Safety-net Subsidies Keep “Toxic” Assets Illiquid
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.