In a capitalist world losers take losses and winners gain. Well, that was the world we lived in previously. Now equity holders, who are supposed to be wiped out in an insolvency are not allowed to fail and debt holders in private companies are insured by the government.
Instead of protecting those who made bad bets it would make more sense to use our existing rule of law to address the situation. That should mean that we allow weak players to fail and organize the orderly transfer of good assets from weak hands to strong hands. The Government can keep using misdirection to put the burden on the taxpayer by citing “financial stability”. Should the obligation lie with the taxpayers or should it remain with bad risk managers and be wound down in an orderly manner? One thing is for sure, the Government you have elected is inoperative.
Below is an idea that I believe would have been more prudent and would not increase moral hazard.
Prepackaged bankruptcy / reorganization plan:
1- MBS Debt ($3.5 trillion): Why not give OFHEO or the new regulator a large line of credit <$500 billion> (just as the FDIC has $30 billion) that can be used to assure MBS holders their timely payments. Over time that line will be repaid to Treasury by the running off of the portfolios, natural foreclosures, and PMI. The GSE MBS will likely incur little loss over time as these debts are backed by real assets and little leverage.
2 – Senior debt of the Companies ($1.5 trillion): Senior debt holders had always understood that all offering circulars, risk weighted capital documents, etc. stated clearly that the debt was not backed by the Federal Government. These holders should, in exchange for their current debt, receive $.90 cents of new long dated senior debt in the reorganized Company and $.10 of new subordinated debt. This would effectively result in the Companies having enough capital (about $150 billion of new capital) to genuinely deserve AAA ratings on a stand alone basis. The new capital should be used solely in support of their core chartered mission. Here is where the bulk of losses ultimately will come from. It is where the leverage is, where the speculation is and where the weakest assets are.
3 – The Government should require that on a going forward basis the Companies should have minimal portfolios and they should be solely for liquidity purposes.
4 – This approach would allow them to, with a well capitalized balance sheet, meet their social mission.
Every day they are allowed to issue more corp debt they are growing their moral hazard position, the Government proposal of 6pm fuels that risk taking. Every time the Government allows investors to believe they will bail out the senior debt holders it becomes harder for them to do otherwise and take the right, confidence building, moral hazard reducing thing.