The Obama administration appears to be rushing headlong down the same bailout path as Those Who Shall Not Be Named. Specifically:
- Overpaying for trash assets to secretly recapitalize banks at taxpayer expense and stuffing the assets in an “aggregator bank,”
- Protecting bank shareholders and bondholders from the banks’ terrible decisions, and
- Not forcing banks to write down the value of their “good” assets, thus ensuring that the banks will continue to hoard capital and that we’ll just have to do it all over again.
Enough already! Change has come to America. It must also come to our financial system.
Professor Luigi Zingales of U. Chicago writes an open letter to Tim Geithner, describing two better bank-fix plans. Here’s an excerpt:
How to restart the lending
One solution is the one I advanced last Fall5. It requires passing a new piece of legislation introducing a new form of bankruptcy for banks, where derivative contracts are kept in place and the long term debt is swapped into equity. As Pietro Veronesi and I have shown in a recent article, such conversion will fully recapitalize the banking sector and bring down the level of risk of debt (as measured by the credit default swaps level) to pre-crisis level.6
When I proposed it in September they told me that there was not enough time.7 When I re-proposed it in October they told me that there was no chance to reconvene Congress after the election. But time has passed and the Congress has been reconvened after the election, but there has been no discussion of this alternative that can save hundreds of billions of dollars to taxpayers.
That is not the only possible plan. An alternative would be to allow banks to divide themselves into two entities, a bad bank with all the toxic assets and a good bank, with lending etc. Ownership of these two entities will be allocated pro quota to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with 30 billion of bad assets and 70 billion of good assets will see its debt divided 30-70 and its equity divided 30-70. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity.
On the face of it, it looks like a useless exercise. If each investor receives pro rata the two parts of the bank, what difference does it make? The answer is very simple. After the spin off, the toxic assets will not contaminate the lending part of the business anymore. On the one hand, bad banks would simply be closed-end funds holding the toxic assets. If these assets turn out to be worth more, the original investors will be rewarded. If they are worth less, the most junior claimants (common and preferred equity) will be wiped out.
The good news is that these entities could be allowed to fail, because their failure would only be a rearrangement of their liability structure with no negative consequences on the economy. On the other hand, good banks will have a clean balance sheet and will be able to raise private capital without too many problems. If private capital is nowhere to be seen is because sovereign wealth funds that tried to take advantage of the situation experienced enormous losses. In November 2007, for instance, when the Abu Dhabi’s sovereign wealth fund took a stake in Citigroup the stock was trading at $29 per share, while today is worth only $3.5. After these bad early experiences all the smart money stayed away.
By eliminating the uncertainty on the magnitude of the losses in good banks, the spinoff will make it appealing for private capital to invest in these banks. Even if private capital would not flow back (which I doubt), a government equity infusion in the good banks would be cheaper and more effective. Cheaper because the value of debt in the good banks would be close to par and thus an equity infusion will not go to bail out the existing creditors, but only to promote lending. More effective, because instead of trying to improve the capital ratio of a $100 billion entity (in the example), the government will do it only with respect to a $70 billion one.
The easy way and the right way
If the solution is so simple why has it not be done before? First, because it is much simpler to get money from the government than to obtain it through hard work. So no bank would consider doing this spinoff if it hopes to receive extra TARP money. Second, because most bank debt has covenants prohibiting exactly these splits. Even if the liabilities are shared equally between the two entities, the equityholders tend to gain from this split and the debt holders tend to lose. If the shortfall in the value of toxic assets is large enough equity in the whole entity would be entirely wiped out, while with the two split entities equity holders will retain some value in the good bank, at the cost of a lower overall repayment for the debt holders.8
This problem, however, can be dealt with by giving debt holders of the bad bank a warrant on the equity of the good bank, increasing their payoff at the expense of the equityholders. Furthermore, the creditors have benefited so greatly from all the government infusions of money so far that it would only be fair that they will share some of the pain for their bad investment. To allow banks to spin themselves off in two units, however, we need to pass a new law. As in October the “nay sayers” will say it is impossible. It was possible to write a $700 billion check to Paulson, it is possible to approve a $825 billion stimulus package, why it is not possible to pass a very short law allowing banks to spin off?
Mr Geithner, incumbent bankers and their lobbyists will always make you believe there is no alternative to the plan that benefits them the most. You cannot fall for this old trick.
The alternatives I outlined above are not only possible, but also fair. They penalise who invested poorly and help provide loans to businesses in need. On top of this, they achieve these goals at zero cost to taxpayers (no small feat in a time of ballooning deficits). Yes, we can Mr Geithner, … if you lead us there.