Failing Banks

How does the simplistic view of bankruptcy compare with what happened with Lehman?

Yes. The bondholders are the new equity owners. It is quite simple, and has a long track record. I guess the size is the only diference this time around but the principle is simple.

There is an interesting plan proposed by the German Economist Ulrich van Suntum to replace those toxic assets by government zero bonds. The idea is to keep them in the bank`s balances until their present value is only equal to the present value of the toxic assets. (CAWM-discussion paper No. 12) Couldn`t that really work?

It seems to me that the question is who will revalue the assets. In a bankruptcy the assets will be revalued at auction, and the debt holders have an incentive to obtain the highest possible price as quickly as possible. If the government seizes the assets, they will be distributed in accordance with political objectives which may very often not mean obtaining the highest possible price, nor will it be done quickly.

Where "nationalize" means to pay at least fair value for equity and to purchase enough equity so that the banks are adequately capitalized using current accounting and capital rules, honestly applied, and sold in three months, shouldn't they be nationalized?

The bonds should be converted except if policy makers are scared of that, this is the next best approach to the problem.

The government's running banks for a time is neither appealing nor necessary. Dealing with the assets that have declined in price and are said to be cheap separately isn't required. They may very well appear attractive once they are detached from the accounting misrepresentation of bank balance sheets that they cause.

Yes, debt-to-equity conversion is an interesting option. However, it could not be applied to public debt. A massive conversion of private debts would create an inventive to lend to governments rather than private entities, in order to avoid the next conversion.

What is the downside of applying conventional bankruptcy proceedings to bank holding companies? I was under the impression that even under current law holding companies could enter bankruptcy. Presumably they don't generally do so because disposing of the bank assets requires the involvement of the FDIC (or some other regulatory agency). Is that correct? If so, perhaps that process could be streamlined so that conventional bankruptcy could actually work for bank holding companies.

One good aspect of a bankruptcy solution is that the process is predictable. All the actors know what the process entails, what to expect, what the likely outcomes will be, etc. That strikes me as a significant advantage that bankruptcy would have over (further) untested government tinkering.

If the bank holding companies are too complex to flush through a bankruptcy-type proceeding, then part of the alternative resolution should include breaking them up. Government guarantees should exist only for the benefit of hapless depositors, not senior debt holders or anyone else in the professional risk business.

Here is my understanding of the problem. Please advise if I have it wrong.

Banks made a series of poor quality loans and these loans were securitized.

A credit default swap market evolved which placed bets on these securities. The banks used this market to hedge their exposure. They also sold and bought default swaps to other actors in the system. This created a false sense that there was no risk in these transactions, or even in trading the swaps because everything was hedged. The only risk was if the counter parties couldn't pay up, and this risk was judged to be tiny. This market ballooned to many times the size of the underlying mortgage securities.

Because of the weakness in the underlying mortgage securities, a significant number of these defaults now will pay off; far greater than the reserves available to cover them. The banks might be able to deal with the losses related to mortgage securities, but there is no way to resolve the current tangle of credit default swaps, which is far larger.

Everyone is depending on the hedges they made against the risks they took. If a major bank fails, it can't pay off the default swaps it guaranteed, and the hedging swaps held by other banks then fail, causing a cascading effect. This has not reached a critical mass yet, but once major banks start to fail, it will take everyone down.

Hi Arnold,
for what it's worth, the Woodward and Hall proposal is good at illustrating how to do the good-bad bank split. But there are some problems, not least the "haircut" problem of bond holders, and the alignment of incentives as between those who run the good bank and those who run the bad bank. For more you may wish to see my post at: http://foolawecon.wordpress.com/2009/02/27/good-bank-bad-bank-reconsidered/