Dealing with the Financial Crisis
Susan Woodward, Robert Hall, and Jeremy Bulow have the cleverest plan I have yet seen:
The right way to create a good bank and a bad bank « Financial Crisis and Recession: Most discussions... presume that the government must inject a lot of new capital to create a well-capitalized good bank together with a still-solvent bad bank.... But... we can create a good bank with a big cushion of capital while keeping the bad bank as solvent as the existing integrated bank. The key idea–from Jeremy Bulow–is that the bad bank owns all of the equity in the good bank.... The good bank will continue to operate under the [established] brands as a well-capitalized operating entity. The bad bank will be a financial fund with no operating functions. The good bank gets the short-terms assets... [and] the better half of the long-term assets... the bad bank gets the poor half, where the impairment has already occurred and suspicions of further price declines persist. The bad bank holds the valuable equity in the good bank....
The deposits remain as liabilities of the good bank. Because the good bank is heavily capitalized, the deposits are safe.... All of the debt goes to the bad bank. The holders of the debt were never promised a government guarantee. The shareholders in [the old banks] become the shareholders in the bad bank. They are indirectly shareholders in the good bank as well, because the bad bank owns the good bank. The bad bank is thinly capitalized.... With further declines in the values of the troubled assets, the bad bank may become insolvent. In that case, the bondholders will need to negotiate diminished values or the bad bank will need to be reorganized. In either case, the shareholders will lose all their value....
[N]either the shareholders nor the bondholders suffer any impairment of their existing intrinsic values. At present, the shareholders own an out-of-the-money call option on the assets. The bondholders own the assets subject to the shareholders’ call. Their combined value declines by the amount of any further decline in the value of the troubled assets. As claimants on the bad bank, they would be in the same situation....
The adoption of the proposed good- and bad-bank separation would result in capital losses for the shareholders and bondholders, because the new policy would eliminate the benefit that they might receive from further bailout money from the government. The potential reorganization of the bad bank made necessary by future insolvency would not create any kind of financial emergency, so there would be no reason for the government to bail out the bad bank....
[O]ne might wonder... why bother? Pundits talk about the toxic assets in the banking system as if somehow they were infectious, and the good assets would become infected by the bad assets. One envisions the mold on one piece of cheese taking up residence on an adjacent piece in the fridge.... What the change does do is make ever-so-clear what the priorities are... the debt claims, including the short-term commercial paper, are direct liabilities of the bad bank. If the bad bank cannot re-fund its commercial paper one morning, the bad bank must be re-organized.... [W]hat this re-organization of the ownership claims does is show how easy and orderly a garden-variety Chapter 11 reorganization of a large bank could be, and how unnecessary it is to throw additional public money into insolvent institutions....
At the most practical level, the advantage of the good-bank/bad-bank separation is to prevent the emergency that would occur if a large bank threatened insolvency... the first symptom would be a run on the bank by those depositors.... By contrast, no run could occur on the heavily capitalized good bank in our example. Reorganization [of the bad bank] could proceed peacefully while the good bank went about its banking business. The claims of the shareholders and bondholders, which are inferior to those of the depositors, can be sorted out without interfering with the operation of the bank...
