What is this Bail-Out all about?

I provide three different expert perspectives on what this bail-out actually means. While Legendary investor, George Soros, believes this bailout is likely to be in-effective if the injection is not in the form of equity, and if foreclosure laws are not amended. Professor Luigi Zingales believes the government should leave the task of ‘pricing risk’ to the markets. While Professor Bradford DeLong opines the bailout will result in a paradigm shift in central bank responsibility, making it as an agent responsible for setting not only the price of liquidity, but also as an agent administering the price of risk.

George Soros believes that the injection of government funds would be much less problematic if it were applied to the equity rather than the balance sheet. $700billion in preferred stock with warrants may be sufficient to make up the hole created by the bursting of the housing bubble. By contrast, the addition of $700billion on the demand side may not be sufficient to arrest the decline of housing prices. Something also needs to be done on the supply side. To prevent housing prices from overshooting on the downside, the number of foreclosures has to be kept to a minimum. The terms of mortgages need to be adjusted to the homeowners’ ability to pay. Soros argues that it is essential to modify the bankruptcy law as it relates to principal residences to avoid the real crisis – a vicious cycle of defaults-foreclosures- and house price collapse.

Acording to Luigi Zingales, Professor of Entrepreneurship and Finance at University of Chicago Graduate School of Business, under Chapter 11, companies with a solid underlying business generally swap debt for equity.  Old equity holders are wiped out and old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt-holders can agree to reduce the face value of debt, in exchange for some warrants. The reason why this is unlikely to work is that we do not have time; Chapter 11 procedures are generally long and complex, and the current crisis has reached a point where time is of the essence. Zingales argues that if banks and financial institutions find it difficult to recapitalize (i.e., issue new equity), it is because investors are uncertain about the value of the assets in their portfolios and do not want to overpay. Will government do better at valuing those assets? In a negotiation between government officials and a banker with a bonus at risk, who will have more clout in determining the price? The expert makes reference to the Great Depression, when many debt contracts were indexed to gold. So when the dollar’s convertibility into gold was suspended, the value of that debt soared, threatening many institutions’ survival. President Roosevelt’s administration declared the clause invalid, forcing debt forgiveness. The other problem in the current crisis, points the expert, is that since the many (taxpayers) are dispersed, individuals cannot put up a good fight in the US Congress, whereas the financial industry is well represented politically - for six of the last 13 years, the Treasury Secretary was a Goldman Sachs alumnus!

Bradford DeLong, Professor of Economics at the University of California at Berkeley, believes that with the looming crisis and the proposed bailout, central banks are about to assume a new role, hitherto unheard of. Historically, while the central banking authority administered the price of liquidity in the form of T-Notes and Fed-funds; the price of risk was left to the vagaries of market. And it is the price of risk that is the source of current distress, points DeLong. It is not that the world economy faces a liquidity squeeze - two-year US Treasury notes with a face value of $1,000 will fetch $998 in cash – the lowest liquidity price since the Great Depression. However, the risk premia on non-Treasury assets have soared - annual interest-rate premium for holding a CD issued by a private bank now stands at five percentage points. And it is this rise in risk premia that threatens the global economy. This is the reason why the expert feels the bailout will result in a paradigm shift in central bank responsibility – making it as an agent responsible for setting not only the price of liquidity, but also as an agent administering the price of risk.