Garett Jones  

The economists' alternative to bailouts

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I'm still shocked at the speed with which bipartisan elites coalesced around TARP. 

A key reason: The proffered alternatives were incredibly painful. No bailouts would have meant bankruptcies much bigger and more complicated than Lehman--and that bankruptcy ostensibly threatened short run cash flows around the world.

Voters don't want pain. Yes, some voters want to see virtue rewarded and wickedness punished--they may even claim that the pain is good for you--but the rest of us want our medicine to taste good. 

This stark choice between 100% bailouts and a cluster of possibly 1907-panic-inducing megabankruptcies was totally unnecessary.  Did the big banks need equity injections?  Well, there were plenty of potential shareholders available for Citi, BofA, and all of the other TARP recipients.  And they had a name: "bondholders." 

The economist's version of bankruptcy (not the lawyer's version) is simple: If what you contractually owe is (very likely) greater than the value of your assets, then you're bankrupt.  It's not primarily about missing a payment: It's about the prediction that you won't be able to repay everyone you've made promises to.  If your assets can't pay off all your debtholders (including depositors) then it's time to head to court. 

But all corporate bankruptcy means (again, to an economist, not a lawyer) is that some of the bondholders get turned into shareholders: Instead of getting the $10,000 you were owed, you get shares that will probably be worth much less.  In the simplest case, the shareholders get nothing (they had their chance to run the firm and blew it), the bondholders become the new shareholders, and the firm keeps right on running.  Seems like something you could do over a weekend.  

You might think "Banks can't do this: they don't have bondholders, they have depositors, and no judge is going to turn a bank account into shares in Citigroup." But ordinary deposits make up half or less of the typical megabank's liabilities.  Citi and the rest raise hundreds of billions in the bond markets--and those bonds would have been ripe for a debt-to-equity conversion in the fall of 2008.

You might think that this is just some blogger writing about his pet theory: And you'd be right!  I wrote a paper on this published in the Journal of Applied Corporate Finance.  But I'm in good company:

[T]he alternative...I've been thinking of is to...convert Citibank's long-term debt into equity.  
               --Robert Hall

The debt holders are told, 'Congratulations, you are the new equity holders.'
               --Greg Mankiw

I]f the banks are undercapitalized, and private money is not available, then the government could force creditors to swap claims into equity, thus instantly recapitalizing the banks while avoiding use of taxpayer funds.
               --Simon Johnson

Bankruptcy scares many people, but it shouldn't...[W]hen things are less serious, some of the debt is converted into equity. [W]ithout the burden of monthly debt payments, the firm can return to profitability. 
               --Joseph Stiglitz

The quotes are all from the paper.

A few economists like the idea, but will debt-to-equity conversions go anywhere in the real world? I'll offer an answer in coming days.  


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CATEGORIES: Finance , Macroeconomics



COMMENTS (16 to date)
Ritwik writes:

Even if Cocos are the right way to go, they don't solve the issue of the 'bottomless pit' that fire sales produce. TARP like programs are not about infusing a capital buffer, they're about preventing the system-wide ramifications of 'Schrodinger's banks'. Conditional on the assumption that the market is pricing the assets roughly correctly in even a 'crisis' state of the world, deliberations about designing robust capital structures make sense. But if you contend that the market is systematically mispricing (or completely failing to price) risk assets, TARP is just doing the job that all monetary policy is supposed to do - to solve the problem of a bad equilibrium.

Indeed, one can argue that from a central bank's perspective, it may be far easier to spot a gross violation of asset market liquidity than a fine tuned violation of the Wicksellian natural rate or the economy's NGDP path, yet we somehow expect the monetary authority to solve those bad equilibria for us!

Also, I wouldn't make much of the lawyer/economist definitional differences. It's relevant only if you have good reason to believe that the only liquidity crisis is a funding liquidity crisis. The two are hopelessly entangled in a market liquidity crisis.

david writes:

In the simplest case, the shareholders get nothing (they had their chance to run the firm and blew it), the bondholders become the new shareholders, and the firm keeps right on running. Seems like something you could do over a weekend...

