Eureka! A Banking Rescue Plan That Could Actually Work!

By now it’s clear to most people that the government’s approach to the financial crisis has been a disaster. Each new program seems worse than the last, adding additional layers of protection from the consequences of failure, socialized losses, profits for the well-connected, moral hazard and a greater government role in financial markets. There’s got to be a better way.

Today’s Wall Street Journal editorial page carries a very important op-ed by Columbia Business School’s Glen Hubbard, Harvard Law Scool’s Hal Scott and Chicago Business School’s Luigi Zingales. It’s a well-thought out plan that has the singular virtue that so many other plans have lacked–it could actually work!

You should probably read the entire op-ed. But here’s the Hubbard-Scott-Zingales plan in a nutshell:

  • The FDIC should immediately announce that the guarantees of short-term debt for banks will end when the current program expires in September. Healthy banks will be forced to raise money before that. Unhealthy banks will find they cannot raise money. Rather than having a government agent declare them insolvent, the market will have determined the outcome.
  • Banks that cannot raise money will be seized by the FDIC.
  • Since the FDIC cannot plausibly run seized banks and won’t be able to find buyers for larger banks, it should split the banks it seizes into a good bank and a bad bank.
  • The bad bank will get all residential and commercial real-estate loans, all securitized mortgages. It will also get a loan from the good bank to fund its operations and assets. Its liabilities will be all of the long-term debt of the old bank.
  • The good bank will get all the remaining assets, including derivative contracts and its loan to the bad bank.
  • Shareholders in the old bank will be given 100% of the equity of the bad bank. If arguments that the bank is not really insolvent and the mortgage assets are actually worth far more than they appear, the shareholders will gain. If they are worth what the market says they are, the shareholders will lose.
  • The long-term debt holders of the old bank will be given 100% of the equity of the good bank. This properly preserves their relative priority to shareholders. If anything, the debt holders will likely be far better under this plan than a straight liquidation of the old bank.

The plan would surely cause huge dislocations, as many creditors are prohibitted from owning equity. Pension funds and the like would have to sell-off the equity. But these dislocations would be temporary, and less painful than the current mess we’re creating with out serial bailout plans.

The great danger with the plan is that it requires new legislation. Congress would need to act quickly to give the FDIC the authority to seize and divide bank holding companies. Sheila Bair has already called for such legislation. But Congress may well screw it up by needless complicating it, or warping it to fit the wishes of lobbyists and special interests.

The great virtue of the plan is that it replaces the judgments of regulators with the judgments of markets at each step. Market will decide which banks are insolvent. Markets will decide the long-term value of the toxic assets. And markets will decide the future of the good banks.

It’s been a long time since we saw a plan to restore the health of the financially system that we actually liked. Can we please get started on this? Like now?

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