A better way to bail out companies "too big to fail"

A major problem with the Bush/Paulson bailout plan for Wall Street is that after Paulson let Lehman Bros. go bankrupt it frightened the rest of Wall Street and most of the world's investors. Since finance is the most globalized industry in the world, this had world-wide chilling effect on lending. That was a significant factor that led Paulson to go in and hand AIG tons of money instead of letting them go bankrupt, and on Paulson's use of the bailout money to recapitalize failing banks instead of letting them go bankrupt. Unfortunately, recapitalizing the banks hasn't given them any incentive to lend, leading to the current economic downturn that goes far beyond the financial industry. If you don't think so, just go look at the car companies.

Hilzoy, riffing off a two-part New York Times article, discusses the problems that have been created, including moral hazard and propping up failed banking institutions in ways that cause well-managed companies who are not on the government teat to fail.

I've always thought that one way to deal with this would be to find a way of bailing out firms while sacking their managers and wiping out their shareholders. Bankruptcy does this, of course, but when for some reason letting a firm just go bankrupt looks like a bad option, we ought to preserve the basic principle that even if a firm is saved, the individuals -- investors and managers alike -- who either took or profited from those risks should be slammed.

The point here is not punishment. It's creating incentives not to do stupid things. You might think of it as a way of turning the divergence of interests between principals and agents to good account. That divergence creates problems when an agent (e.g., a manager) who is supposed to be working for a principal (e.g., a firm) finds it in his interests to do things that damage the firm -- for instance, taking risks that produce short-term profits, and thus large bonuses for him, but that place the firm itself at unconscionable risk. But I think it can also be used for good.

In the case at hand, we want a firm (or significant parts of it) to survive, and we think that bankruptcy is, for some reason, not an option. We thereby risk moral hazard. But if we ensure that even though bad things do not happen to the firm, they absolutely do happen to its senior management and its investors, we might be able to create a set of incentives that work against taking unconscionable risks. After all, if managers know that if things go badly wrong, they will abruptly lose their jobs and their bonuses, they will not be nearly as likely to take those risks. And if shareholders know that they will not be made whole, they will be more likely to ask just how much risk a company is taking, and not to accept blithe assurances in place of real evidence.

But we haven't done this. We have not asked managers to resign. We have not tried to separate sound from unsound banks, or parts of banks. We have not tried to purge our financial system of the parts that got everyone into trouble. Instead, we have tried to prop up everyone, and to inflict as little pain on the financial wizards who created this mess as possible.

I think this is a profound mistake.

I thought from the beginning that the best solution was to nationalize the bank, wipe out the shareholders and replace the management, but keep the essential operations going. This was the solution used by the Bank of England with Northern Rock Bank failed because of problems with subprime mortgages. Northern Rock bank was nationalized in February 2008.

In my opinion the main reason this was not done was the belief in free market fundamentalism that permeates the Bush administration, the Republican Party, and some misguided Democrats. True it is an extreme decision, but it would put the good of the financial system and the American people as greater priority than the good of the bank managers and shareholders who are currently the ones being bailed out as the economy collapses around them.

Socialism? No. It's not. It's a form of bankruptcy that allows the financial system-critical portions of the failed organization to continue operating as the rest of the organization gets sold off as would happen is Chapter 7 bankruptcy. Face it. AIG was and remains bankrupt, as to most of Wall Street's investment banks. (I haven't heard of one that is still operating successfully on its own. The business model has failed.) AIG is not a going business. It is on life support because it has too many operations that are needed to keep the rest of financial system operating. In the long term the government does not want to be in the bank operating business, but in the short term it has to step in in some way to keep the financial system operating and help it come back to health.

But the health of the financial system is important to the government only because it is necessary to keep the economy operating. The government should not be bailing out failed managers and investors, which is what the current Bush/Paulson bailout operation is doing.

The Bush/Paulson market fundamentalism bailout is both not working, and too damned expensive. It is also rewarding the exact same people who caused the problem with taxpayer money. It's time for a complete rethink of the financial bailout without ideological blinders on.