Alternative to Treasury Bailouts: One that does not violate the Spirit of Democracy

by Janet Tavakoli - September 25, 2008

Creditors including credit default swap counterparties failed to renegotiate terms when they had the chance. Financial institutions did not recapitalize when it was easier (within the past 2 years) and now they cannot because no one trusts the value of the assets.

Now we do not have time for Chapter 11 in which either 1) creditors agree to discount debt in exchange for warrants (for potentially viable enterprises) or 2) creditors agree to transform (possibly discounted) debt into new equity (a new capital structure in which former shareholders are wiped out).

Rather than adopt any form of the Treasury's plan (a spin of the Paulson Plan), which uses billions of taxpayer dollars and forces risk and potential losses on taxpayers—instead of those who enjoyed the gains—I advocate an alternative.

Instead of TARP and handing out money to cover banks' losses, we can force creditors to accept a restructuring plan (this was done during the Great Depression). Creditors (debt holders) including credit default swap counterparties would be compelled to accept a restructuring plan. That requires partial forgiveness of debt in many cases and/or a debt for equity swap.

If we are determined to violate personal property rights, I prefer it be done through a forced debt forgiveness and a forced capital restructuring (debt for equity swaps), rather than through a massive bailout (any of the various forms of the Paulson Plan). The current plans destroy capitalism (those who stood to gain--and already made off with large gains--should bear the risk) and violates the spirit of democracy established by the Founding Fathers of the United States.

Letter to the Editor - Financial Times - September 29. 2008

JT Note: The Act released on September 28 extends the SEC's authority to suspend mark-to-market accounting (FAS 157) (P. 88) when it is "in the public interest and protects investors." Do not expect a thaw in the market freeze. The proposed Act buries problems and prolongs price uncertainty. This bill did not pass, but future versions may include this provision. This a huge mistake. FASB board members support mark-to-market accounting, especially in illiquid markets. The SEC should, too. This provision is ridiculous and seems meant to promote hold-to-maturity pricing for credit derivatives trading books and CDO portfolios. The danger is that Federal portfolio managers can claim they are making money on carry trades while the assets are declining in value due to defaults or permanent value destruction of collateral. This situation can continue for a long time to create the false appearance of profitability. In other words, U.S. taxpayers can be told they are making money on their $700 billion investment, when in reality they are losing money. I would rather know the market price, even if the news is bad news.

Warren Buffett came out strongly in favor of mark-to-market accounting for the bailout in an interview with Charlie Rose (and Warren Buffett) on October 1, 2008 and CNNmoney on October 2, 2008. He proposed another viable alternative to the Bills floating in Congress. He proposes to let private equity investors put up 20%. The U.S. Treasury will put up 80% with the following terms: it gets paid back first, receives interest on its investment, and gets a share of the profits. This is a way of ensuring market pricing and allowing the banks to delever while the Treasury (the only source of a large enough balance sheet) levers up with the protection of a 20% cushion and mark-to-market pricing. This proposal is a good one for viable banks.

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