A New Menace to the Economy: 'Zombie' Debtors
Zombies. Seen one lately? If not, you may soon, because they are about to menace the U.S. economy. In financial lingo, zombies are debtors that have little hope of recovery but manage to avoid being wiped out thanks to support from their lenders or the government. Zombies suck life out of an economy by consuming tax money, capital, and labor that would be better deployed in growing companies and sectors. Meanwhile, by slashing prices to generate sales, zombie companies can drag healthier rivals into insolvency.
Sometime in the past few months, zombies went from being a latent risk to a genuine threat—one that is likely to increase in the months ahead. The Bush Administration has already ladled out billions of dollars in assistance to weak banks and automakers. As the economy goes into what may become the worst economic downturn since the Great Depression, the Obama Administration will come under even more pressure to prop up sick financial and nonfinancial companies to save jobs. The debate will center on wounded giants such as Citigroup (C), General Motors (GM), and insurer American International Group (AIG). Other sectors with their hands out include steel, airlines, retail—and homeowners, who may be the scariest zombies of all.
Hard choices lie ahead, so it's important to have a sturdy framework for making them. The right approach, say those who have studied the matter, is to prop up a company if its core business is healthy but its financing sources have temporarily shut down. Otherwise, let it go. Postponing the decision by supporting sick and healthy alike will only make the eventual pain greater and reduce growth. "If an institution is poorly managed and does not have a reasonable plan for working out its problems, they ought to go ahead and shoot it," says William M. Isaac, a former Federal Deposit Insurance Corp. chairman who now heads bank consultancy Secura Group.
Japan was plagued by zombies during its lost decade of slow growth in the 1990s. Weak Japanese borrowers used the proceeds from new loans to pay interest on old ones—a process called "evergreening" that kept banks from having to acknowledge losses. In the '80s, the U.S. airline industry was pulled down by Eastern Airlines, which was allowed to keep flying (and charging low fares) while in bankruptcy court. That doesn't help anyone. "At some point, you need to wake up and accept the fact that, 'Oops, that's not going to work,' " says Stéphane Téral, an analyst with Infonetics Research who tracked the demise of scads of telecom carriers in the early 2000s.
Protecting zombies can stunt long-term growth by blocking what economist Joseph Schumpeter called "creative destruction"—the painful but necessary reallocation of resources from declining companies and sectors to rising ones. That turns out to be crucial. In the U.S. manufacturing and retail sectors, a huge share of productivity gains have come from such reallocation, says economist Steven J. Davis of the University of Chicago Booth School of Business. Case in point: the growth of hyperefficient Wal-Mart (WMT) at the expense of mom-and-pop shops, which were allowed to die. The absence of such reallocation could slow productivity growth.
The problem with the current bailout is that the government may be giving money to companies that don't have a long-term future: zombies. On paper, for example, the Treasury Dept. says it invests Troubled Asset Relief Program (TARP) money only in "healthy banks—banks that are considered viable without government investment" because "they are best positioned to increase the flow of credit in their communities." That's the right idea. In practice, though, the criteria aren't so stringent.
Banks like Citigroup still aren't strong enough to lend. "The bailout model is socialism," says R. Christopher Whalen, senior vice-president for consultancy Institutional Risk Analytics. He advocates selling failed institutions in pieces, as was done to resolve the savings and loan crisis in the late '80s and early '90s. In fact, Washington may be moving toward something like that with Citigroup.
When a big employer runs into trouble, it's tempting to keep it going at any cost. Economists call this "lemon socialism"—the investment of public money in the worst companies rather than the best. The impulse is misguided, says Yale University economics professor Eduardo M. Engel. "You don't want to protect the jobs," he says. "What you want to protect is workers' income during the transition from one job to another."
There's already a powerful and underused weapon against zombies: bankruptcy law. Bankruptcy courts liquidate the weakest companies while allowing the potentially viable ones to extinguish enough of their debts so they can make money again. Even GM, which is staggering now, could emerge as "a new, revitalized company" if it goes through a cleansing bankruptcy reorganization that changes its obligations to dealers, workers, and retirees, says economics professor Edward W. Hill of Cleveland State University.
Right now, the biggest zombie problem may lie in housing. Millions of homeowners are juggling mortgages they can't afford to pay alongside other debts: credit cards, auto loans, and so forth. In struggling to keep their heads above water, they're slashing consumer spending, which is harming economic growth. Until 2005, bankruptcy filings would have lowered their consumer debts, freeing up more money for mortgages. But a law passed that year has exacerbated the zombie problem by making it much harder to discharge bad debts. Halfhearted modifications of loan terms haven't helped much. According to a new study by Alan M. White, a Valparaiso University School of Law professor, only one-third of modifications of subprime and near-subprime mortgages in November 2008 involved reductions in the monthly payment, often because late fees got tacked onto principal. As a result, he writes, "many modifications are temporary." That's the zombie condition.
Looking ahead, economists are trying to devise ways to make the financial system more resilient and less likely to breed zombies. A group of 16 top financial economists calling itself the Squam Lake Working Group on Financial Regulation is quietly working on a plan it hopes will get the attention of regulators in Washington and other capitals. Kenneth R. French of Dartmouth College, who helped organize the first meeting at New Hampshire's Squam Lake in November, says one goal is to invent a way to shut down or restructure failing institutions with a minimum of collateral damage to other firms and the general economy.
Recessions cause great harm, but they can also do some good if they force a needed reallocation of resources toward the most promising sectors. "If we can ride this wave the right way, this is going to be great for the future of the American economy," says Massachusetts Institute of Technology economics professor Daron Acemoglu. Right. Just as long as the zombies don't get in the way.