No; four years later we are still sorting out who exactly owed and owes who what. Creditors involved in the contract may be insolvent themselves, etc. That's fine for the enforcement of creditor claims, where courts can tear through it one by one, but shareholders en masse have to be able to appoint leadership right now. They need to know who actually owns how much.

If you want clarity like this accessible in an instant, you would have to oblige everyone to pre-register their contractual claims with a central authority, as many Western states already do with land. We don't do this for financial claims though.

Charlie writes:

I think you should be more explicit about how your view differs from what a corporate lawyer's view is. When I talk to corporate lawyers, their view of bankruptcy is the same as the economist's view in theory, but in practice this stuff is not easy. The corporate structures are very complicated figuring out who owns what and how much is not trivial. It makes our view of bankruptcy as "the simple case" where equity holders are wiped out and bondholders (as if that's one class of people with all of the same claim on the firm's value).

We love the simple case in economics, but this is a time when you have to grapple with the really complicated case to be persuasive, because that's what bankruptcy law actually has to do.

I largely agree with the prior comments, timing is crucial. The 'medicine' has to be applied immediately. Working it out in bankruptcy court is way too late.

Which brings up the Dodd-Frank 'Living Wills' solution. I should say 'hopeful solution'. It almost surely will fail if it ever comes to being tried, because it will be too time consuming, and subject to litigation.

Interestingly, Gramm, Leach, Bliley had a provision that would have allowed the Fed (in their role as banking regulator) to insist on banks issuing some CoCos, as 'canaries in the coal mine' that would tip off markets as to which banks were in danger of failing. The Fed declined the invitation, due to lobbying by the banking industry.

Even more interestingly, prior to 'Glass-Steagall' in 1933, bank shareholders had 'double liability' (a bankruptcy referee could come after them for more money to make depositors whole) and bank executives were required to be bonded for up to triple their annual salaries.

Both incentives against reckless lending were eliminated, and deposit insurance instituted because of that law. Which stands folk-wisdom on its head.

Costard writes:

This would be a haircut to bondholders. As you say, financial institutions had a lot of debt to roll over. Unlikely they could do so if bond value was called into question.

Converting bonds to equity makes sense for a non-financial company; they can often weather the loss of credit. But for a bank leveraged 20 or 30-1, we're talking about a bullet to the head.

Perhaps a virtuous bullet -- there at least you'd have an argument.

david writes:

All that said above, 'nationalize-and-liquidate-gradually-later' would've probably been better than reversing the historical order of priority between bondholders and shareholders. If you're setting out to screw shareholders anyway...

This, or at least something very similar, has been circulated in Spain by various Spanish economists, usually those associated with the Austrian School; they call it the 'bail in.'

Daniel Artz writes:

From the perspective of one who has a substantial background in economics while also having 20+ years of experience in the practice of commercial bankruptcy law, the economist's view of a bankrupt firm is much too simplistic. When a firm goes into a Chapter 11 case, the end result may well be that debtholders become the new shareholders. But the process is messy and expensive. First, althout existing equity owners may be completely "underwater", they still exercise significant control over the process, which translates into significant leverage in bargaining a cut for themselves. Second, asset valuation is never as simple as "lets just look at market valuations". Usually only a small portion of a company's assets (even a financial intermediary) are capable of quick, clear, market based valuation - there is almost always room for significant fights over valuation, making the divvying up of ownership in a going company complex. Chapter 11 is a compelled negotiation, and the bargaining can be hard fought and stretched out, often by those with the lowest priority claim on the company's assets. And the transaction costs - attorneys' fees, investment banker's fees, expert witness fees, brokerage costs, etc., etc., can be very high. Before deciding that bankruptcy is better than a bailout, consider the costs and delays inherent in the process. That's not to say that bankruptcy (or, in the case of regulated financial companies which are NOT eligible debtors in a Chapter 11 Case, liquidation or purchase & sale transactions through a receivership) won't usually result in better final outcomes, at least for those companies which are truly insolvent on a balance sheet basis (as opposed to liquidity insolvency). But the comparative costs of the process must be considered in the decision.

