CHAPTER 24
The Role of Government in Reorganizations*
Bailouts or Capital Infusions?
Too Big to Fail Is a Phony Concept
The Government and Private Sector Are in Partnership Whether They Like It or Not
Wall Street Professionals and Corporate Executives Are All in the Business of Creating Moral Hazards
Taxpayer Bailouts Are a Phony Concept
Strict Regulation of Financial Institutions Is Absolutely Necessary
As we have already pointed out in the previous chapter, there are three ways of rescuing troubled companies so that these companies have odds in their favor that they can be made feasible going forward.
Sometimes capital infusions are made by the private sector. Sometimes governments have to make the capital infusions because no funds are available from the private sector. This occurs at the all-too-frequent times when private markets freeze up because these markets, for these purposes, are notoriously capricious and grossly inefficient. All sorts of businesses, especially most financial institutions, need continuous access to capital markets. Capital infusions are their lifeblood. Sometimes the infusions have to be supplied by governments.
BAILOUTS OR CAPITAL INFUSIONS?
To economists, capital infusions by governments are known pejoratively as bailouts. It isn’t necessarily so. It certainly isn’t so if the government earns a reasonable profit from the capital infusion and/or otherwise obtains productive concessions from the entities that receive the capital infusion. To distinguish between a bailout and a capital infusion, a bailout exists where a capital infusion is made into an economic entity with no prospect of any return whatsoever. If a return is expected, however measured, it is a capital infusion.
In many recent cases—Lehman Brothers, AIG, Citigroup, Fannie Mae, Freddie Mac—it would have been extremely difficult, if not impossible, to either reorganize or partially liquidate each company in order to rehabilitate it. This was the case whether the rehabilitation would have taken place through voluntary exchanges or by seeking court protection, usually under Chapter 11. First, voluntary exchanges frequently don’t work since, as we have already pointed out in the previous chapter, in the United States no creditor can be compelled to give up a right to a money payment unless the individual creditor so consents, or a court of competent jurisdiction, a Chapter 11 Court, imposes an automatic stay on payments. Seeking Chapter 11 relief (or its rough equivalent from a State Insurance Department), might not contribute to an effective rehabilitation since many assets of troubled issuers, such as derivatives, don’t deliver to the troubled issuer the benefits of the automatic stay. Thus, as if almost by default, the preferred method for rehabilitating troubled financial institutions in 2008–2009 was making capital infusions by the government and government agencies.
The basic problem with the various government stimulus packages certainly has nothing to do with the taxpayer bailouts or whether or not the returns to the government agencies from providing the financing result in an accounting profit. Rather, the problems revolve around quid pro quos. There was an apparent failure of the government to negotiate terms for the capital infusions, which might have compelled various financial institutions in return for the government’s capital infusions, to undertake actions, which would have been beneficial to the economy even though they entailed realizing losses for the financial institutions.
EXAMPLE
One quid pro quo could have been the required restructuring of large amounts of underwater residential mortgages held as assets by the financial institution receiving the capital infusion. Another quid pro quo might have revolved around counterparty risk inherent in derivatives, such as Goldman Sachs, under the threat of AIG insurance subsidiaries entering state-supervised conservatorship, might have been coerced into compromising its claims as a policyholder of credit default swaps.
Admittedly such strong-arm tactics probably were politically unfeasible. However, we bet that if it were private, profit-seeking entities negotiating the terms for capital infusions into troubled companies, lots of strong-arm compulsion would have existed. Quid pro quos would have occurred.
TOO BIG TO FAIL IS A PHONY CONCEPT
Bank holding companies and commercial banks are two different financial institutions. Bank Holding Companies own the common stocks of commercial banks, frequently the common stocks of other eligible businesses and perhaps other assets. Bank holding companies are financed conventionally—perhaps with several layers of debt, mostly publicly held preferred stocks and publicly owned common stock.
Commercial banks are primarily financed by deposits plus, to a much smaller extent, loans from U.S. government agencies.
Failure of a financial institution occurs when the holding company’s common stockholders are wiped out, or almost completely wiped out, whether that holding company is a bank holding company, an insurance holding company, a broker-dealer holding company or another type of holding company. Thus, in 2008 and 2009 many giant financial institutions did, in fact, fail. Such failures included AIG, Citigroup, Lehman Brothers, Fannie Mae, Freddie Mac, Bear Stearns, GMAC, and Countrywide Financial. With the possible exception of Lehman Brothers, all of the above-named failed companies are still in business.
Those inexperienced in rehabilitating companies don’t really mean Too Big to Fail. They mean:
Too Big to Be Reorganized or Liquidated in an Uncontrolled, Contested Proceeding Whether Out-of-Court or in Chapter 11.
