Bankruptcy

The Bailout -- another perspective (part 1)

By Stephen Lubben

First, I want to thank Bob Lawless and the rest of the Credit Slips folks for having me back yet again -- I'm getting to be like the guest who would not leave.

Second, while it might make me part of the "establishment," I'm going to say right from that start that I join those who favor the bailout.

I also think we need to avoid a whole lot of knee jerk reactions that are floating around out there -- like the SEC's ban on short selling, which is quickly becoming the Bad Management Protection Act of 2008.  Of course, the notion that the administration can open the door on this issue "just a little" is also equally suspect.

I view the economy and the larger financial system as being at a Titanic like moment:  post iceberg, per submersion.  It is certainly reasonable to disdain those who got us into this situation, but I'm not going to let my feelings for them get in the way of saving as many people as possible.

That said, I understand why there is a good deal of skepticism about the bailout.  In part chapter 11 is to blame -- there has been almost no effort to explain why AIG is different from Enron, United Airlines, or any other really big corporation that has recently failed.  And the financial industry needs to fess up that it blew its chance to self-regulate the credit default swap market -- too many people, even myself to some degree, bought the "trust us, we're experts" line from ISDA and other market players.

No wonder people aren't buying that line in connection with the bailout -- especially when the administration has its own credibility problems in this regard in connection with other big, complex projects in the non-financial area.

More on the chapter 11 issue, and why I think the administration has done a terrible job of selling this but still generally support the bailout, after the jump.  I'll save my thoughts on the CDS market for another post.

One of the reasons why I believe that the bailout has been greeted with such widespread skepticism is the complete lack of explanation by the Fed/administration.  Yes, they're starting to talk to Congress, but who is going to speak directly to the rest of the country?  And, as Bob has previously noted, there is a serious lack of transparency here.  We still don't know what the precise terms of the AIG warrants are, the only clear information coming from a cryptic 8-K that says almost nothing.

In this environment, I think is fair to ask why this is not just more of the same kind of panicky talk we've always heard from executives that get themselves in too deep.  The Penn Central executives pleaded for a bailout, auto industry executives have pleaded for bailouts (with occasional success) for three decades.  Yet today it is quite common for big corporations to enter bankruptcy without the world coming to an end.  Why are AIG et al. any different?

The short answer is that chapter 11 is much more suited to "real economy" firms.  Even before 2005, financial firms were going to have a tough time reorganizing under chapter 11.  The Code really can't force people to trade with a debtor unless they are under contract -- hence the much talked about "critical vendor" motions in big chapter 11 cases.  The 2005 amendments to the Code made a financial firm's entire business the subject of a critical vendor motion:  even folks under contract don't have to continue trading, because most financial instruments are now outside of the Code.

So Congress might want to rethink some of the 2005 amendments -- no news flash there.  But I think we also need to think about how much of our economy is presently "financed."  Retailers, car dealerships, mortgage lenders, and major trade creditors have all gotten used to the notion that they can quickly free up their capital by moving these credits into the financial market.  The entire private equity concept relies on debt finance.  Leverage is a pillar of our financial system.  Forgoing the bailout likely means freezing up the financial system for a good, long time -- are we really ready to say no home or car loans until 2010?

To be sure, the financial market and its cheerleaders (ISDA and others -- more in my next post) really seem to have believed their own "it will never rain again, the sun will shine forever" rhetoric.  That's why this bailout needs to be a tool for ripping the Band-Aid off and forcing the market back to reality. Diluting shareholders might be a good way to start the process, while also protecting against a windfall to the industry -- if shareholders don't like it, they should hold their elected directors accountable.

The financial industry also needs to be told this is the a gun buyback program -- turn in your bad stuff now, in the future we show you no sympathy and you get the Lehman treatment.  This avoids the holdout problem that some have talked about.  But we still need the bailout, and the American public needs to be told exactly what is at stake.

In part 2 I'll talk about the implications for the CDS markets.

(edited for grammer and clarity)

Full post as published by Credit Slips on September 23, 2008 (boomark / email).