JeffM writes:

I have virtually nothing to say in favor of TARP, but this analysis is way too simplistic.

The lawyers distinguish between two types of bankruptcy, one being where the fair market value of assets is less than the legal value of debt, and the other being an inability to pay obligations as they come due. In a perfect market, of course, those two would be different aspects of the same situation, but markets are seldom perfect.

There are a number of questions about TARP: (1)why the discount operations of the Federal Reserve were not used AS INTENDED to maintain the liquidity of insured depositories with decent collateral (no bailout, just regular central bank lending); (2) why the TARP funds were not restricted to too-big-to-fail banks that were bankrupt or close to bankrupt on a solvency basis; and (3) why the TARP funds were not treated as debtor-in-possession debt ahead of all other debt except deposits.

I can give a good guess at the answer to question 2. During FIRREA etc, the ability of the regulators to relax temporarily capital requirements for banks that took over failing banks was eliminated (because that discretion had been radically abused by the FSLIC). The pressure that was exerted on banks that had no need of TARP funds to accept them was tremendous. The result was that they had the capital to take a long view of what the workout value of assets of failing banks was. PNC may have made a good deal by acquiring National City, but they would have been hard pressed to do so had they had to find the requisite capital in that market. I doubt, however, that BoA's deals worked out so well for it. If this is the reason that TARP was not restricted to banks in trouble, the result was to tranfer a great deal of risk away from the government. It also transferred public anger away from the government toward the banking industry, which may explain why TARP was popular among politicians. This does not justify TARP to me: the government should bear the risk and obloquy arising from the existence of banks too big to fail.

As always, this was a good analysis, professor; and as always, I have a question. You wrote:

This stark choice between 100% bailouts and a cluster of possibly 1907-panic-inducing megabankruptcies was totally unnecessary.

That sent me to check back on what I thought I knew about the Panic of 1907, with J. P. Morgan engineering the recovery. My earlier research was motivated by the "Clearinghouse Scrip" of 1907, an ad hoc medium known to numismatists. This time, I went the Smithsonian and read their 2008 article on the Panic of 1907 here.

First, the Panic of 1907 seems to have been triggered by the San Francisco Earthquake of 1906 which "drained liquidity" i.e, in addition to the obvious destruction, demand in SF for capital for rebuilding outbid and drew investements away from NYC.

More to the point, though, in that article was another easy claim I have come to doubt:

J.P. Morgan ... was in the twilight of his extraordinarily successful career as a financier of the boom era, the Gilded Age of American expansion from 1865 to roughly 1900.

That "gilded age" has also been called "the long recession." I believe that the reconciliation of the apparent contraries comes from considering that this was a time of gold money. It looked like a "recession" to us in our Keynesian times because prices were falling. But prices were falling because money was stable and new inventions, discoveries, and innovations were bidding for a relatively fixed stock of money. This is one of the strengths of commodity money.

Therefore, the Panic of 1907 was short-lived and manageable by one wealthy person who had the confidence of his peers. Can you name a single firm of 1907 that went bankrupt? The bankruptcy of Chrysler, GM, and Bear-Stearns seem noteworthy to us, but was anything comparable in 1907?

Thus, I am not sure about your allusion to the earlier panic.

JeffM writes:

Yes, there were plenty of bankruptcies and a very severe economic contraction following the Panic of 1907. And one of the precipitating events was the failure of a major New York bank, namely the Knickerbocker Trust.

What Morgan did, assisted by other bankers and the US Treasury, was to end the liquidity crisis. In fact, if I remember correctly, he deliberately let the Knickerbocker Trust fail because he assessed its assets to be worth less at non-panic valuations than its liabilities. In other words, he did what the Federal Reserve was later designed to do, namely to prevent a liquidity crisis in New York from causing solvent banks across the country to fail. (The importance of the New York banks was that most banks across the country kept their reserves on deposit at New York banks; interbank clearing through the Federal Reserve did not yet exist.) Morgan did not prevent, nor did he try to prevent, depression or bank failures of unsound banks.

