Good Banks, Bad Banks: My Proposal

The economic landscape has changed after the 'short selling debacle' causing runs on some of our nation's largest institutions.  The problems stemming from the failure of the CDO - CDS markets are becoming more and more clear.  For those that don't understand the significance, this Market was approximately $46 Trillion in 2006-2007, according to some estimates.  The Treasury is about $5 Trillion, just to offer a comparative analysis.  Translated, banks hold a significant amount of synthetic debt.

This is the root of the problem in our economy right now.  This is what congress is faced with, and this is what Paulson and Bernanke are trying to combat with their $700 Billion Proposal.  This is a byproduct of the Investment Rate by the way, and a major variable in the probability equation of a Greater Depression.

First, risk analysis tells us that the balance of risk given the $46 Trillion synthetic debt Market vs. the $700 Billion proposal is significant.  Can $700 Billion really cover the cost?  Also, many Wall Street pundits are asking why the Government would acquire ownership stakes in the banks who choose to engage the Government for solvency.  The answer is quite clear...

By definition, synthetic debt only holds value IF the loans are paid.  If the loans fail, the portion of the bundled debt package that was tied to the failed loan dies along with it.  In many ways this can be analogous to an expiring option.  This option just happens to pay interest.  However, there is no underlying asset!

The risk is complete default. 

Owners of synthetic debt will lose all of their investment if all of the loans in the bundle default.  If only a portion default, the losses will be limited to that portion.  Although the bundling of loans dilutes the potential for complete loss, the risk is still very clear: The potential for 100% loss exists.  This is why the Government is proposing an option to acquire equity in the banks who engage this program.  Otherwise the risk to the taxpayer would be 100%.  Wall Street pundits, including Larry Kudlow, need to recognize this.  Do they realy want Government to bail them out without paying for it?

Either way, that doesn't change the bailout's lack of efficacy. 

$700 Billion without associated risk controls is penance to the US Taxpayer.  This is the resolve of Congress, and this is where the debate comes from.  I don't blame them.  I personally have a problem putting $700 Billion of US tax dollars in an option!  Especially in the face of the 3rd major down period in US history, according to the Investment Rate.

The banks should be left holding the bag....but not the banking system or taxpayers.

Maybe this is where the capitalist structure really begins to work?  Maybe this is where Darwinism applied to economics becomes relevant?  Maybe this is where the potential insolvency of the banks who own the synthetic debt becomes a reality?  Maybe this is where the shit hits the fan?

I personally feel that Paulson and Bernanke have done a horrible job developing and selling the proposal and although I do expect congress to pass something to patch this immediate issue, I do not expect this proposal to pass.  Further, for Paulson not to recognize the significance of this issue after his tenure with Goldman Sachs (GS) is catastrophic.  He may be a true free market capitalist, and if so he should be willing to let the banks fail.  That may be the answer...sort of....

This leads me to my proposal.

We have already heard the terms 'good bank' and 'bad bank,' and these are excellent terms. Unfortunately, the proposals that we have been hearing thus far are to sell the bad banks to the US Government to get the synthetic debt off the books, and allow the good banks to remain in the hands of shareholders.  Not so fast!

I appreciate the notion of good bank and bad bank because that clears up plenty of the associated risk tied to the synthetic debt market.  However, I do not agree that the Taxpayer should buy the bad bank to provide solvency to the underlying entity.  Nor do I want the US Government to own shares in companies they do not control.

Instead, I believe that the Government, where needed, should buy the good bank instead!  The Government, for a short while, will own the solvent, operational bank, but it will never own the synthetic debt under my proposal.

The remaining portion of the potentially insolvent bank owned by shareholders and bondholders would be tied directly to the bad bank if the entire entity needs Government assistance, and those shareholders would bear the entire risk associated with the synthetic debt.  The Government should not be willing to buy the bad bank in any circumstance whatsoever!  Definitions of good and bad assets would have to be made clear through policy.

In fact, banks should be required to differentiate between good and bad assets now, prior to the risk of insolvency.  By dividing these assets now potentially insolvent banks might also have the ability to spin off the bad bank to shareholders, leaving them with a significantly smaller equity percentage in the good bank of course, but avoiding bailout proceedings at the same time.  This, in turn, would still leave shareholders with some equity in the good/ solvent bank, complete ownership of the bad bank, and the banking system would remain in tact because the good bank would not dissolve.  The shareholders and bondholders would remain owners of the synthetic debt.  Alternatively, the good bank could be sold in a separate public offering with similar results.

If the Government is forced to assume control of the good bank based on the insolvency of the underlying entity, the US Government would then revert the existing 'good bank,' which should be solvent and operational, back to the public through special offerings of its own.  This would allow the taxpayer to recoup the expenditure and it would put the onus of 100% loss on the 'bad bank' instead.  If those CDOs hold value, the shareholders of the bad bank should be able to liquidate those assets for fair value in the open Market.  If they don't, the bondholders will lose everything.  But the risk will be on them, not on the Government. 

The Government is already overleveraged.

This proposal would require the development of new agencies and it would require the active involvement of the Treasury in direct connection to Wall Street to spin off these 'force majeure' banks.  However, it would prevent taxpayers from assuming the risk on behalf of the banks which caused this problem in the first place, and it would allow the banking system to remain operational.

In the case of bankruptcy without prior differential, the US Government would impose a mandate to restructure the bank into two entities based on policy, sell the good entity to the Government, and dispose of the bad bank in the open market under bankruptcy proceedings.

Given a declining Investment Rate, the Government should not leverage itself without protection, and the 'bad bank' policy being proposed does not offer any protection whatsoever, while increasing the risks measurably. 

My proposal offers protection, and it will allow the banking system to remain in tact.  My proposal pays no consideration to the shareholders or owners of potentially insolvent banks, but instead it focuses on the banking system itself.  Significantly lower equity values would be a natural byproduct of my proposal, and warranted.  Bad decisions result in consequences. 

It's time for Darwinism to take over!

Paulson and Bernanke have failed thus far.

Disclosure: None

Comments

[rawdawgbuffalo:]

it will be one big bank soon

2008 Sep 25 07:57 AM

[mouth:]

Time is running out The deal will be done by Friday at the latest

2008 Sep 25 08:29 AM

[JCC:]

It is obvious to most that when you arteries are clogged, the blood doesn't flow. When you have blocked arteries it is an emergency, and to avoid a heart attack it is critical to get the blood flowing, which implies the use of a stent or open heart surgery. A complete blockage will result in a heart attack or worse. Time is critical, and the required correction is an emergency.

Analogous to your vascular system, the financial markets are the arteries of the economy. Analogous to your arteries, when the financial markets are frozen, the monetary supply does not flow. This creates an emergency situation where it is imperative that we restore the monetary flow.

In today's environment it is critical that we on an emergency basis thaw the financial markets thereby enabling the required monetary flow. There is not a lot of time to react. Waiting too long will create a severe recession or a depression.

2008 Sep 25 11:50 PM

[Steven Hansen:]

i wonder what the hurry is except that congress wants to recess. this toxic waste is not going to come screaming off of the balance sheets in one day. it will evolve over several years.

2008 Sep 26 12:32 AM