Little Red Riding Equity and the Big Bad Debt

Little-Red-Riding-Hood_thumbOnce upon a time, there were two sisters in the land of Liability: greedy little Equity and big fearful Debt. Even if they were sisters, they sure were not twins. There was a clear difference between Equity and Debt. Equity was the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid, while a debt is an obligation owed by one party (the debtor) to a second party (the creditor). These definitions are helpful in understanding the liquidation process in case of bankruptcy. At first, all the secured creditors are paid against proceeds from assets. Afterwards, a series of creditors, ranked in priority sequence, have the next claim/right on the residual proceeds. Ownership equity is the last or residual claim against assets, paid only after all other creditors are paid. In such cases where even creditors could not get enough money to pay their bills, nothing is left over to reimburse owners’ equity. Thus owners’ equity is reduced to zero. Ownership equity is also known as risk capital or liable capital.

What did these sisters use to mean in practical terms? Simple. If I bought equity (common stock) I was making a speculative investment in a company assuming the full risk of the venture, meaning that there were no guarantees regarding the return on my investment. If I ever buy a company’s stock it is because I think the company has good prospects, I expect its value is going to increase and I plan to benefit from that increase in value in a more or less uncertain future. On the other hand, if I lent someone, a company or a state, what I expected was a more or less secure return on my investment after a clearly stated period of time.

One day, Red Riding Equity ate the Big Bad Debt, or maybe it was the other way around. It was right after the orgy of debt burst and the inability of political leaders to deal with the financial crisis was patently revealed. In my humble opinion, the difference between equity and sovereign debt may still have some legal meaning of course, but no economic meaning at all. In other words, the probability to be fully repaid in case you own sovereign debt does not differ from the one to be fully repaid if you have common shares of a new technology start-up. Given that we are all being forced to pay more taxes to fund our states or supra-national entities(*), in order to save the banking system (and by the way pay for the excesses of their supposed stewards), and given that nobody with minimum judgement assumes that this is but an act of pure faith in our institutions, countries, or the human race for that matter, I think it would be fair to grant everyone at least the opportunity to profit from this high risk, highly speculative investment emergency.

Therefore, I strongly suggest to our poor unimaginative politicians to start talking more properly and acting more fairly. Here is my proposal:

  1. Let’s stop raising taxes to fund governments to save the economy. Let’s instead create a no-nonsense Save-the-F-Economy Fund (SFEF),  everyone will be obliged to contract and contribute according to his or her own capacity. (Yes, like extra taxes or pension contributions right now) Let’s invest the money of the fund as equity instead of debt in the states, the banks and any of those funny little beasts we have created which are, oh-no! too big to fail. And yes, let’s do with the money raised whatever is necessary to solve this mess (as we are supposed to be doing right now).
  2. Let’s explain to everybody that there are absolutely no guarantees that this is going to work, but that provided that for the time being we don’t have any other planet to live on and that this crisis has planetary scale, there is no other possibility than just trying to bail out “this” planet economy. Just do notice, that this is exactly the same situation that with taxes. We are forced to pay and we are going to have nothing in return, except the promise someone is going to save us from something worse yet to come. What? Hell?
  3. My point is that the fund would give us the possibility to profit from an eventual, if improbable, increase in the value of “this” planet economy even if that happens in an uncertain future. I am fully convinced that there is a chance, that a completely different way of management would reveal the huge potential we still have, that there has to be a Steve Jobs of the Government and Administration awaiting his or her moment. In the improbable case Steve “Government” Jobs saves the match ball, the value of the then well managed states, banks, etc. will be reflected in the value of our participation in the SFEF that we used to bail then out with.

My last plea: Dear politicians, stop thinking that we are all stupid and stop complaining that the F-legal-mess prevents you from acting quickly, properly and fairly. And if you want some candidates for the Job, let me suggest you hire 2 or 3 of the super-smart opinionators of the moment, like Paul Krugman, Sala-i-Martin, Daniel Lacalle and the like.

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(*) If you think this is sweeping generalization, while writing I am thinking specifically about Spain, but the situation in many highly indebted countries is not actually too different

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