Morgan deserves much credit (and made a lot of money) for halting the liquidity crisis, but that does not mean that the Panic of 1907 did not have serious economic ramifications. What Morgan's actions do show, however, is that a liquidity crisis can be solved without major government intervention by identifying quickly who is likely to be solvent and who not and providing liquidity to the likely solvent. This was not done in 2008. The Federal Reserve absolutely failed, and failed miserably, in its statutory role.

Mike Rulle writes:

Two for two Garrett on todays blogs. Bailouts were not required. I like to compare AIG with LTCM and how the Fed treated the latter versus how Treasury treated the former. We had huge demand for cash in 2008, because those with mark to market write downs demanded cash from counterparties who had none. When they sensed weakness at Treasury, they pounced and claimed the world was about to end.

In 1998, they tried to do the same thing. But the much despised and hated Greenspan stood up to the street. His so called bailout was insisting that the banks figure it out for themselves. That meant not demanding cash on marks which LTCM could not pay. He welcomed them to ignore him, but he promised no backstop.

One of the interesting things about both events is that both AIG and LTCM had positive cash flow despite massive mark to market losses. In the case of LTCM, their counterparties assumed their positions and gradually unwound them, at a profit. AIG was also unwound at a profit to the street and a loss to taxpayers.

Panic and corruption make previously bad and corrupt decisions even worse.

Shayne Cook writes:

Dr. Jones:

I'm certainly glad you emphasized the distinction between the "Lawyers" version and the "Economists" version.

What you and the other economists fail to note in your elegant solution, is that debt is a contractual phenomena - defined and controlled by contracts law - and equity is not.

And consequently what you and the other economist advocate is that the non-judicial portion of U.S. government should have both the legal right, and obligation, to intervene in ANY contract, entered freely into by any two private parties - to benefit of whichever contractual party seems politically "pretty" at the time.

Good luck with that.

I too consider the 2008 "Bailout" exercise a horrible abomination. But not due to its monetary scale, or even the cost burden transferred to the U.S. taxpayer. The real abomination was and is, that the non-judicial branches of the U.S. Federal Government wantonly intervened in those debtor/creditor contracts. As a matter of fact, the "Bailout" was intentionally and specifically constructed to preclude the contracts dispute from ever reaching the judicial branch, and resolution from ever having to pass judicial review.

Are you and the other economists you cited actually expressing your preference for political expediency over judicial review/settlement? Ostensibly on the grounds of some clever economic theory I've never heard of?

As an aside, bankruptcy courts have long and often considered and imposed precisely the sort of debt/equity exchange you advocate. But they have done that as a matter of, and within the scope of, pre-existing contracts and bankruptcy law. I'd prefer it remain that way.

Doug writes:

Pretty much every bankruptcy lawyer understands the basic economics of bankruptcy. Economics has deeply infiltrated the law schools and the legal profession. No need to implicitly disparage lawyers to make your point.

Julien Couvreur writes:

Shouldn't those procedures be laid out before the fact?
Maybe a company should declare its bankruptcy procedure when it is created, rather than when the problem arises.

John Thacker writes:

Michael E. Marotta:

I believe that the reconciliation of the apparent contraries comes from considering that this was a time of gold money. It looked like a "recession" to us in our Keynesian times because prices were falling. But prices were falling because money was stable and new inventions, discoveries, and innovations were bidding for a relatively fixed stock of money. This is one of the strengths of commodity money.

The way I generally have heard it put is that if you have a tremendous increase in aggregate supply (due to new inventions, innovations, etc.) then deflation is perfectly fine. Inflation being basically growth in nominal money supply (times velocity) minus real growth. In the Gilded Age, the stock of money still increased, simply the real economy grew by leaps and bounds so prices on net decreased.

I'm not convinced that this real growth was actually caused by the commodity money in any sense.

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