Letting the Zombie Banks Fail: A Viable Plan 24 comments
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Some know the story of the man, looking under a street lamp for something. A passer by asks, "What are you looking for?" "My wallet," the man replies. "Where did you drop it?" the stranger asks. "On the other side of the street." "Why are you looking for it here, then?" "Well, I need some light to find it, and this is the only light!" The PPIP scheme is like that man – looking for a solution in the wrong place, only because it’s familiar to Mr. Geithner and his Wall Street cronies: let’s use leverage and have the taxpayer pick up any losses. Everyone except the emperor and his gang can see he wears no clothes. Now he’s asking us to foot the dry cleaning bill. Because there are no clothes, guess what, there will be no end to the dry cleaning bill either. That is a problem for us, the ones who have to pay the bill with our taxes. (In passing, we notice that putting the burden on us, taxpayers, is easy for someone like Mr. G., who isn’t one of us.) Is there another solution? Yes, there is. It sounds simple and in some respects it is. However, no single solution to a mess of this magnitude is either simple or painless. The solution I propose is letting the big banks fail. In a related article comment, Chris B. raises questions which boil down to: didn’t we learn from the Great Depression? Why propose a solution that didn’t work then? It is a good question, which I shall attempt to answer below. The comparison to the Great Depression IMHO overlooks one key difference: in the Depression, it was hundreds of small banks failing. This time round, the smaller banks are the healthier ones (relatively speaking, and that is an important caveat). By contrast, I’m proposing we only let the dinosaurs fail. C and BAC are the two obvious candidates, but there may be more. "Letting the dinosaurs fail" creates the dramatic image of locking the doors and telling everyone to go home. That sounds quite dramatic, but is not quite necessary. These "banks" are actually contain a multitude of businesses which can be split up easier than most people think, because they were cobbled together through acquisitions. Split up, these businesses are probably more valuable and more viable than the current agglomeration of companies and businesses. We have several precedents in history for this. Some may recall the late seventies, when conglomerates were all the rage. Names like Textron, Gulf & Western, W.R. Grace, United Technologies, ITT and General Electric (GE) were commonplace, and held out as the state of the art in business, management and corporate strategy. We even had theories added to our business education literature, such as the Boston Consulting group’s famous matrix, which coined the terms cash cow and dog. As is so often the case with fads, the fallacies of the conglomerate strategy became exposed when the economy slowed, courtesy of the second oil crisis, and their growth premiums were stripped away. In the eighties, most of these conglomerates became unglued as the corporate raiders, such as Jimmy Goldsmith and our old friend T. Boone Pickens, saw that the pieces were worth more than the whole. So, they gained control of these behemoths and sold off the pieces for more than the price paid for the whole, making billions in the process. In the short term, this caused tremendous dislocation as the pieces, needing to stand on their own two feet, shed unneeded jobs, coining the phrase "downsizing" in the process. Although painful, this process was not fatal. As a country, we got through it and then prospered, because the result was corporations that were leaner and more competitive. I believe it’s no accident that this coincided with one of the longest bull runs ever. The point here is there is ample precedent for the notion that breaking up is not as hard to do as the Righteous Brothers would have us believe. There are other cases, such as the government mandated, and successful, breakups of AT&T and, many years ago, Standard Oil. Most of the zombie banks are conglomerations that satisfy megalomania more than business sense. C, BAC, GS, JPM and WFC come to mind. There is no intrinsic reason the various business types need to be under one roof. For certain, the investment and commercial banking businesses need to be split apart. There's also no reason a credit card company, insurance agency and stock brokerage all need to be part of a commercial bank. Those are just a few for instances, but there are more. Many, if not most, of the underlying businesses are more viable than the umbrella entity holding them. This is a classic case of the parts being worth more than the whole. (GE would also qualify for this description.) Breaking up the big banks, then, is a viable strategy. It also has the benefit of ridding the economy of "too big to fail." Back in the eighties, the raiders used junk bonds and S&L money to buy the dinosaurs of their day and split them up. We can make it easy for those who want to buy the viable pieces of the zombies: we’ll lend them the money at low interest rates and 5 to 10 years to repay. To sweeten the pot, they need put no money down. This solves the liquidity problem. But their knickers are in a vise – they have to sign their houses, boats and Aspen