The Bad Bank Owns the Good Bank -- Brilliant!
Susan Woodward and Bob Hall illustrate nicely how a partitioning of an existing bank into a good bank and a bad bank could work. The key is that the good bank is a wholly owned subsidiary of the bad bank. The good bank holds the insured deposits of the current bank, along with all of the assets of sufficiently high quality. The bad bank holds the liabilities other than the deposits and owns the remaining assets and all of the equity in the good bank. Here is how they describe the rationale for making the partition:
Now one might wonder, given that the intrinsic claims of neither the bond holders nor the equity holders has changed, why bother? Pundits talk about the toxic assets in the banking system as if somehow they were infectious, and the good assets would become infected by the bad assets. One envisions the mold on one piece of cheese taking up residence on an adjacent piece in the frig. Or that somehow if the bad, hard-to-value, assets were moved somewhere else, both sets of assets would be easier to value and the banking system somehow more sound. We don't think the bad assets are infectious. Nor do we think this re-arrangement increases or changes values or facilitates the valuations of the assets behind the banking system. What the change does do is make ever-so-clear what the priorities are in an insolvency. Note that in this re-arrangement, the debt claims, including the short-term commercial paper, are direct liabilities of the bad bank. If the bad bank cannot re-fund its commercial paper one morning, the bad bank must be re-organized. Some of its claims must be turned into equity. This is the standard sort of Chapter 11 re-organization.
Exactly -- no more bailout in lieu of bankruptcy, and no run on the solvent part of the bank. Read the whole thing.
Bad Bank
This whole idea sounds insane. Not only will the bad bank go under, but it will bring down all of the good banks, and we will be paying for it for the next 20 years. This country needs to bite the bullet now and move on.
Joe from California
Not If All Banks Are Partitioned
A bad bank cannot take down its own good bank -- the good bank is an asset of the bad bank, not vice versa. The uninsured creditors to the (now) bad bank are the ones who lose if it goes down. Call that Bank A.
Some of those creditors may be other banks. Call that Bank B. Bank B should also partition itself in this way, with the risky liabilities of Bank A partitioned into the bad bank part of Bank B. In this way, the failure of Bad Bank A cannot cause Good Bank B to have trouble, only Bad Bank B.
The partition won't work for banks that don't have enough high quality assets to be well capitalized against their deposits. They will fail -- as they should be failing now -- and the FDIC will be on the hook to cover their depositors. But that is no worse than the status quo.
one more
Someone needs to give a reason to believe the prospective good bank will not (at some point in the future) get into the same situation as the old bad bank.
Why do the managers of the
Why do the managers of the good bank have different incentives (in deciding how much to loan and what kind of risks to take in doing so) than the managers of the existing bank? The subsidiary's balance sheet looks much stronger but the managers of the good bank know they are owned by the bad bank, and would be expected to respond by acting to maximize the value of the enterprise as a whole (good and bad bank combined). If they did otherwise, the bad bank would be expected to hire other managers. If so, the good bank's decisions (in making loans etc.) would be no different from those the existing bank would have made. A change in the form of ownership won't change conduct unless a wholly owned subsidiary is a lousy agent in advancing the interest of its principal. Is that the theory here?
The insolvency priorities are
The insolvency priorities are already clear enough, as any lawyer could tell you. The problem is that of affiliate separation. In the insurance business, people are used to the insolvency of affiliated insurers--happens all the time: no big deal. It doesn't work this way in banking-securities land. People get antsy, notwithstanding Section 23A of the Federal Reserve Act, which pretty much insures that there aren't any strange interaffiliate transactions among banks and nonbanks. Maybe the good bank is really good, but it's easy to pull yur money out and fund somebody else.
You go into a crisis with the counterparties and attitudes you have, not the counterparties and attitudes that you wish you had.
Woodward and Hall's proposal on good and bad banks
It's not really brilliant. If involuntary, it violates due process and equal protection. You can modify it to induce bondholders to go along, but then you still need public funds.
For more:
http://foolawecon.wordpress.com/2009/02/27/good-bank-bad-bank-reconsidered/
The Swedes agree
FWIW, the Woodward and Hall model seems to be very much that utilized successfully by Sweden during its financial crisis, as explained by Anders Aslund (and contrary to the popular notion that Sweden nationalized its banks).