Bailouts and Phantom Bankruptcies
I have found it hard to read the newspapers each morning without throwing up. Everyone is lining up to dump off their bad investments on Uncle Sam, meaning, of course, you and me. The University of Texas Medical Branch in Galveston wants $609 million, because they only bought $100 million in hurricane insurance, and the rest of Galveston wants $1.5 billion more. (We should only give them money if they promise to spend it somewhere other than Galveston; this should be about exit, not replacement.) And that seems like seat-cushion change compared to the $700 billion figure in the Sunday version of the Paulsen bailout legislation.
To the greatest extent possible, any bailout should decouple—separate—bailing out the credit system from bailing out individual participants in that system. We need to separate out controlling systemic externalities from insulating individuals from the consequences of their actions. That is abstract, so try this.
Absent a bailout, many of the firms that will glom onto the bailout would have filed for bankruptcy, just as Lehman Brothers did. Filing for bankruptcy triggers a number of consequences designed to protect creditors from shareholders, management insiders and each other. We have long talked about phantom stock. Now we should implement a phantom bankruptcy regime in setting up any federal bailout. Think of this as “as-if” bankruptcy: the firms would have filed for bankruptcy absent the bailout and so have no claim to do better than they would otherwise do in a bankruptcy.
We should condition access to the bailout vehicle on the acceptance on many of those bankruptcy consequences. We can get there either through the F-word—fairness—or the E-word—efficiency—as the broad no-conditions bailout will serve as the poster child for moral hazard going forward, plus the Paulsen plan seemingly has adopted as its core plan just overpaying for the assets.
Think of this slightly differently. A successful chapter 11 reorganization is typically about injecting new cash into the firm, reworking the balance sheet—often eliminating different classes of debt and preexisting shareholders, hiring new managers and working through the “avoiding” powers which make it possible to undo fraudulent transfers and preferences. (A fraudulent transfer is a transfer for less-than-reasonably equivalent value made while insolvent; a preference is an unusual payment to one creditor that prevents other creditors from receiving a pro rata share of the assets.)
The Paulsen bill just makes it possible to inject new cash—at, says the emerging consensus, inflated prices—but it skips all of the other steps that we associate with bankruptcy. No wiping out of equity and no efforts to claw-back payments made to favored insiders.
We need to make it more unattractive for firms to participate in the bailout. Not completely unattractive if you take contagion and externalities seriously, but the standard lemons argument means that we should be extremely nervous when firms are eager to sell their bad assets to the government.
As cases like Eastern Enterprises suggest, we may face real constitutional limits on our ability to impose retroactive liability or penalties on firms and individuals who seem to have played heads-I-win, tails-you-lose. But those same limits should not apply to the right to access the bailout and so it is at that point that we must impose conditions. The most natural place to look for those conditions is in our standard off-the-rack insolvency regime, the Bankruptcy Code itself. Any federal bailout must be coupled with its own phantom bankruptcy regime.