condos as collateral. This increases the likelihood that we get our money back. I can hear the critics howl about the use of debt. Good point, but in this case it’s a choice between an option that has us getting our money back, and the other which sounds more and more like a toilet being flushed with our wallets in it. There are incentives that can be written into those loans to encourage quicker repayment, higher down payments, or both. Once the healthy business units have been auctioned off, only the un-viable units that are left get shut down and liquidated. This is where human pain is inevitable. Jobs will be lost. Compared to the overall dinosaurs, though, this is likely to be much smaller in scope. In addition, most of our 401(k) plans will suffer as well, because stockholders and bondholders will get nothing. However, that’s still preferable to a hi-flow hose attaching our wallets to bank executives’ bonuses. Counterparties, or whatever they call themselves, will also get nothing. This will not be as devastating as Wall Streeters want to make it. It is like an insurance company calling you up and telling you the insurance policy on your house is canceled. There’s no immediate cash outflow or bankruptcy. All you have is an unprotected risk, and you’re out your premium. Just the loss of the insurance premium paid shouldn’t bankrupt you. Find someone else who will insure your bonds. There still are some insurance companies who will do that for you. The rates might suck, sure, but they’re not likely to be fatal. (If higher rates alone sink your hedge fund, you have no business being in business.) If you can’t find someone to write you a new insurance policy, then you have to manage the asset you bought yourself. Inconvenient, sure, but (again) not likely to bankrupt you. (Think of the nice jobs it will create, though, managing those loans.) If the bonds, loans, or packages of both you bought default, then you have a problem. But it’s your problem, not mine (as a taxpayer). If the defaults on those loans or bonds bankrupt you, you fold. But don’t worry. We, the taxpayers (the ones who actually pay our taxes) have a viable plan for you: At the bottom of your loans, bonds and packages of assorted debt instruments, you should have property. That provides us with a tool of recovery. How? Again, a lesson from history. The last time we had mass bank failures was just over ten years ago, when all those S&L’s went belly up. It may sound sacrilegious in these times, but we actually allowed them to fail back then, and survived. We took their loans and sold them off to whomever would buy them, for whatever they would pay. Then we formed the Resolution Trust Company (RTC) who assumed all the loans nobody would buy. We foreclosed on the delinquent loans and kept the real estate. By taking that real estate off the market, the RTC helped stabilize the real estate market. When the market recovered, it sold all the real estate. As a net result, we (taxpayers) ended up solving the problem for next to nothing. The plan worked, and actually worked very well. So, it’s been done before. Surely we can find a way to make something similar work again. In summary, there is a viable alternative to the current approach to the banking crisis: split out the viable business units and sell them off, then liquidate the un-viable parts. Taxpayers are involved at two points: offering notes to people who buy the viable units, and RTC2. Both are clearly geared toward repayment. Every element of this plan has been time-tested. Split-ups have been done successfully by the government and private business. And the RTC model was a success. All in all, such an approach can be worked out. I'm not the genius to figure it all out, but it's clear that a viable strategy can be fashioned on the premise of unbundling the zombie banks and liquidating them in an orderly fashion. My point is the current approach (a) is not the only option (b) has not shown any promise of working and (c) is expensive beyond belief, way too expensive, needlessly so. Why embark on an approach with a record-setting price tag when we don't know if it will work and there is a simpler, proven alternative? Disclosure: No positions
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The RTC approach also addresses that little matter of moral hazard which every bailout incurs. It's all about the reward system - if prudent businesses aren't rewarded and irresponsible businesses aren't punished then the entire system loses the compass by which decisions are made.
The Gasp is worse than you think
By Laurence Kotlikoff and Jeffrey Sachs
Published: April 7 2009 03:00 | Last updated: April 7 2009 03:00
Economists' Forum (Laurence Kotlikoff, professor of economics at Boston University, and Jeffrey Sachs, professor of economics at Columbia University and director of the Earth Institute): The Geithner-and-Summers Plan (Gasp) to buy toxic assets from the banks is rightly scorned as an unnecessary give-away by virtually every independent economist who has looked at it. Its only friends are the Wall Street firms it is designed to bail out. In an article in the FT, one of us (Sachs, March 23) described the systematic overbidding entailed by the proposal. Others have since made similar calculations, including Joseph Stiglitz and Peyton Young.