The solution to preventing Lehman-type debacles seems to be not to restrict the size of financial institutions, but rather to set in place mechanisms whereby financial institutions—large and small—can be reorganized, if troubled, via prepackaged, prenegotiated plans of reorganizations (POR) where relevant government regulators have a strong influence on what the POR will be. The reorganization of General Motors, Chrysler, and CIT, all accomplished after less than 60 days in court, may have set a very good precedent for where major U.S. reorganizations ought to go.
In other countries, the existence of giant financial institutions doesn’t seem to cause a problem. Canadian finance seems to function extremely well, dominated by five super-large commercial bank holding companies.
Most financial institutions need relatively continuous access to capital markets to refinance short-term indebtedness of all sorts. As such, even well managed companies can be in trouble when markets freeze up as they did in 2008. Mechanisms ought to be in place to provide capital, and/or expeditiously reorganize these companies, which are reasonably well managed but lack access to capital markets. Badly managed companies ought to be permitted to be sick—that is, go out of business either through liquidation or the reorganization process. This is the case regardless of the size of the enterprise. The thing that ought to be avoided in the United States at any rate is uncontrolled reorganizations and liquidations; these are inordinately expensive and inordinately unpredictable. Very little will be accomplished, we fear, without intelligent courts, and intelligent, powerful regulators.
THE GOVERNMENT AND PRIVATE SECTOR ARE IN PARTNERSHIP WHETHER THEY LIKE IT OR NOT
The real environment that exists is that the government is part of the problem and part of the solution. The private sector is also part of the problem and the solution. If you don’t believe that the private sector is part of the problem, look at the ultrapoor performance of various parts of the private sector in the last thirty years ranging from the 2008–2009 fiasco in residential housing and going through the myriad of failed companies in automobile manufacturing, textiles, shoes, TV set manufacturing, steel, motion picture exhibition, real estate, and retailing, among others.
It is important for the government to provide meaningful incentives to the private sector, and, in general, the government should earn reasonable returns for providing such incentives. There are myriad relationships between the private sector and the government. There are three areas, though, where the private sector reacts instantly, massively, and efficiently to government policies. It is as if government policies, in reality, direct the invisible hands that Adam Smith wrote about in 1776. These three areas are tax policy, credit granting, and credit enhancement.
In terms of tax policy, much more important than the tax rate are tax provisions that give the private sector incentives to undertake activities that might be highly productive. For example, there seems to be a crying need for the private sector (rather than the government) to be making equity investments in financially troubled companies. Corporations such as AIG, General Motors, Chrysler, and Citigroup, all have hidden assets, in the form of billions of dollars of unused tax loss carryforwards. It would be highly productive if Section 382 of the Internal Revenue Code (IRC) were repealed or amended to eliminate the change of ownership rules in order to ensure that these tax loss carryforwards would be available to offset future income taxes that would otherwise be payable by such companies. Under Section 382, the issuance of a significant amount of new stock by a troubled company could result in a change of ownership, which could dramatically reduce the ability of the issuing company to use its tax loss carryforwards. The change of ownership rules deter financially troubled companies from issuing significant equity, which could provide much needed capital for use in expanding their existing businesses or in acquiring new and potentially highly profitable businesses. Under present law, it is pretty much impossible for a troubled company to issue significant amounts of new shares of its common stock without sacrificing the ability to use its net operating loss carryforwards.
Tax loss carryforwards become a tremendously valuable asset for troubled companies insofar as:
The repeal of the ownership change rules would encourage the country’s leading entrepreneurs, investors, and investment bankers to make massive equity infusions into troubled companies. Furthermore, equity capital would improve the issuers’ balance sheet, but fear of triggering an ownership change drives companies to borrow, which overextends them.
The virtual ban on the trafficking in tax losses is a relatively new phenomenon. The current version of Section 382 was promulgated as part of the Income Tax Reform Act of 1986. In our opinion, it is likely that increases in productivity from the repeal of Section 382 would far outweigh the losses of tax revenue for the government.
WALL STREET PROFESSIONALS AND CORPORATE EXECUTIVES ARE ALL IN THE BUSINESS OF CREATING MORAL HAZARDS
The environment for moral hazard exists where an activist can create a situation vis-à-vis a passivist, so that the activist can believe “Heads I Win; Tails I Don’t Lose or I Don’t Lose Too Much.” That’s what corporate executives do vis-à-vis their stockholders. That’s what Wall Street professionals do as underwriters, salesman, investment bankers, hedge fund general partners, leverage buyout general partners and mutual fund managers.
