Henry Paulson is Wrong

CHICAGO – When a profitable company is hit by a very large liability, the solution is not to have the government buy its assets at inflated prices.  The solution, instead, is protection under bankruptcy law, which in the United States means Chapter 11.

Under Chapter 11, companies with a solid underlying business generally swap debt for equity.  Old equity holders are wiped out and old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt-holders can agree to reduce the face value of debt, in exchange for some warrants. So why not use this well-established approach to solve the financial sector’s current problems?

The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the current crisis has reached a point where time is of the essence. But we are in extraordinary times, and the government has taken and is prepared to take unprecedented measures. As if rescuing the big insurer AIG and prohibiting all short selling of financial stocks was not enough, now US Treasury Secretary Henry Paulson proposes buying up (with taxpayers’ money) the distressed assets of the financial sector. But at what price?

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity), it is because investors are uncertain about the value of the assets in their portfolios and do not want to overpay. Will government do better at valuing those assets? In a negotiation between government officials and a banker with a bonus at risk, who will have more clout in determining the price? Paulson’s plan would create a charitable institution that provides welfare to the rich – at taxpayers’ expense.