Congress Should Pass an ARISE Act for Systemically Important Firms

The following expands on ideas from a previous post, but is similar in spirit to a wonderful essay by Luigi Zingales (hat tip Tyler Cowen, Arnold Kling). If you have not read that, please do. I think it is the most important document to have arisen from this debate this far.

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Rather than a bail-out, Congress should pass an "ARISE act". ARISE would stand for Automatic Reorganization of Insolvent Systemically-important Enterprises. It could be very simple.

The Secretary of the Treasury, in consultation with the Chairman of the Federal Reserve and subject to judicial review, would declare certain firms systemically important according to criteria specified by the act. Those firms would be subject to a streamlined form of bankruptcy rather than ordinary Chapter 11 reorganization or Chapter 7 liquidation. The Treasury would compile a list of all systemically important firms, not just those considered to be imperiled, so inclusion would not signal any sort of distress. Should a systematically important firm find itself unable to meet its obligations, it would be subject to a very simple reorganization procedure: common and preferred equityholders would be wiped out (but would be given deep out-of-the-money warrants on stock of the restructured firm), and a new class of $1 par value common equity would be established, which would replace existing debt claims dollar for dollar, until the resulting firm would be no more than 4x leveraged and can be certified as conservatively solvent and liquid by independent auditors. Junior debt would be swapped for equity before senior debt, and secured debt would become unsecured. All creditors would have the option of exchanging their debt for equity in the new firm. Further, reorganized firms would have the right to pay off unsecured contingent liabilities (including, for example, liabilities under derivative contracts) in stock at par value rather than in cash.

An intended "unanticipated consequence" of this proposal is that it would make the debt of firms that are potentially "systemically important" much more equity-like, long before any hint of financial distress or reorganization (and even before an explicit listing by the Treasury). That would raise the cost of capital for such firms, serving as a kind of a tax on scale and criticality. Leveraged firms that are "too big or interconnected to fail" create negative externalities for markets, taxpayers, and the public at large. Under the ARISE act, lenders would absorb some costs that the general public would otherwise bear, and would charge appropriately for the insurance. Firms that prefer inexpensive debt financing to the strategic options associated with scale can spin-off independently controlled entities as they grow.

Those who claim this would be a radical abrogation of contract should note that it would only be a change in the bankruptcy code, basically a new form of reorganization. Individuals have been subject to many retrospectively applicable changes in bankruptcy law over the years, and property rights have survived. This change would affect a very small fraction of firms (although a much larger fraction of debt, since it would predominantly affect very large firms).

Comments

[ineedacookie:]

Well, here’s something that goes beyond the trivial discussions that go on within seekingalpha; Something that’s beneficial & important especially to you here on seekingalpha. Today we are going through a financial crisis in the world and its concentrated within the US. Changes are occurring at a rapid pace and we have reached a point right now where we have hit a crossroad for what the world's future would be like the next decade; (1) one road leads to a collapse of our economic system that will destroy the country's ability to preserve jobs & create future jobs, lead to destruction of the remaining value of what we own & earn, lead to higher costs for you, your family (grandparents & sons & daughters), and friends who'll no longer be able to scrape by to pay for housing, food, healthcare, and transportation, and lead to government control that goes beyond anything we can imagine today; OR (2) the other road that leads to flushing our economic system to preserve our ability to create future jobs, save the value of our livelihoods & standard of living for all of us, and salvage our base freedoms & rights to prosperity-which have been undermined but we need to atleast preserve the base that we have today so we can fight to reclaim all our freedoms & deserved rights that any world citizen should enjoy.

Anyways, this is what brought me out of my apathy, getting turned on to an amazing man fighting for us, Karl Denninger who put up this 10 min video that lays out what happened to our financial system from banks down to us these past 5 yrs in a comprehensive, logical manner;
www.youtube.com/watch?...

Here is the SOLUTION he posted today, September 21, 2008. Very important - Watch this:
www.youtube.com/watch?...
Again this solution is a document you can read through and has been submitted to the senate this weekend. It has been hand-signed and distributed to each member of the Senate Banking Committee and hopefully is considered there.

This is the solution & the best, realistic shot at starting to address & fix the problems we are facing today. All I ask of you is to check out the videos, consider it, think about it, discuss it, share it with others, distribute it please. At the very least this will create much needed discussion amongst us for a realistic solution today or at the very best it will lead to the first step in many to halt a finacial collapse & stop a government shutdown on the people, preserve our ability to financial prosperity and ability to get a job (a good paying one in this country), and provide an example for others to follow. It can lead to a much brighter future for our ourselves, our families, and friends.

Please tell me what you think and copy/paste this to others you know.

Thank You,
Pete
(I had not had any communications with Karl Denninger, however since he moved me to get out of my seat & do this, I copied and pasted this message to him and I hope he appreciates this message as a token of respect to the message he is fighting to get out to the rest of us).

2008 Sep 22 03:43 AM

[biomedlives:]

Though I like this proposal, I believe that it's also important to have capital requirements and other regulations that keep financial firms away from the brink of failure. I also think we need to keep in mind William Poole's comment in an SA piece a few months ago: "On the too big to fail issue, I don't think it is the size of firms alone that is the problem. For example, suppose that we take a firm too big to fail and break into two smaller firms of one half the original size. If the factors that would have caused the one large firm to fail would have also caused the two smaller firms to fail, then we really haven't accomplished much, the size of the banking disaster will be the same."

2008 Sep 22 08:56 AM