An Alternative to the $700,000,000 Bailout

Everyone is worried about the economy, including me. What really worries me though is the speed with which things are happening and how quickly we seem to be on the verge of spending a staggering amount of money to prop up private companies.

Last week, while we were on our family vacation in Disneyland, it felt as if we’d dropped into an alternate universe, where up was down and down was up. We were, of course, having a ball and wandering around in “the happiest place on earth,” which was the perfect antidote to the news of the day. One morning that news was of plummeting stocks (meaning our 401Ks were rapidly halving in value); then it was huge companies filing for bankruptcy or being bought by other huge companies (did Bank of America really buy Merril Lynch?). Finally, it seemed that global credit markets had simply ground to a halt and were on the brink of collapse. Every day the news seemed more and more unbelievable.

And to cap it all off on the last day of our trip, the government rolled out the idea of the bailout. Seven hundred BILLION dollars. I’ve been trying to get my head around how much money that is. The Iraq War so far has cost $2 trillion so this bailout would cost roughly 1/3 as much. But the Iraq War has been going on for five and a half years! The government is now proposing to give the Treasury Secretary the authority to spend these hundreds of billions as fast as he can.

In all the questioning of the bailout that I’m hearing on the news and radio, what I haven’t been hearing is alternatives. Surely there is some alternative to spending an ungodly amount of taxpayer money to prop up the economy?

It turns out there is. Two of the countries leading economists, writing in an online economics journal I subscribe to called “The Economists Voice,” recommend a plan that sounds much more sensible. It’s called debt for equity swaps and it is what normally happens when big companies file for bankruptcy. The idea comes from an article written by Luigi Zingales, who is a professor of economics and entrepreneurship at the University of Chicago School of Business. He has won all kinds of awards for his work. Interestingly, he wrote a book called Saving Capitalism from the Capitalists. He is now proposing a way to do just that since his fear is that greedy capitalists (my words, not his) will destroy capitalism with this bailout. The heart of the matter is that people who work at the big banks and investment firms – and more importantly their shareholders -- have all profited over the years while this crisis was brewing. But the losses they would now suffer if the full meltdown occurs won’t be borne just by them. Under the bailout plan those losses will be suffered by all taxpayers since we’ll be paying for it. So they get the profits and we get the losses? Not only does that seem morally wrong, it is also wrong in terms of how capitalism is supposed to function. If you profit, you take risks in order to do so. But surely it should be those who profit who also stand to lose or else how will they ever adjust the risks they take?

Back to Zingales’ idea. He explains that normally, when companies have a huge liability to pay, they file for Chapter 11 bankruptcy and they basically get debt forgiveness in exchange for equity. He explains how it works:

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.

Zingales goes on to explain that the reason this “normal” way of dealing with the current situation is not being talked about much is time. It takes time to negotiate Chapter 11 arrangements. And U.S. credit markets don’t have time anymore. But our existing bankruptcy system has a way of dealing with this already. Bankruptcy judges just cram a restructuring deal down the throats of shareholders when they’re out of time or when the proceedings are too large or contentious for a negotiated settlement.

He also gives an example of how a similar situation happened during the Great Depression – when the government and courts forced a debt forgiveness plan onto firms -- and how both stock and bond prices soared afterwards. In other words, markets ended up liking this solution because it had benefits for everyone and it restored confidence in our finance system. That sounds like exactly what we need right now. It is certainly an idea worth exploring before we give away $700,000,000 of taxpayer money.