Prof. Luigi Zengales (University of Chicago) has presented an interesting alternative to the Paulson Plan. Zengales recommends establishing a special fast-track, pre-packaged form of Chapter 11 Bankruptcy to restructure ailing Wall Street investment banks and get them operating again. By way of encouragement, the Federal Reserve would only open its lending window to investment banks which accept this restructuring.
As I understand it, this plan would force banks that now have opaque, questionable balance sheets to write down and finally accept the diminished value of their devalued mortgage-backed securities. This would be a painful process that would entail corporate restructuring, but the special Chapter 11 Bankruptcy procedures would get these firms solid and running again as fast as possible. Zengales describes his plan thus:
Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants.
Again, as I understand it, the credit markets are freezing because banks are unwilling to lend money to institutions with opaque and questionable balance sheets. This was not a problem before, but now everyone is worried that that these banks are not solvent. This tough proposal would force banks with too much exposure to deal with the "toxic" assets once and for all. Ultimately, this should restore confidence in the financial markets, and the cost would be borne entirely by Wall Street without any infusion of taxpayer cash.
I am intrigued by this "tough love" proposal and I would very much like to hear our bankruptcy experts explain the plan... Because, frankly, I have to admit that really don't understand it. I hope what I have said here is merely distorted instead of dead wrong!