A couple of months ago, I posted about the problem of debt overhang in the financial sector. The problem is a conflict of interest between debtholders and equityholders when the debt becomes risky and there is no small chance that equityholders claims will be wiped out. The post came after I made a presentation at the Cato Institute. The brief paper I wrote for that conference is here. Last week, I made another presentation at the Vermont Economic Outlook conference focusing on the same ideas, with more background and some discussion of why financial institutions are different than non-financial institutions. The slides from that presentation are here.
In brief, the government has three places where it can intervene when there is a looming bankruptcy:
We can think of #1 as foreclosure relief to households unable to pay their mortgages. I refer to #2 as "bailout in lieu of bankruptcy." We can think of #3 as the Fed's interventions to make credit more widely available.
My main point continues to be that "bailout in lieu of bankruptcy" substitutes a reduction in taxpayers' disposable income for a reduction in the claims of non-insured debtholders of the distressed firm or bank. I see no justification for this. It is special interest politics in one of its worst forms. We have procedures for bankruptcy for both financial and non-financial firms. We should use them, and then consider some variant of #3 in the most extreme cases.
For more on this topic, see this post by Eugene Fama at his new blog with Ken French, where he puts it quite succinctly:
When this prescription is followed, the bad news is that the failed bank has been nationalized (I hate nationalization), but the good news is that nationalization is accomplished without a taxpayer subsidy to the bank's debt holders. I suspect the Fed and the Treasury think they avoid nationalization (or at least perception of it) if they inject equity capital into a bank without solving the debt overhang problem. This is an illusion. The bank has been nationalized, but in a more expensive way. The additional expense is the subsidy to the old debt holders because of the debt overhang problem.
The FDIC's powers are written so that taxpayers should not have to pay when a bank goes bad. The logic is that the bank's stockholders and its lower priority debt holders get the benefits when the bank does well so they should pay the costs when it does poorly. Stockholders and lower priority debt holders should be pushed out of the game until the value of the bank's assets are sufficient to cover its remaining liabilities. My view is that this blueprint should be followed when the subsequent injection of equity capital that a failed bank needs to survive comes from the public sector (the Treasury or the Fed), as well as when it comes from the private sector. It produces all the benefits of a recapitalization without a taxpayer subsidy.