A Viable Alternative to Nationalization?
Brad DeLong recommends this plan from Susan Woodward, Robert Hall, and Jeremy Bulow as “the cleverest plan I have yet seen.”
And, indeed, it is clever. Here’s the plan in chart form:
The other two columns show the balance sheets of the new good bank and bad bank. The good bank will continue to operate under the Citi 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 “other” assets because many of these are related to its operating activities. It gets the better half of the long-term assets, taken to have book value, while 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 to the tune of $427 billion.
The deposits remain as liabilities of the good bank. Because the good bank is heavily capitalized, the deposits are safe. Most are uninsured, so the creation of the good bank eliminates the danger of a run on the bank by those depositors. All of the debt goes to the bad bank. The holders of the debt were never promised a government guarantee. The shareholders in Citicorp 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. In fact, it has exactly the same amount of capital that Citi had in the first place. 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, just as they would have lost that value had Citi not been divided and there had been no further bailout from the government. The bondholders will lose part of their value, because there is no reason or justification for bailing them out.
This seems suspiciously like magic, so I’d like to know what others with some expertise have to say.
12 Responses to “A Viable Alternative to Nationalization?”
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February 22nd, 2009 at 8:17 pm
It’s always been a question of who pays for the problem – stockholders, bondholders or taxpayers. This gives the stockholders and bondholders some hope (the bank fairy increase values enough to make them whole), while sticking them with the full cost.
No magic, just an allocation of the pain to the current holders.
February 22nd, 2009 at 8:18 pm
I believe part of the problem is that the bondholders are mostly other banks, who may become insolvent themselves if the bad bank defaults. I’m not sure of that, though.
Fun times.
February 22nd, 2009 at 8:22 pm
Oh, and another problem, if the bad bank owns the good bank, what’s to stop the bad bank from cannibalizing the good bank? Presumably, the bad bank represents the interests of *it’s* stockholders, not the ‘greater good’.
February 22nd, 2009 at 9:37 pm
Oh. My. God.
If these figures are real, Citi is already insolvent. First column, bottom figure shows Citi leveraged at a minimum of 74:1, & that is using the maximum range of a rounding error. Any bank not too big to fail would have been in receivership months ago. If it wasn’t for the fact that much of its debt is foreign owned, it probably would be anyway, in spite of its size.
It seems like magic because it is. Take a look at the total assets line, adding the 2 new bank totals & subtracting Citi’s current assets (which as you pointed out, are decreasing daily). $427B of that amount came out of nowhere – it doesn’t exist. The only place it could come from is new capital invested – IOW, money the Feds borrow & loan to Citi’s new, improved, good bank. Since Citi is likely not the only bank in almost as bad shape, what do you think the odds are of getting that kind of appropriation through Congress? I would say practically nil, especially since all the large banks, worldwide, appear to be overleveraged.
We have heard hints from Treasury & the Fed about a combination of public & private funds to finance such a bailout. I hope they can pull it off, but I have serious doubts.
February 22nd, 2009 at 9:57 pm
Looks fine to me, so long of course as the current shareholders of Citi don’t mind being wiped out and the bondholders believe their debt is actually worth what the bad assets worth (in other words, so long as they don’t demand the YTM on their loans to the now-bad bank). The relevant passage in Hall/Woodard/Bulow is “[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.” The operating entity is separated, financially, from the bad assets, which is what you would want to avoid financial instability. Sort of a Structured Investment Vehicle (ala Enron) for all time.
But the question in my mind is: Why doesn’t the bank do this now? This is basically a financial restructuring that is largely within the bank’s reach. I spose it is possible that they think the Pr(Fed Bailout)> Pr (value under this scenario). But that seems myopic. So why don’t they do it today and avoid further sturm/drang/risk?
February 23rd, 2009 at 5:39 am
It’s a very good plan. However, it will require the consent of Citicorp’s creditors.
The plan involves Citicorp transferring its good assets to a wholly owned subsidiary. Since Citicorp is insolvent, its creditors have a claim over the good assets. If the good assets are transferred to the “good bank” together with deposits, the depositors (and any creditor of the good bank) will have a prior claim to the good assets. The creditors of Citicorp would be subordinate to those prior claims. Citicorp creditors are unlikely to approve the transfer since it essentially involves giving depositors a prior claim over the assets that are transferred to the good bank.
February 23rd, 2009 at 9:05 am
Interesting approach.
Currently there are two interest groups working together to prevent Citi from being nationalized and to induce the government to pour in more free money.
This divide and conquer the interest groups approach could work. The government could structure the deal to appease management, while hanging the creditors out to dry.
As others said, the only real question is who is about to get screwed. The candidates are shareholders, creditors (many foreign who we depend on to finance our gov’t debt), depositors, management, and taxpayers.
This is first and foremost a political problem, not a financial one.
February 23rd, 2009 at 11:41 am
Well, it’s a moral hazard for either the shareholders or the managers to not get screwed, so screw both of them.
Bondholders are, and IMO should be, next in line. Any bondholder (domestic or foreign) who takes a loss today will look more carefully tomorrow, and that’s on balance a good thing. So they should at least get burned enough to make them careful down the line.
The hangup here is that if the bondholders are other banks on the verge of insolvency, sticking them with part of the loss could create an insolvency chain reaction. That might be so bad that it would be worse in terms of actual outcome for taxpayers to *not* shoulder this loss than to shoulder it – the only scenario, IMO, in which the taxpayers *should* shoulder the risk, because socialization of losses is in general very very bad and you should do it only when you are *positive* that all the alternatives are worse.
February 25th, 2009 at 7:04 am
Magic usually has a flaw. Here, it is, as Kien commented a while back, the problem of depositors (presently uninsured) becoming preferred creditors, and effectively insured. I comment on this further at:http://foolawecon.wordpress.com/2009/02/25/bankruptcy-and-good-bad-bank-proposals/
February 26th, 2009 at 2:58 pm
Nice info! Very cool post.I have looked over your blog a few times and I love it.
April 9th, 2009 at 4:39 pm
If you ever want to hear a reader’s feedback
, I rate this article for 4/5. Decent info, but I just have to go to that damn msn to find the missed bits. Thank you, anyway!