Look, we all know what is going on. Paulson is proposing a system wherein profits go to investors, but losses become socialized. That is NOT what Adam Smith envisioned. It’s not even capitalism.
Read "Why Paulson is wrong," a two page essay being circulated by Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago. An excerpt:
When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices: the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity…If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.
What’s the alternative? Well, what do we normally do when companies go belly-up? They file for Chapter 11.
The problem is that going through bankruptcy court takes time. A looong time. And the economy doesn’t have that kind of time.
But so what? Zingales argues that we simply "ram" a restructuring program down the throats of these investment banks. The government basically forgives the debt — wipes it out — in return for some equity in the companies. In effect, the government would own parts of these companies as a whole, rather than buying the "toxic" assets of those companies. And pretty soon (one hopes) the government will recoup its investment (because the debt-to-equity ratio of these companies will go down). This was done before, in the 1930’s.
The benefit? Well, it means the taxpayers won’t be burdened with $700 billion in a bailout. Not that much.
Why isn’t anyone proposing this? Because Wall Street lobbyists have the hearts and minds of the people in Washington, including Paulson. Under Zingales’ plan, Wall Street will actually bear a portion of the pain. And they don’t want that. The common taxpayer, you and I, don’t have a voice.
UPDATE: It looks like the Dodd proposal is pretty close to the equity-for-debt "bailout" that Zingales envisioned. It also has provisions limiting top executive pay and bonuses.