Monday, April 6, 2009

It's Still A Bad Plan

In a post dated February 13th, we made two key points. First, we felt that forcing financial firms into some form of bankruptcy was superior to substantial direct investment by the government. Second, we believed that the plan-without-details for buying toxic assets through private-public partnerships was an extremely bad idea.

Now with the passage of time and some more details, we feel even more strongly about these positions. In a paper by Kenneth Ayotte and David A. Skeel, Jr., "Bankruptcy or Bailouts?", the authors note that it has been a guiding principle of Fed Chair Bernanke and former Secretary Paulson to "..avoid bankruptcy filings by the distressed firms...based on the belief that if a troubled firm files for bankruptcy, the consequences would be severe." The risks are categorized as firm-specific, including the rapid dissipation in value of the firm's assets, and systemic, such as the continued erosion in confidence. They note that three days after filing for Chapter 11 protection, Lehman Brothers had garnered court approval for the sale of its North American investment banking operation to Barclays, which provided $450 million debtor-in-possession financing. Two weeks after filing, Lehman had sold its European, Middle East and Asia operations to Nomura and its investment management business to two private equity firms. Through this example they show that the concerns about bankruptcy being slow and increasing firm specific risk, are not as significant as interventionists say they are. The authors are, respectively, law professors at Northwestern and the University of Pennsylvania.

Nobel Laureate Joe Stiglitz, writing in the New York Times ("Obama's Ersatz Capitalism," March 31, 2009) exposes the Geithner plan to purchase troubled assets via public-private partnerships. His characterization, drawn through two scenarios, shows that the plan socializes the potential losses, while offering private investors, pre-crisis returns of more than three times their equity investment. Professor Stiglitz sums it up best when he says, "The Geithner plans works only if and when the taxpayer loses big time." Yet, this plan cannot die at this point, for political reasons.

Today it is being tweaked again, not for its fundamental construction, but for issues of access by smaller firms to the candy being handed out by the Fed and Treasury. As several observers have noted, the ongoing financial crisis is not fundamentally about liquidity, but about confidence in the financial system. Despite all the press conferences and releases, very little of substance has been accomplished to restore confidence in the efficiency, transparency, fairness, and governance of the financial system.

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