English is a metaphorical language. This leads most members of the press to welcome colorful phrases like government bailouts, zombie institutions, and toxic assets. As in a horror movie, the black magic of extensive bailout credit support creates zombie institutions that transcend their natural death from accumulated losses on soured business plans and feed ruthlessly upon the resources of taxpayers and competitors (Kane, 1989). As long as industry lobbying can persuade the government to continue “bailing,” safety-net managers can keep a huge herd of zombies on their feet. Other things equal, the size of the safety-net subsidy that a zombie firm enjoys increases with depth of the hole in its enterprise-contributed net worth and with the degree of counterparty, interest-rate, and default risk that it can manage to load into its portfolio. (The term “enterprise-contributed” is employed to underscore the need in valuing zombie stock to strip out the value of government support.)
Bailout programs spread rather than cure “zombieness” and make the officials that administer them look like dupes. In praising the TARP program, the AIG rescue, and the Fed’s willingness to lend on increasingly poor-quality collateral, industry spokespersons refuse to acknowledge how severely a firm’s zombieness distorts its risk-taking incentives. The industry’s dirty little secret is that zombies do not want to surrender their holdings of “toxic assets” for anything approaching a fair market value. Far from it. Cheap volatile assets with a huge upside are precisely the kinds of option-like investments that clever zombie managers are energetically looking for.
High-risk assets are attractive to zombies because the safety net promises to absorb the downside of further loss, while the upside provides a small, but palpable chance of filling the gaping holes in their balance sheets. To a zombie, dicey projects that have negative present value make sense as long as they show a small chance of a very large payoff. High-stakes gambles may represent the firm’s only prayer of paying off its government loans and guarantees. During the S&L mess, zombie managements booked a series of longshot loans and investment. Only a few of them experienced good luck with their bets. These fortunate firms restored themselves to health, while taxpayers footed the bill for their unlucky confreres.
In today’s crisis, it is hard for large zombie firms to lay down dicey bets in sufficient volume. Taxpayers are so angry that the press and government are peering anxiously over most zombies’ shoulders. However, because they could advertise it as a public-spirited act, if the TARP program had actually held the common-value auctions that Secretary Paulson originally envisaged, instead of taking toxic assets off their balance sheets, zombies would have unloaded their truly worthless trash on the Treasury and found ways to end up as net purchasers of securities based upon deeply discounted instruments.
If the government were to offer prices high enough to persuade zombies to surrender underperforming assets that carry a long shot option, it would set a horrible precedent. But the Fed’s still evolving $1 trillion Term Asset-Backed Securities Loan Facility (the TALF “re-securitization” program) promises to prove only slightly better. Starting on March 25th, TALF will allow zombies and nonzombies alike to keep their longshot options open while borrowing for up to three years on the worst-quality collateral the program makes eligible. Initially, eligible collateral is limited to recently issued AAA securities backed by consumer loans, but that is only the program’s starting point. One must expect the definition of eligible collateral to expand over time to include older securities that slow-moving and incentive-conflicted credit rating organizations prove willing to rate as investment grade. Throughout the process, zombies will try to load up on the most-toxic tranches of whatever asset-backeds TALF officials float back into private hands.
The efficient solution is for the government to commit firmly to a plan that would identify the zombies by forensic accounting procedures and recapitalize them in a way that would treat government and private suppliers of new funding in an equitable way. It is disinformational to claim that “financial institutions must be kept in private hands at all cost.” Private financial institutions would not disappear if safety-net support for zombie shareholders were withdrawn. Their assets would not disappear either. Rather the creditors and other counterparties of troubled firms could be made to absorb their fair share of losses and private entrepreneurs would -- after a period of temporary government conservatorships -- reorganize the industry.
George Bernard Shaw famously said that when you are robbing Peter to pay Paul, you can count on the support of Paul. Taxpayers need to take a lesson from community banks. These banks -- which had remained quiet until now -- complained loudly about the cost to them of funding a proposed 20 basis-point assessment that the FDIC was authorized (if not actually obliged) to levy on them (Adler, 2009a). In less than a week, these firms were able to forge a deal that promised to cut the proposed assessment in half (Adler, 2009b). Healthy banks understand that unless and until zombie firms are rounded up and relicensed appropriately, authorities’ competence and their own long-term viability will fall increasingly into doubt. In the absence of a program of effective triage, the FDIC’s emergency assessment will serve to refuel zombie competitors and their go-for-broke risk-taking will continue to push industry profit margins to unsustainably low levels. As it did in the S&L mess, zombieness will deepen and spread, making the case for temporary nationalization of wrecked firms stronger and stronger.
Edward J. Kane
Adler, Joe, 2009a. “FDIC’s New Assessment Blasted as Unfair,” American Banker (March 2), p.1.
Adler, Joe, 2009b. “FDIC to Slash Special Fee,” American Banker (March 6), p. 1
Kane, Edward J., 1989. The S&L Mess: How Did It Happen? Washington: the Urban Institute Press.