How To Clean A Dirty Bank

In the New York Times, Andrew Rosenfield writes:

Commercial banks in the United States are not subject to the bankruptcy statute — when they become insolvent they are simply acquired by the government. This is what banks sign on for in return for a charter, deposit insurance and direct access to the Federal Reserve lending window, which generally allow banks to prosper as long as they control risk.

Now Treasury Secretary Timothy Geithner wants to apply this same swift acquisition process to large insolvent “shadow banks” that risk doing damage to the financial system — big hedge funds, investment banks, insurance holding companies and the like — because bankruptcy proceedings move too slowly to allow these institutions to be quickly refinanced or restructured.

Secretary Geithner says the lack of a good mechanism to restructure Lehman Brothers contributed to that firm’s failure last fall. And it is why the Bush administration’s ill-designed overnight infusion of capital into American International Group turned out to be such a mess. The company avoided bankruptcy, but could not be properly restructured.

Mr. Geithner is right to want a rapid seizure system for shadow banks. What’s odd is that at the same time that he is proposing one, the government is failing to use powers it already has to restructure insolvent commercial banks. Instead, Mr. Geithner continues to suggest a variety of other actions that seem unlikely to solve the banks’ central problem — a lack of equity capital. Perhaps he fears what would happen if large bank holding companies were to default on their bonds, which are held by insurance companies and other institutional investors. But that is a problem that needs to be tackled head-on, not by propping up failing banks.

Consider what happens when the government acquires an insolvent bank. The shareholders and the debt holders of the bank’s holding company may be essentially wiped out — even as the bank itself is merged into another institution. That is what happened, for example, when JPMorgan Chase “acquired” Washington Mutual bank; its holding company promptly went bankrupt. This approach allows the market to properly discipline banks. The fear of loss gives investors the critical incentive to deny capital to those that take excessive risks. Also, when the price of a bank holding company’s stock and debt plummets, it is an early warning of trouble.

Treasury’s new plan, the Public-Private Investment Program, reduces that incentive by preserving shareholder and debt holder ownership of insolvent banks. It also injects capital into those banks in a roundabout, unproductive way. Under the program, the government will help private investors buy at auction the banks’ toxic assets (what Treasury now calls “legacy assets”). Private firms will use government funds, along with some money of their own, to buy the assets at prices above current market value.

The government will bear almost all the exposure to losses from these transactions, but earn only a small fraction of any profits. Another problem is that if the buyers of these assets harvest significant gains, they will have to worry that Congress might seek to recapture the money in the future, as it has threatened to in the recent bonus turmoil at A.I.G. This fear will lower the bids and therefore the amount paid for the toxic assets.

Even if it is successful, the program will add very little new capital to the banks — roughly only the amount paid for toxic assets that is over and above their current value.

There is a simpler, sounder and fairer way to recapitalize an insolvent bank. The government should seize it, as it is already authorized — indeed, compelled — to do. Then it could inject cash (in the form of Treasury notes) as equity in the bank and, at the same time, remove the toxic assets the bank holds. Bank regulators might perhaps swap Treasury securities for toxic assets “at par” — that is, in an amount equal to the original purchase price of the assets removed. This would be a fair transaction, and it would cost nothing, because the government would own both the bank and the bonds. The toxic assets could then be placed in the basement of the Treasury building while we wait to see what they turn out to be worth.

The government could then quickly — say within a month — auction off the bank. Speed would be critical: If Treasury were to hold a large bank for a long time, it would be difficult to retain the most talented employees, and it is the people, along with a clean balance sheet, that make a bank valuable.

If markets work at all (and if they don’t, Treasury’s new plan is doomed to fail), such an auction would produce a new privately owned “clean” bank, with ample capital to lend. It would also generate proceeds from the sale that would be at least as great as the value of the securities injected into the bank as equity — and likely greater.

If the recapitalized bank could not be sold at a price that amounts to (at least) the new cash injected, then the bank would be worthless, but not because of the toxic asset problem. It would be because the bank has been mismanaged or has other bad loans unrelated to the mortgage crisis, and such a bank should be allowed to fail.

If the sale succeeds, however, the government would have created a fully financed private bank at essentially no incremental cost to taxpayers, and Treasury would still hold the toxic assets on its books — to be sold whenever it becomes economical to do so.

This is a simple and fair plan. And unlike the Public-Private Investment Program, it would not reward bank investors for their folly or inject too little capital when more is needed.