Legal Commentary

The Treasury Bailout is not rocket science

By Tom Kirkendall

The debate over the proposed Treasury bailout of Wall Street firms is coming at a fortuitous time -- the election season. Be wary of any candidate who, after looking appropriately concerned about the dire predictions of the plan's promoters, throw up their hands and vote in favor of the bailout because "we just have to do something" even if they don't understand what they are doing.

The fear mongering that the promoters are using to sell the bailout is laughable. This is not rocket science.

For example, when Enron tanked in late 2001, it was one of the largest publicly-owned companies in the U.S., the market-maker in the natural gas trading industry and an leader in hedging corporate risk through structured finance transactions.

As a result of the Enron bankruptcy and the government's demonization of the company and its leaders, the trading industry nearly fell apart completely, costing companies and their customers untold billions of dollars that they otherwise could have saved through hedging risk. Similarly, the market for many structured finance transactions dried up, also costing companies another valuable avenue for hedging risk of loss.

Not one government or Wall Street leader proposed a bailout of Enron in order to preserve the huge value to the public of the natural gas trading industry and the market for structured finance transactions. As a result, Enron's bankruptcy prompted enormous tremors through various industries -- particularly the energy industry -- because valuable resources for hedging risk of loss had evaporated seemingly overnight.

However, the financial system did not break down. Companies adjusted to the changed circumstances and endured their additional costs as best they could. Markets also adjusted. Slowly but surely, both the natural gas trading industry and the market for structured finance transactions rebounded so that both are again providing companies with valuable alternatives for hedging risk and saving money.

Now, the tables are turned on Wall Street. Its politically well-connected leaders are weaving their tales of doom for the economy to compliant governmental leaders who are only too willing to their bidding.

In reality, each of these Wall Street firms should be required to endure the same thing that Enron and its creditors did -- a chapter 11 reorganization where equity gets wiped out and creditors either take a haircut on payment of their debts or convert their debt to equity in a reorganized firm that emerges from bankruptcy with a cleaned-up balance sheet.

That process ensures that investors and creditors who undertook the risk of investing or dealing with the bankrupt firms share the losses of their risk-taking. Moreover, it allows the firms that really are worth saving (as opposed to simply liquidating) to emerge from bankruptcy with an improved financial condition that should provide the firm with an enhanced opportunity to create wealth again.

What the bailout plan proposes to do is insulate investors and creditors from risk of loss by having the government -- funded by taxpayers such as you and me -- undertake that risk. There is simply no moral justification for foisting that risk on taxpayers and the only possible practical justification is that sorting all of these firms' problems out in chapter 11 might take awhile.

But even if the government saw fit to accelerate the Wall Street reorganizations to hedge the risk of a prolonged economic downturn, there is simply no reason for the government to overpay for assets from financially-troubled firms. Rather, the government should simply propose a plan that implements the going-concern liquidation and debt-for-equity reorganization features of chapter 11 on an accelerated basis in return for some reasonable financial contribution to the process. And you can bet that contribution doesn't need to be close to $700 billion.

Luigi Zingales, the Robert C. Mc Cormack Professor of Entrepreneurship and Finance at the University of Chicago, has written the most cogent piece I've seen to date on why the bailout is a bad idea. Even though it was wrong for the government to contribute to the massive amounts of wealth destruction that resulted from the demonization of Enron, the government was right not to bail out Enron. The circumstances are different now, so perhaps a different approach is more prudent than simply allowing all of these Wall Street companies to be sorted out in chapter 11.

But throwing $700 billion at investors and creditors who should be sharing the losses of their risk-taking is not even close to the best way of doing it.

Full post as published by Houston's Clear Thinkers on September 24, 2008 (boomark / email).