ARISE

From the invariably thoughtful Steve Randy Waldman.

Rather than a bail-out, Congress should pass an “ARISE act”. ARISE would stand for Automatic Reorganization of Insolvent Systemically-important Enterprises. It could be very simple.

The Secretary of the Treasury, in consultation with the Chairman of the Federal Reserve and subject to judicial review, would declare certain firms systemically important according to criteria specified by the act. Those firms would be subject to a streamlined form of bankruptcy rather than ordinary Chapter 11 reorganization or Chapter 7 liquidation. The Treasury would compile a list of all systemically important firms, not just those considered to be imperiled, so inclusion would not signal any sort of distress. Should a systematically important firm find itself unable to meet its obligations, it would be subject to a very simple reorganization procedure: common and preferred equityholders would be wiped out (but would be given deep out-of-the-money warrants on stock of the restructured firm), a new class of $1 par value common equity would be established, which would replace existing debt claims dollar for dollar, until the resulting firm would be no more than 4x leveraged and can be certified as conservatively solvent and liquid by independent auditors. Junior debt would be swapped for equity before senior debt, and secured debt would become unsecured. All creditors would have the option of exchanging their debt for equity in the new firm. Further, reorganized firms would have the right to pay off unsecured contingent liabilities (including, for example, liabilities under derivative contracts) in stock at par value rather than in cash.

An intended “unanticipated consequence” of this proposal is that it would make the debt of firms that are potentially “systemically important” much more equity-like, long before any hint of financial distress or reorganization (and even before an explicit listing by the Treasury). That would raise the cost of capital for such firms, serving as a kind of a tax on scale and criticality. Leveraged firms that are “too big or interconnected to fail” create negative externalities for markets, taxpayers, and the public at large. Under the ARISE act, lenders would absorb some costs that the general public would otherwise bear, and would charge appropriately for the insurance. Firms that prefer inexpensive debt financing to the strategic options associated with scale can spin-off independently controlled entities as they grow.

Those who claim this would be a radical abrogation of contract should note that it would only be a change in the bankruptcy code, basically a new form of reorganization. Individuals have been subject to many retrospectively applicable changes in bankruptcy law over the years, and property rights have survived. This change would affect a very small fraction of firms (although a much larger fraction of debt, since it would predominantly affect very large firms).

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3 Responses to ARISE

  1. JC says:

    How exactly would his proposal clean the balance of those firms that are not near Chapter 11 but hold a great deal of radioactive paper?… that is the walking wounded.

    it seems to me this proposal would make things worse. Every time a bank downgrades the value of the problem assets other firms have to follow suit and mark their own paper at a lower value. This is what’s been going on.

    For better of worse Paulson’s plan cleans up the balance sheets of those firms that can make it allowing for fresh lending to take place.

  2. A NON FARMER says:

    There are some ‘firms’ out there in the Great South Land that are forced to operate without any support from any financial institutions whatsoever.
    In some ways – thank God for that!

    It is only these last few days that has made a person aware of the complete fraud that has been committed internationally.

    As ‘they’ say ‘at the end of the day’ there is a situation that has been created where an US Gov/t ‘bailout’ of a complete cluster—- cannot be addressed without the US Gov/t printing several more zeros at the base line of the document owed to the rest of the world. Not a problem. All on worthless paper.

    Without any stretch of the imagination – they have blown it – and they are now even more massively in debt.
    In concert with this; US approved financial institutions (to use that term loosely) have essentially been defrauding the rest of the world, blind.
    Without something binding like bullion, productivity, or real specie the US economy is in more trouble than Flash Gordon.

  3. Tel says:

    I don’t quite understand what is wrong with the existing bankruptcy law?

    I mean, in the case of Freddie Mac, the government decides that mortgages are politically sensitive and important for national stability. So, having made such a decision they can walk into bankruptcy court and make an offer to buy those assets from the troubled firm. They can do this under existing law, with no particular “bail out” other than buying key assets that they don’t trust to the harsh hands of free trade.

    Having bought themselves political protection, the government can rewrite those contracts with additional clauses (whatever they think will do the job) and then sell them back into the market (presumably for less than the purchase price). Maybe hold them long enough for things to settle or sell them a bit at a time as they find someone they feel might be responsible enough to hold these assets.

    I would have thought that, with any firm holding ownership of critical infrastructure (water supply, electricity, etc) we would expect the same safety net to exist FOR THE ASSET. Since the firm sitting in Chapter 11 can’t exactly say no to any offer, the government only has to offer one dollar more than the highest private bidder (which won’t be high) and they only ever buy the assets, not the failed firm. Certainly they have no need to buy any senior employees who were probably the reason the firm failed in the first place.

    With assets sold, the firm goes through bankruptcy just like normal, cents in the dollar, that sort of stuff. Creditors squabble over the corpse, but the key assets are gone so no one cares.

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