I’m still shocked at the speed with which bipartisan elites
coalesced around TARP. 

A key reason: The proffered alternatives were incredibly painful. No bailouts
would have meant bankruptcies much bigger and more complicated than Lehman–and
that bankruptcy ostensibly threatened
short run cash flows around the world.

Voters don’t want pain. Yes, some voters want to see virtue rewarded and
wickedness punished–they may even claim that the pain is good for you–but the
rest of us want our medicine to taste good. 

This stark choice between 100% bailouts and a cluster of possibly 1907-panic-inducing
megabankruptcies was totally unnecessary. 
Did the big banks need equity injections?  Well, there were plenty of potential
shareholders available for Citi, BofA, and all of the other TARP recipients.  And they had a name: “bondholders.” 

The economist’s version of bankruptcy (not the lawyer’s version) is simple: If what
you contractually owe is (very likely) greater than the value of your assets,
then you’re bankrupt.  It’s not primarily
about missing a payment: It’s about the prediction that you won’t be able to
repay everyone you’ve made promises to.  If
your assets can’t pay off all your debtholders (including depositors) then it’s
time to head to court. 

But all corporate bankruptcy means (again, to an economist, not a lawyer) is
that some of the bondholders get turned into shareholders: Instead of getting the
$10,000 you were owed, you get shares that will probably be worth much less.  In the simplest case, the shareholders get
nothing (they had their chance to run the firm and blew it), the bondholders
become the new shareholders, and the firm keeps right on running.  Seems like something you could do over a

You might think “Banks can’t do this: they don’t have bondholders, they have
depositors, and no judge is going to turn a bank account into shares in Citigroup.”
But ordinary deposits make up half or less of the typical megabank’s
liabilities.  Citi and the rest raise hundreds of billions in the bond
markets–and those bonds would have been ripe for a debt-to-equity conversion in
the fall of 2008.

You might think that this is just some blogger writing about his pet theory:
And you’d be right!  I wrote a paper on this published in the Journal of Applied Corporate Finance.  But I’m in good

[T]he alternative…I’ve been thinking of is to…convert Citibank’s long-term debt into equity.  

The debt holders are told, ‘Congratulations, you are the new equity holders.’
               –Greg Mankiw

I]f the banks are undercapitalized, and private money is not available, then
the government could force creditors to swap claims into equity, thus instantly
recapitalizing the banks while avoiding use of taxpayer funds.
               –Simon Johnson

Bankruptcy scares many people, but it shouldn’t…[W]hen things are less serious,
some of the debt is converted into equity. [W]ithout the burden of monthly debt
payments, the firm can return to profitability. 

               –Joseph Stiglitz

The quotes are all from the paper.

A few economists like the idea, but will debt-to-equity
conversions go anywhere in the real world? I’ll offer an answer in coming days.