I think John Hussman’s latest market commentary is a must read for anyone following the US Economy and who questions the generally accepted idea that massive amounts of public money is the only solution for insolvent financial institutions. He also addressed the glaring need for government to coordinate (note the absence of the term ‘bailout’) debt restructuring in the mortage market before the next wave (which looks like it will be of significant size) of Alt-A and Option-ARM defaults hit. Hussman has been on this for months, and this article is a comprehensive summary of his major points. If I could some up his point in one sentence, it would be that the government should stop bailing out bondholders and create an environment in which orderly receivership occurs (see Washington Mutual) and also in which orderly mortage debt restructuring can occur. A few key points of his:
From the beginning of the recent crisis, starting with Bear Stearns, I have emphasized that nearly all of the financial institutions at risk of insolvency have enough liabilities to their own bondholders to fully absorb all probable losses without any loss to customers or the American public. The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense….
….The bondholders of distressed financial institutions – not the American public – should bear responsibility for the losses of those institutions. This can be accomplished, without harm to customers or the broader financial system, in one of two ways:
1) The bondholders could voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps , preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like). Alternatively;
2) The U.S. government could take receivership of the financial institution, defend the customer assets, change the management, wipe out the stockholders and a chunk of the bondholders claims entirely, continue the operation of the institution in receivership, and eventually sell or reissue the company to private ownership, leaving the bondholders with the residual. Indeed, this is how the largest bank failure in history – Washington Mutual – was handled so seamlessly last year that it was almost forgettable. This is not Argentina-style “nationalization,” but receivership – a form of “pre-packaged bankruptcy” that protects the customers and allows the institution to continue to operate, followed by re-privatization. This would fully protect all of the customers and depositors at no probable expense to the public.
What should not be done is what was allowed in the case of Lehman Brothers – a disorderly failure, by which the company was allowed to fail with no conservatorship of the existing business. It was not the failure of Lehman per se, but the disorder resulting from its piecemeal liquidation, that caused distress to the financial markets….
….As with financial institutions, insolvent mortgages would best be addressed by a) voluntarily swapping debt for equity, or failing that; b) technical default and restructuring of the debt obligation.
From the standpoint of homeowners, a debt-equity swap is equivalent to writing down the mortgage principal, while at the same time giving the lender an equal and offsetting claim on the future appreciation of the home. As I noted in The Economy Needs Coordination, Not Money, From the Government,
