Tuesday, July 15, 2008

The Fanny/Freddie Bailout:
More Jam for Me, No Jam for Thee

Virtually all of my betters appear to be turning thumbs up (even if tepidly) to the Fanny/Freddy bailout, so I guess I do too. But it still seems to me that there's a fundamental issue here of "socialism for the rich" that shouldn't be dismissed quite so, well, quite so dismissively.

Yes, they tell us, it is true that we are (or may be) saving the owner's ass, but you have to do it save the economy. Well, who can argue with "save the economy"?--no thanks, not me. But phrasing the issue this way seems to conceal a rookie error.* That is: it is one thing to save the going concern and something quite different to save the equity. We may well need to save the business. But we can save the business even though equity doesn't get squat. Consider the crudest numerical example (I'm not deft enough with blogger to sketch a balance sheet, so bear with me): Liabilities $100. Assets, $50 in a simple liquidation, $80 if we preserve the going concern. Since $100>$80 and $100>$50, there is nothing for equity either way. But $80>$50, so creditors have a powerful motive to preserve the going concern even so. Tom Jackson used to call it "sellling the business to the creditor." Under Chapter 11 of the Bankruptcy Code, we do it all the time. There's no reason why we can't do it here, too.

A critic will object that I've made my life too simple by assuming I "know" the values--that equity owners deserve protection even when the balance sheet is upside down because they have a "lottery ticket value"--something might turn up--that deserves to be protected. I think there is a good deal of merit to this view (it would explain, for example, why Bear Stearns equity continued to trade even as the enterprise appeared to fall off the cliff. But this is an entirely separate issue: it's only a matter of how we parcel out the ownership stakes, not how we define them in the first place.

I suppose this was what I had in mind a few weeks ago when I asked: why doesn't the government just buy Bear Stearns, rather than planting a big wet kiss on the chops of JP Morgan (link)? I got a bit of offline flack on that one from people who said no authority blah blah socialism blah blah, government can't be trusted to run a blank blah blah and blah. Well, of course the government can't be trusted to run a bank. But it can perfectly well enjoy the residual share if, as, and when (if ever) that stake has value. And let JPM run it in the meantime, as a private contractor.

I haven't noticed anybody giving any serious thought to this kind of proposition. I suppose one argument for staying away from this perspective is that it is unfamiliar and therefore risky: in times of great uncertainty, we don't want to play around with the tried and true--so pay off the equity and move on. It's hard to argue with that. But I do wish I could see the wise men giving these kinds of concerns just a bit more thought.

Afterthought: Just for perspective, I am not that nuts about giving a lot of relief to homeowners in trouble, either. I think it is fair to assume that most of them understood perfectly well the risks that they were running, and that if the risk came out badly, why, them's the breaks. And not incidentally, I sign on with those who point out that if we spend a lot of public resources puffing up the wealth of current homeowners, we make housing just so much more inaccessible to all those who have not yet had their chance.

*I see I discussed this same "rookie error" a while back in complaining about Gretchen Morgenson (link)--and even included a balance sheet. Well, fair enough. Hey, you didn't listen before, you gotta listen again.

2 comments:

Unknown said...

Absolutely right, and there's precedent: the Chrysler bailout. Okay, it wasn't a bailout, the government guaranteed loans made to Chrysler by private banks, and in the end there were no calls on that guarantee.

In exchange, the government received warrants to buy 14.4 million shares of Chrysler stock at $13 a share, for stock that was then trading for around $5 per share. The government ultimately exercised its warrants when the stock was trading around $26 a share and made over $300 million.

And all of this was done in the Democratic administration of Jimmy Carter, the President that Republicans love to hate. In contrast, the Republicans model seems to be "heads I win, tails you lose." JPM/Chase gets the spoils while the taxpayers pick up the losses, with no public participation in the upside. Nice work if you can get it.

The Carter-Chrysler formula seems to me to be an equitable way of sharing risk/reward rather than the current administration's public risk/private reward model.

Buce said...

Waterguy has a great point. But refresh my memory here. As I recall, when--against all expectations--Chrysler recovered and the government funnymoney turned out to be actually worth something, then Chrysler management said--mygawd, you don't expect us to honor that contract, do you?

What happened in the end? Did the government get to enjoy the fruits of its labors? Or did Chrysler wiggle out? A voice in my head is saying "wiggle out," but I'm not sure I remember.