From Luigi Zingales (emphasis, except for headings, mine):
Get a strategy
To begin, you need an overall strategy. Even a mediocre strategy is better than an ad hoc approach that confuses markets and fuels the perception of playing favorites. Legendary portfolio manager David Swensen (who in 23 years transformed the $1 billion of Yale endowment into $23 billion) in reference to the government intervention in this crisis commented “the government has done it with an extreme degree of inconsistency. You almost have to be trying to do things in an incoherent and inconsistent way to end up with the huge range of ways they have come up with to address these problems.”
One solution is the one I advanced last Fall. 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.
When I proposed it in September they told me that there was not enough time. 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.
Other plans
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.
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.
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?
I recommend reading the entire article. There's a great section that I didn't excerpt discussing how the interests of the financial companies really are not aligned with those of the country. Also, from Henry Blodget:
You don't have to subsidize banks and their stakeholders at taxpayer expense to avoid another Lehman. You just have to fix the banks the right way.
What's the right way?
Temporarily seize the banks
Write their assets down to nuclear-winter levels (or, if desired, put them in a big bad bank, as Sheila Bair wants to do.)
Convert enough of their debt to equity to put them in a strong capital position.
That's it. No taxpayer money. No citizen outrage. No comical "Yes, we're lending" assurances when what the banks are really doing is, sensibly, hoarding everything.
The drawbacks? It's hard to even call them drawbacks:
Today's common shareholders would get wiped out
Today's preferred shareholders would get wiped out
Today's debtholders would take a big hit, with unsecured debtholders ending up with equity stakes.
But wait--isn't that unfair? Arbitrarily deciding that shareholders and debtholders will get dinged? Isn't that an abandonmnent of free-market capitalism?
Please. These banks have already failed. If it weren't for our having already abandoned free-market capitalism, they'd all have ended up like Lehman. Adults made bets on these securities on their own free will (on the apparent assumption that they come with implicit taxpayer guarantees). These adults can now, finally, accept responsibility for their decisions.
Blodget's solution is effectively having the banks go into reorganization. I prefer Zingales' proposal of a new bankruptcy regime for financial institutions, which would take into account the precarious nature of counter-party risk.
But in the end, what both authors are suggesting to the almighty Fed is... it's time that the shareholders in these financial institutions have their legs cut out from under them. This is not a mere credit crunch/liquidity situation, these are companies that are flat-out insolvent. And shareholders, as the risk-bearers in companies, should actually bear the risk. First. Before taxpayers.
Of course, given that BOA's CEO Lewis and JPMorgan's Dimon both put enormous amounts of money buying their own companies' respective stocks today (in other words, becoming even larger shareholders in these two financial companies), how likely do you think it is that our government might actually listen to some voices of reason?
Can you say Special Interest... FAIL!
either one of these choices are dramatically superior to the insanity of what we are doing now.
we have to do something now ... BEFORE the bank run ... because there is no after
Posted by: caustic | January 21, 2009 at 08:33 PM