlington Connection http://www.connectionnewspapers.com/article.asp?article=324496&paper=60&cat=104 about Democrat Jim Moran is astounding but typical from members of congress
    Moran said that the hastily organized meeting was necessary because of the amount of money involved in the bill and the extremely accelerated pace at which it is moving through Congress.
    The bill contains billions of dollars for transportation, energy, education, healthcare and technology, among other areas. Moran said that the spending would revitalize the countrys infrastructure and decrease unemployment. The emphasis is upon jobs, he said. Thats what its about: getting people to work, hiring as many people as you can.
    But Moran said that this opportunity to procure huge sums of federal money would be short lived. Once this is done the gates may start to close, he said. So we need to be on board right now. Im not sure how much longer were going to be able to put out more money given the deficit situation.
    In truth the whole idea of a stimulus plan contradicts itself. Note this interesting comment from Louis Woodhill.
    lets call the belief in stimulus stimulunacy and the people who believe in stimulus stimulunatics.
    As they battle to the death over the specific allocation of the spending (infrastructure, aid to the States, food stamps, tax rebates, etc.) the stimulunatics ignore the one thing that all such plans have in common. The very first step in every stimulus program is for the government to go out into the market and sell bonds.
    When the government sells bonds, it takes moneyand therefore demandout of the economy. Then, some time later, the government puts the money back into the economy in the form of spending or tax rebates or whatever. Later, when the data becomes available, economists are shocked, shocked to find that consumers saved their rebates or business investment fell by an unexpected amount, or imports increased, thus completely negating the stimulus. Their hopes dashed, but their belief in stimulus unshaken, the stimulunatics then call for more stimulus.
    The fact is that for the government to be able to sell the bonds in the first place, consumers have to save, or businesses have reduce their investments, or foreigners have to sell more in the U.S. Otherwise, where would the dollars to buy the bonds come from?
    Wait! the stimulunatics cry. What if the Federal Reserve buys the bonds with newly-created money? Wont that increase demand?
    The answer is, Surebut then you dont need the stimulus program.

  24. Footwedge

    Hear, hear Dave! That has been my contention for a long time. I think we have greatly inflated the size and power of our economy, confusing debt-fueled consumption with productive activity. I’m starting to wonder if the odds of a depression – or what feels like a depression – haven’t greatly increased as policy makers have diddled at the edges of the problem as described here.

  25. Mike Laird

    Bravo, JDH ! and well said. Warren Buffet’s deal terms have been published, and they are much tougher deals than Paulson negotiated. Some one should collect Buffet’s deal terms, and any other private deal terms (Prince Alaweed and Citi?) and put them forward to Bernanke and Geithner as the minimum that they should accept in a deal. The lender of last resort should drive a tough bargain – to leave the message that the other party should not be back again for more, and must get their management house in order.

  26. jg

    Professor, with the recession now official, and given the accelerating deterioration of the economy…
    …I move that you change the metric from ‘Recession indicator’ to ‘Depression indicator.’

  27. Anonymous

    Re: “The problem is not that labor and capital are physically incapable of producing more, but instead that certain key institutions have existing legal commitments that they are unable to fulfill.”
    I think the problem is exactly that labor and capital are incapable of producing more, in the sense of producing that which current preferences in the economy favor. People and institutions have made a lot of investments in both human and physical capital that have turned out to be worth considerably less than anticipated. Two key wealth drivers, software and finance, have become decimated. Money less easily earned will be spent on different things then the easy money of the past 2 decades. I for one have made purchases that are plainly indefensible from today’s viewpoint. I will certainly not make those sort of decisions again in the remainder of my lifetime, even if I could afford to ten times over. My tastes have changed. But someone out there put up the production facilities and learned over years how to make those things, betting on customers like me a mere year or two ago. My point is: It’s not about matching actual to “potential” output and I also don’t agree that the problem is on the liability side; the problem is on the asset side and bailouts should be about buying time to make _new_ investments.

  28. Anonymous

    Or more concretely, some of these institutions or firms really need to go bankrupt. It’s not a restructuring question but a question of do their assets match preferences in the economy. And I think they don’t. So the state should mitigate the effect but facilitate new investments, not operate on the assumption, as Barack Obama seemed to in his inauguration speech, that the asset side is still solid. Perhaps our capabilities and assets and technology _are_ less worth than they were 2 months ago!

  29. Barry

    The other reason that people might want bailouts is because the alternative s*cks soooooo bad…
    For example, the Army is now having much less difficulty meeting their recruiting goals.
    I can imagine that, in the Great Depression, a CCC camp in the middle of nowhere, offering 10 hours/day of hard labor, was preferable to the alternative of nada.

  30. ntl

    The solution is easy to say than to implement it. There is no simple situation that only has 4 related parties. Even in that case, secured creditors such banks will not come to negotiate if they know that they will get back all money in case of bankrupcy. If the restructure solution violate their terms they can object it if not they will risk losing their money.
    AIG case is an example that there is only way is to bailout it if American don’t want its financial system to collapse. Firstly, there is no time for such negotiation. You can not call all counterparties onto the table before the world financial system was melt down. Even though you have time for such a negotiation then there is not much chance of success because not all counterparties will perceive the situation in the same way. These institutional investors are clever enough to know that the American goverment will bailout AIG after the Lehman Brother lesson. Why they have to negotiate if they know that they will be better off if they did not come.
    If all creditors think that bankrupcy is wasteful social resources then then there were no bankrupcy in the world at all.

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