Breakingviews.com How to Improve the Bank Rescue

January 26, 2009
Breakingviews.com How to Improve the Bank Rescue

The "bad bank" schemes being considered by President Obama's administration have a central flaw: they involve government-backed entities buying banks' dodgy assets, which in turn requires the immediate valuation of assets that trade at distressed prices, if at all. That increases the likelihood of error, risks rewarding obfuscation, and could leave taxpayers in a hole. There are better ways to structure bad banks.

To work properly, the incentives of all parties should be aligned as closely as possible. Bank rescues must distinguish between banks that are troubled but can be saved and those that should be allowed to die. As little as possible of the industry should be taken into public ownership. And taxpayers must be properly protected, so that the bad bank process does minimal damage to their economic interests.

There is a way to meet these objectives: allow banks to sell any assets they want, and have the government's bad bank acquire them on a consignment basis with no initial cash outlay. Banks would achieve a return on their consigned assets only as the bad bank sold them or allowed them to mature. This "consignment shop" structure removes the initial valuation challenge that bedeviled the original concept of the Treasury's Troubled Asset Relief Program.

One result of this approach, however, is that when banks remove assets from their balance sheets, it eats into capital. To replenish it, the government could hand the banks cash or, in a pinch, liquid Treasury bonds in exchange for preferred stock equal to the book value of the assets transferred, possibly with some warrants attached as well.

Meantime, the bad bank would act like the Resolution Trust Corporation, which gradually liquidated the assets consigned to it. Since it would have assets from many banks, it could combine them to help unscramble securitizations and maximize proceeds from sales. The bad bank could retain a modest commission, perhaps 5 percent, and return the net proceeds of asset sales to each bank.

The banks would then be required to use the proceeds to repurchase the government's preferred shares until its total investment had been repaid. After five years, any remaining preferred shares would convert to common shares.

By way of illustration, suppose the book value of a bank's assets is $100 billion. It consigns $60 billion of worrisome paper to the government's bad bank, leaving it with a $40 billion "good bank," which issues $60 billion of preferred stock to the government. Five years later, the government has sold all the bad assets, but managed to get only $25 billion for them. Meanwhile, though, the good bank has doubled in size.

So the good bank has $80 billion in book value, but the government still owns $35 billion of preferred stock. That then converts into common shares, and the good bank survives in public ownership with a government stake of 44 percent.

If, however, the good bank ends up worth less than the outstanding preferred stock, the government would take it over and begin an orderly liquidation, just as the Federal Deposit Insurance Corporation already does with failed banks. The worst banks would be eliminated from the market and survivors would have room to expand.

Under the consignment shop structure, banks would consign only assets with doubtful values. And banks that had not marked assets down enough would have to issue more preferred shares to the government, endangering their long-term survival or at least leaving them with higher levels of government ownership in the future.

Meanwhile, banks with assets that are not badly impaired could redeem the government preferred shares within five years, avoiding any government shareholding thereafter. And taxpayers would risk losses on bad assets only if a "good bank" ran out of capital completely, minimizing the potential cost and the risk of over-paying for assets.

Banks' share prices would, of course, remain uncertain while preferred shares were outstanding. But their standing as debtors would be much clearer, enabling them to raise private sector finance. This kind of structure, avoiding many of TARP's flaws, makes for a less bad "bad bank."

MARTIN HUTCHINSON

http://www.nytimes.com/2009/01/26/business/26views.html?sq=How%20to%20Improve%20the%20Bank%20Rescue%20Hutchison&st=cse&scp=1&pagewanted=print

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