The situation is even worse than it looks, however, since the Gasp can be gamed by the banks that own the toxic assets to boost the purchase prices for their bad assets even higher than has been suggested to date.
Suppose that Citibank holds $1bn face value of toxic assets that will pay $1bn with 20 per cent probability and $200m with 80 per cent. The market value is $360m. The Gasp calls on investors to establish a public/private investment fund (PPIF) to bid for the toxic assets. For each $1 that a private investor brings in equity to the PPIF, the Treasury will put in another $1, and then the Federal Deposit Insurance Corporation (FDIC) will leverage the $2 in equity with $12 of non-recourse loans (6-to-1 leverage).
It's easy to show that a risk-neutral and arm's-length PPIF will bid $636m, financed with an FDIC loan of $545m, Treasury equity of $45m and private equity of $45m. (The expected profit to the private investor is a half of 20 per cent of $1bn minus $545m, or $45m. The private investor therefore has a net expected profit of zero.) The PPIF overpays by $276m, which equals the expected loss to the Treasury. The ultimate beneficiaries are Citibank's shareholders and bondholders, whose net worth rises by $276m at the taxpayers' expense. But the outcome could be even more outrageous than this. Citibank can arrange to receive even more than $636m for its assets by setting up its own Citibank PPIF (CPPIF) to bid for its bad assets. The CPPIF will bid the full $1bn in face value for its own toxic assets!
To see this, note that on a bid of $1bn by the CPPIF, Citibank would finance $71m in equity of the CPPIF, the Treasury would add another $71m in equity, and the FDIC would add $857m in loans to the CPPIF. The CPPIF will either break even (20 per cent of the time), or go bankrupt (80 per cent of the time). The CPPIF is therefore a wash-out - with no chance of profits, yet also zero liability.
On the other hand, Citibank gets a sure boost of $1bn minus $360m, or $640m in net worth, for which it pays $71m. Citibank's gain from the CPPIF's overbidding is $569m, which exactly equals the taxpayer's expected loss that is incurred by the FDIC loan and Treasury equity. The real icing on the cake is that Citibank still ends up owning the toxic assets even after the assets are "auctioned", but this time in an off-balance-sheet structured investment vehicle called the CPPIF. The toxic assets revert to the FDIC when the CPPIF goes bankrupt.
It's possible that some fine print of the Gasp would try to preclude explicit hyper-self-dealing of the type just described. But when there is free money on the ground, Wall Street will figure out ways to pick it up. For example, Citibank could arrange to overpay Bank of America for some unrelated securities in exchange for having Bank of America do its bidding at the auction. Indeed, Citibank, Bank of America and other toxic asset owners might join together in a consortium to finance an "arm's-length" PPIF on favourable terms, with the proviso that the PPIF bid for the toxic assets of the consortium. BusinessWeek has reported that "administration officials confirm Treasury may allow such seller financing".
The sad part of all this is that there are excellent alternatives to the Gasp that are vastly more transparent and cheaper for the taxpayers.
The best of these involves separating a weak bank such as Citibank into a "Good Citibank" that holds Citibank's good assets and its deposits, and a "Bad Citibank" that holds the toxic assets, the bondholder debt and the shares of the Good Citibank. The Good Citibank returns quickly to normal business, while the Bad Citibank is eventually liquidated under bankruptcy, with the bondholders and other uninsured claimants getting partial repayments depending on their priority under bankruptcy. The best description of this approach is by Jeremy Bulow and Paul Klemperer.
Over time, we should consider more fundamental reforms, including the idea of establishing limited purpose banking, in which the liquidity services provided by banks are undertaken by institutions with 100 per cent reserve requirements and which, therefore, are immune from runs, panics and reckless gambles. It would be absurd and self-defeating to bear the enormous social costs of the current financial crisis, only to return to the same kind of flawed banking institutions that got us into this mess.
The Geithner-and-Summers Plan should be scrapped. Mr Obama should ask his advisers to canvass the economics and legal community to hear the much better ideas that are in wide circulation.
ft.com/economistsforum
Copyright The Financial Times Limited 2009
The counterexample to the author's approach is to use taxpayer money to cover the bad assets and bad decisions of the financial institutions. This is TARP and TARF, or the TARx experiment as I call it.
