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America's new menace: 'Zombie' debtors

Peter Coy, BusinessWeek | January 17, 2009

Zombies. Seen one lately? If not, you may soon, because they are about to menace the US 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, General Motors, and insurer American International Group. 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 US 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 St�phane T�ral, 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 US 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 at the expense of mom-and-pop shops, which were allowed to die. The absence of such reallocation could slow productivity growth.

"Lemon socialism"

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 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.


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