Bailing Out Rich Guys
The recently tabled scheme to put another $700 billion in bailing out financial firms isn't making economists happy. Ron Paul is upset too: the scheme sounds like bailing out rich guys (investment banker types) at the expense of tax payers.
Professor Raghu Rajan (University of Chicago) has an alternative solution: ask the shareholders of financial firms to recapitalize. Financial firms have been reluctant to raise capital thus far. One difficulty is that an equity issuance may send a negative signal, suggesting to the market that there are more losses to come. It may also be difficult for them to cut dividends to stem the outflow of capital, for such cuts may signal management's lack of confidence in the firm's future. Another difficulty comes from what is known as the debt overhang problem: when a highly indebted entity issues equity, much of the value raised effectively bolsters the value of the risky debt. Because of this value transfer, essentially at the expense of existing equity, equity holders are unlikely to look upon a recapitalization favorably.
Professor Rajan suggests two specific measures. First, all levered financial firms (including banks and investment banks – defining who these are is an important but not impossible detail) should be asked to impose a temporary moratorium on dividend payments. Second, all large well-capitalized levered financial firms should make rights offerings (if the rights are offered at a large enough discount to the market price, shareholders will be forced to subscribe) to their shareholders amounting to 2 percent of their risk-weighted assets. The value of mandating these decisions is that no individual bank sends an adverse signal to the market. And implemented collectively, they could recapitalize the system, with those getting the most upside from a healthy system paying for it.
Restricting the rights requirement only to well-capitalized entities may seem like penalizing shareholders of well-performing firms. But in fact these are institutions that could use more capital very profitably in buying underpriced assets, and taking over weaker financial firms. Authorities could also reward these firms by facilitating acquisitions, possibly through favorable tax treatment. By contrast, forcing weak firms to issue rights risks tanking an already fragile share price, and is not a risk worth taking now.
Most importantly, tax payers are not footing the bill.
Comments (2)
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Simeon- - I believe Prof. Rajan assumes implicitly that the shareholders are more "liquid" than the firms in question. Of course, the Warren Buffets and other heavy institutional investors may fit the bill here. But believe you me, there will not be enough to go around.
Posted by: Daniel Amponsah | Sep 24, 2008 5:04:17 PM
there was a time not too long ago when everyone was talking about the demise of multilateral lending -- that the capital markets had become so efficient...; that cash was so abundant...; that private equity was the wave of the future. now, we are talking about how to nudge positive capital flows from a market that is still essentially over-capitalised, but now scared.
two thoughts: multilateral lending has always been and should always be about providing assistance and stability during financial crises; and multilateral lending should not be subject to market "jitters," but act as an indicator of true value and economic prospects.
on one level, the "baker plan" and the notion of structural adjustments from the 1980s seem misguided. but perhaps in this current climate, there is merit to the potential psychological impact -- stablisation -- such a notion was intended to produce. on another level (as a former UofC alum), this is probably not a time when indirect support to the bottom of the economic "pyramid" through equity stabilisation schemes should be considered.
there is real fear that could cause the "engine" of capital markets to seize up. the failures and reallocations of resources at the top of the system have already begun to filter down to consumers. the real boost needs to be injected at the bottom through cash and incentives that will free up consumer and commercial liquidity which in turn will encourage the financial sector to move more agreesively towrads freeing up capital reserves in the form of free market competition.
such an approach would stop the "blight" caused by the current financial crisis and inject more than government subsidies into an already uncertain market. indeed, by revitalising the consumer side, the immediate benefit to government cash-flow would be significant and alleviate concerns about increased debt service in the near- and long-term.
Posted by: spook | Sep 25, 2008 1:15:19 PM