Economists seem to believe that much of the problem in commercial banking revolves around moral hazard—banks financed largely with government insured deposits could take special risks in lending because if the loans turned bad, the government would bail out the depositors. Virtually all these commercial banks were, and are, wholly owned subsidiaries of holding companies. Insofar as the banks took excessive risk, holding company security holders were compromised, or in many cases virtually wiped out (see Citigroup Common). Prior to 2008–2009, bank management caused the banks to take risks for which they were not close to adequately compensated. The blame for these management shortcomings seems not to be on moral hazard, but rather incompetence and a follow-the-herd mentality.
We are troubled by all these moral hazard attacks. First, we’ve never met a bank executive who did not care very much about the interests of the holders of holding company common stock. Second, and more important, if moral hazard were eliminated, we fear the economy would be much less innovative and productive than it is.
TAXPAYER BAILOUTS ARE A PHONY CONCEPT
In Chapter 11 proceedings, there are questions of substantive consolidation, for instance, should a parent company and its subsidiaries be treated as one entity for reorganization or liquidation purposes, or should they be treated as separate entities. The government is the government; it is not the taxpayers unless one stretches the concept of substantive consolidation beyond reason. If the government provides financing to the private sector on a basis where there are positive returns to the government or the country, there has been no bailout. If the government provides financing to private sector entities at a loss to the government or the country, then it is the government providing bailout funds, not taxpayers who can be deemed to be the equivalent of common stockholders. In the first instance, the funds for the “bailout” are provided to the government by lenders to the government, such as the Chinese much more than average taxpayers.
The concept of taxpayer bailout seems to be a pejorative uttered by sincere people who do not understand that capital infusions can be an extremely useful tool, but only one tool, useful in the rehabilitation of financially troubled entities.
A REVOLUTION IN CORPORATE REORGANIZATIONS AND LIQUIDATIONS MAY HAVE OCCURRED IN 2009 WITH THE CHAPTER 11 REORGANIZATIONS OF GENERAL MOTORS, CHRYSLER, AND CIT CORPORATION
We are the authors of, Distress Investing—Principles and Technique (John Wiley & Sons, 2009). We finished writing the book in December 2008. At that time, we never dreamed that if a major corporation like General Motors filed for Chapter 11 relief that anything could be done in the short term. Rather, we thought it had to be an uncontrolled proceeding full of uncertainties, with an unpredictable outcome, lengthy and very, very expensive with administrative costs probably running to several billion dollars. In our book we pointed out how important it was to have controlled reorganizations or liquidations: prepacks, prearranged, or whatever. At the time, we wrote that controlled reorganizations appeared doable only for small companies.
Perhaps General Motors, Chrysler, and CIT have set a new precedent that will give rise to new legislation that will permit, and even encourage, all sorts of troubled issuers to reorganize expeditiously in a controlled manner while still preserving creditor rights. If so, such developments would be highly constructive for the U.S. economy.
STRICT REGULATION OF FINANCIAL INSTITUTIONS IS ABSOLUTELY NECESSARY
The enormous success of the mutual fund industry over the last twenty-five years seems directly attributable to ultrastrict regulation under the Investment Company Act of 1940 as amended (the Act). Because of the strictness of the Act, investors woke up to the fact that the industry could be trusted; fund investors would get a fair shake. There is no question that the existence of the Act has stifled initiative, is very expensive, is sometimes unfair and places burdens on a fund manager, such as ourselves, that we’d rather not have. Granting this, we have no question that the existence of the Act has been beneficial to the Industry.
In seeking strict regulation for other financial institutions, legislation might well look at the Act as a template for regulation, adapting the principles of the Act to the regulations of other financial institutions all of whom are vastly different from mutual funds and need vastly different regulations. Comprehensive regulation should cover the various areas covered by the Act: asset composition; how financed; how operations are conducted; executive compensation; corporate governance; disclosure requirements; and income tax issues.
SUMMARY
Making capital infusions into troubled companies is one of the three methods available to rescue these entities so that they have odds in their favor that they can be made feasible going forward. Sometimes capital infusions are made by the private sector. Sometimes governments have to make the capital infusions because no funds are available from the private sector. This occurs at the all-too-frequent times when private markets freeze up because these markets, for these purposes, are notoriously capricious and grossly inefficient. All sorts of businesses, especially most financial institutions, need continuous access to capital markets. Capital infusions are their lifeblood. Sometimes the infusions have to be supplied by governments. The concepts of taxpayer bailouts and too big to fail are phony concepts, and we explain why. The government and the private sector are in partnership whether they like it or not. A revolution in corporate reorganizations occurred with the reorganizations of GM and Chrysler. It is clear to us that strict regulation of financial institutions is necessary.
* This chapter contains original content and parts of the chapter are based on ideas contained in the 2005 4Q letter to shareholders.