Regular readers of this blog — and you might even number in the double digits at this point — know that I am a big fan of the “good bank” solution for dealing with the toxic assets clogging the banking system. In a recent paper, Jeremy Bulow and Paul Klemperer flesh out the idea in some detail (via Mankiw).
Can we really afford to try something so radical? We can’t afford not to. Via Interfluidity comes this sobering essay. He is right. If we do not take this opportunity to break the power of the largest financial firms, then even if the current plan “works”, we are setting ourselves up for a catastrophe in the future.
What we really need, I think, is fewer 15-minute news cycles and more serious public debate and deliberation. I am not sure there is any way to get that, though.
That we cannot afford a half-measure is the critical observation here. Everything about the Administration’s behavior has hinted at trying to defer the challenges of the banking sector to focus on their core priorities (health care, clean energy, education). Obama said as much in today’s press conference.
Since he knows he cannot tackle these problems with pressure from a low stock market and a financial meltdown, he has decided – consciously or not – to try to reinflate the bubble just long enough to get the rest of his agenda through. Then he will get religion again.
Unfortunately, as people from Prime Computer to Bernie Madoff have discovered, it’s really tough to cheat for just a while. The price for this giveaway is going to be a Wall Street that keeps swinging for the fences and a broke FDIC. And my guess is it never fully recedes enough for Obama to get the rest of his agenda passed.
Better to confront the problem full-force with the good bank proposal – and actual bankruptcy for AIG – and use that victory to get to the other objectives.
More here: http://tauntermedia.com/2009/03/22/in-his-own-words/
Good that Compulsive Theorist works at the Centre [sic] for Complexity Science, as while a “good bank” solution may be the optimal, there is IMHO a real danger of a violent further dislocation in following idealistic plans, which anyone studying complexity theory would understand. Again, I have no understanding of any of this, but I think I recognize somebody being a little too academic/idealistic, at least sometimes, vs. scrounging together a plan that, while being optimal in the long run, may avert very substantial problems in the short run. This is a fundamental tradeoff here.
Furthermore, nothing in the business world is permanent. Like ordinary species, over 99% of all firms ever established no longer exist. Not to say we shouldn’t worry about it, but that a) the perfect plan may cause more pain in the short run than we can realistically tolerate, and b) things change anyway. Again, a complexity theorist knows this cold, or ought to.
I have no solution, am not proposing one, and think that 99% of the people who are now shouldn’t be either :-). Except for entertainment value.
sorry, line above came out 180 degrees opposite: should read:
vs. scrounging together a plan that, while being non-optimal in the long run, may avert very substantial problems in the short run.
> Such equity would simply equal the good assets minus the deposits. So this scheme is feasible as long as the former exceed the latter.
The good assets minus the deposits is less than zero in some cases.
Oops, I take that back. I misinterpreted some information.
but i do have a question about this. why is this fundamentally different from not splitting the bank but recapitalizing it via wiping out the current equity and swapping junior debt for equity?
grr —
In terms of who has claims on what, I believe it is similar.
However, this plan cleanly separates the good assets from the unknown/bad assets which lie at the heart of the crisis of confidence. Banks operate on trust, and until people believe the write-downs are done, they will continue to trust banks only to the extent that they are guaranteed by the government.
Paulson’s idea all along, from his original “super SIV” proposal to his original pitch for the TARP, was to get the bad assets into some sort of new “bad bank”. That is not a crazy objective if the goal is to restore confidence. The observation here is that we already have plenty of bad banks, so maybe we should use taxpayer money to fund and insure one or more new GOOD banks instead. Those new banks would be instantly credible because they would be known to have no questionable assets on their balance sheets.
It doesn’t seem to. Unless I am misreading something, all the assets go with the new bank; some of the liabilities stay with the old bank plus and the old bank gets equity in the new bank. It seems to me that a big advantage of this plan (or a simple, definitive recapitalization on a large scale) is that once this is done, it doesn’t matter so much what the marks are. Sure, it matters to investors in the bank’s equity, but not to the US Taxpayer at large, and it’s certainly not a ‘crisis’. If there is a large scale recapitalization, the bank will be definitively solvent.
If you take a balance sheet like Citi’s there is really no way to slice it with respect to debt seniority and “toxicity”. You can’t, say, take the unpriceable assets out and put them against subordinate debt and equity and come out with a definitively solvent bank. There’s just too many toxic assets. Other banks are a bit simpler. It’s also not clear to me that you could have a really clean balance sheet, as any bank balance sheet will have tons of questionable loans that are just loans on the balance sheet and not marked to market. (It’s not necessarily just a problem with ‘toxic assets’ — there are a lot of bad loans as well.)
Then there are other questions, like how to prevent ‘too big to fail’.
grr —
Whoa, you are right! I did not read the paper carefully enough; I thought it was just a refinement of the earlier paper (also co-authored by Bulow and described in detail by Willem Buiter).
But this new paper actually presents a new version of the proposal, which is to separate the “bad liabilities” rather than the “bad assets”. So you have a very good question, which is how does this approach differ from simply converting those “bad liabilities” into equity? Maybe you could write to the authors of the paper, Bulow and Klemperer, and ask…
Buiter gives a link to and article by Hall and Woodward which I think is along the lines of what you expect. (http://www.voxeu.org/index.php?q=node/3132). They are able to get a split of Citigroup along the seniority/toxicity lines.
Essentially they would split the bank into two (‘good’ and ‘bad’). The ‘good’ bank gets all the deposits plus some other assets and liabilities (the ‘good’ assets and secured liabilities only); the ‘bad’ bank gets the bad assets and subordinated liabilities. Plus the bad bank gets all the equity in the good bank.
This gives the good bank a clean balance sheet. The bad bank will not exist long as it almost certainly is insolvent. I would think liquidation would be a bad idea in the present climate; you’d probably want to just put it in run off mode and give subordinated debt holders equity in the bad bank and let them sell it if they would rather have cash.
So what this is equivalent to is hiving off the bad assets from good assets, wiping out current equity holders or seriously diluting them, and giving subordinated debt holders a share in both hives.
I could see this working.