by Simon Johnson and James Kwak
The government plans to bail out the banking sector by buying up to $700bn (for now) of “impaired assets” … but at what price? Pay too little, and the banks will not have sufficient capital to remain solvent; pay too much, and the wealth of the American taxpayer will be unilaterally handed to the banks and their shareholders. Last week Hank Paulson, Treasury secretary, said the government would pay “fair market value”, which, many pointed out, would do little to help the banks. On Tuesday, Fed chairman Ben Bernanke equated the current market with a “fire sale” and proposed paying “hold-to-maturity” prices. But what does this mean?
by Gilad Livne and Alistair Milne
The credit crisis has had a seismic impact on the global financial landscape. A central reason is an unforeseen interaction of fair value accounting rules and the illiquidity of structured credit products. Firms are required to mark to market their large portfolios of structured credit products, but for most of these products there is no longer any functioning market. Instead, as has happened on several occasions, we observe cumulative death spirals, in which the only prices that can be used for valuation are based on the fear that a Lehman or similar large firm will implode, and thus forced to sell a large structured credit portfolio. Mounting fears bring about large mark to market losses, increase counterparty margins, and bring about the very implosion that is feared in the first place.
Clearly recapitalisation of the banking sector is needed. But this malign interaction of accounting rules and illiquidity actually creates an opportunity, making it possible to substantially recapitalise the banking sector at little cost either to taxpayers or to bank shareholders. We believe this can be achieved through a direct solution to the trading paralysis, the setting up of a specialised exchange to allow a large number of traders to exchange information and views on the value of the underlying structured credit products and conduct trades at fundamental not fire sale prices. Prices established in such an exchange will provide more reliable valuations than those emerging from current bilateral over the counter trading and restore much of the banking net worth that has vanished in recent months.
By Luigi Zingales
When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices: the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity: the old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debtholders can agree to cut down the face value of debt, in exchange for some warrants. Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. 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. However, we are in extraordinary times and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector. But at what price?