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He writes:
Concerns about the Treasury Rescue Plan: One approach is to purchase mortgage-related debt or other troubled securities.... Yet this approach has significant disadvantages.... First, the affected debt instruments are quite heterogeneous, which makes setting appropriate prices and quantities very difficult.... A second problem with buying troubled debt is that it provides the most help to the financial institutions that made what are, in retrospect, the worst investment decisions.... Third, this approach saddles taxpayers with significant downside risk but limited potential upside gain....
An alternative... is for the government to make equity investments in a wide cross-section of such institutions. For concreteness, suppose that the government offered to make an equity investment in every firm regulated by a federal or state banking regulator equal to 10 percent of the market value of the company as of September 1st in exchange for a 10 percent equity stake in the company. (The 10 percent figure is illustrative. As with the first approach, a judgment about the appropriate total amount of government funds would need to be made.)... [T]he government would not need to determine the appropriate prices and quantities of individual mortgage-related securities, it would not be providing a greater reward to companies that have made the worst investments, and it would gain the opportunity for taxpayers to receive a higher return if the financial system recovers more strongly. Still, objections can be raised.
First, the even-handedness of these investments means that they would not focus on the firms facing the greatest stress, which might damp the immediate bang-for-the-buck.... A second difficulty would be choosing the companies that would be eligible for this offer.... Third, firms that were optimistic about their future prospects without government assistance would likely decline this offer. But shareholders would be unlikely to hold out in expectation of a better deal from the government in light of the losses suffered by shareholders in the Federal Reserve and Treasury rescue operations this year.
A fourth objection is that the government would be a minority shareholder and could not control the institutions in which it invested. Therefore, this approach could not be used to help struggling mortgage borrowers directly; any additional assistance to borrowers would need to be channeled through the Federal Housing Administration or some other entity. In addition, the government could not dictate corporate strategies regarding asset accumulation or liquidation. This passive shareholder position creates some risks, but it avoids substantial risks associated with the government attempting to control and manage the entire financial system.
Whichever of these broad alternatives the government pursued—buying mortgage-related debt and other troubled securities, or investing in a wide range of financial institutions—the assets acquired would need to be divested over time. After the financial crisis has passed, the government would sell its holdings to private investors on a gradual basis over a period of years.
Luigi Zingales for Deputy Secretary:
The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.... Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision. My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices, but bond prices as well, soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equityholders, but also the debtholders....
Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.
The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.
