Bailouts and Deficits or Haircuts: How to Restore U.S. Financial Market Stability

Abstract:     
There is a growing consensus that the U.S. government programs of bailing out the large financial institutions is deeply flawed, and that there are much better ones available. The programs of the U.S. for the purchase of toxic assets potentially transfer trillions of dollars from the US taxpayer to the financial institutions and risk the credit of the U.S. government. Estimates suggest that the troubled asset purchases are inadequate to put the financial institutions on a sound footing. So zombie banks persist, and their avoidance of normal business lending constitutes a roadblock to economic recovery. The right approach is to take the banks that require substantial subsidies into FDIC receivership, wiping out shareholders and giving the bondholders a haircut. Chapter 11 bankruptcy proceedings are another viable option in many cases. The restructured institutions will be re-privatized as financially viable institutions. The smooth resolution of the Lehman Brothers bankruptcy, that financial market regulators assessed occurred with "no major operational disruptions or liquidity problems," shows that the allegation of systemic financial market failure from bankruptcy of a large central player in the counterparty transactions is grossly exaggerated. Crucially, bailing out these institutions provides perverse incentives to financial firms that they can take risks at taxpayer expense, sowing the seeds for the next crisis.

Number of Pages in PDF File: 10

Keywords: financial crisis, bailouts. credit default swaps, bondholder haircuts, deficits, zombie banks, toxic assets, receivership

JEL Classification: G00, G1, G2

working papers series