Our money was never intended by law to be used for such a purpose, but to back depositors' savings accounts and to some extent, their money market funds and CDs up to $100k (now $250k).
The TARx experiment continues at our expense, with our money being used to cover gambling losses and interfere with the capitalist system in place. It subsidizes the losers so that they can compete with honest institutions. It raises the cost of capital, causes greater disparity, greater mistrust, greater uncertainty, and rewards dishonesty. The policy also fails the anti-trust test for all corporations. These companies were too big in the first place and should have been broken apart under existing law.
This experiment has failed, lastly, on moral grounds. It must end.
www.bloomberg.com/apps...
Interesting to see that people way more qualified than I am are beginning to think the same way...
Cetin, Wall Street Rally because People like Wall Street "Pro" and you are clutching on straws. If you are so sure, maybe you should buy stocks with the maximum leverage allow to you now. Even better, put your family fortune all into the market so that you will become unspeakable rich with this BULL RUN.....................
But make no mistake, the pain and destruction will be enormous. If these institutions are liquidated, the true scope of the losses will not only become apparent, it will be realized.
Thousands of small institutions will instantly become insolvent, and this will cause a panic. And then there will be civil unrest.
But delaying in my opinion only postpones the day of reckoning until such a time as we are in a weaker position and less able to deal with it.
On Apr 08 06:09 AM Cetin Hakimoglu wrote:
>
> We need to bailout the too big to fail because the consequences of
> NOT bailing them out exceeds the cost of the bailout itself. Some
> companies are too big too fail.
On Apr 08 12:06 PM @TexasER wrote:
> I agree that no institution should have ever been allowed to get
> "too big to fail." And I also agree they should be allowed to fail.
On Apr 08 09:47 AM Cetin Hakimoglu wrote:
> Market surging after news of government aid for life insurers. This
> follows a 1% decline in the futures so the gain is almost 2%. This
> is irrefutable proof wall street likes bailouts and stimulus. maybe
> because they work.
On Apr 08 07:45 AM D. McHattie wrote:
> Agree with the author completely. I can't fathom why the RTC approach
> to bank insolvency wasn't used right from the beginning.
>
> The RTC approach also addresses that little matter of moral hazard
> which every bailout incurs. It's all about the reward system - if
> prudent businesses aren't rewarded and irresponsible businesses aren't
> punished then the entire system loses the compass by which decisions
> are made.
The Cure Will Be Worse Than The Disease.
On Apr 08 06:09 AM Cetin Hakimoglu wrote:
>
> We need to bailout the too big to fail because the consequences of
> NOT bailing them out exceeds the cost of the bailout itself. Some
> companies are too big too fail.
On Apr 08 12:47 PM Cetin Hakimoglu wrote:
> mises.org/story/2442
>
> Milton Friedman supported intervention
On Apr 08 06:09 AM Cetin Hakimoglu wrote:
>
> We need to bailout the too big to fail because the consequences of
> NOT bailing them out exceeds the cost of the bailout itself. Some
> companies are too big too fail.
The problems in the US today goes beyond that. Consensus from Main Street to Washington agrees the system needs to be redone. If reinventing the wheel is the objective, bailout money should be used for an orderly liquidation of these ill financial giants and rebuild a sound financial system from its ashes.
Alternatively, US gov can buy those banks for $1 to acquire the staff and technology, fire the incompetent and run the bank themselves. If the Fed wants banks to lend again but they are not willing to, let the state runn'ed bank show them how its done.
On Apr 08 10:28 AM William Cowie wrote:
> And this morning, this appeared on Bloomberg.
>
> www.bloomberg.com/apps...;sid=aJJ_MkIv9VvA&...
>
>
> Interesting to see that people way more qualified than I am are beginning
> to think the same way...
If companies such as GM cannot sell their cars, they should be allowed to fail. No exception. If banks made bad loan decisions, they too should be allowed to fail. No exception. Why should so many be expected to pay so much for the mistakes of so few? Those who think otherwise obviously have a vested interest in bailouts that the remaining 99% of Americans do not have.
On Apr 08 06:09 AM Cetin Hakimoglu wrote:
>
> We need to bailout the too big to fail because the consequences of
> NOT bailing them out exceeds the cost of the bailout itself. Some
> companies are too big too fail.
All of these stocks are up 10-25% today.
Nice call, dude.
Don't quit your day job.