Go With Bankruptcy Over Nationalization

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The decision before us is being set up as a choice between nationalizing the banks quickly and “temporarily” as recommended by Alan Greenspan or slowly “as losses occur”, as recommended by Ben Bernanke. We should do neither. Insolvent banks should not be nationalized; they should go bankrupt.

Many large American banks are insolvent, meaning their liabilities are greater than their assets. For such institutions a bankruptcy-type restructuring is the best solution for many reasons. Insolvent banks need not be liquidated. They should have their assets written down and then be put under the control of a conservator. The only question is, who should be the conservator? It should not be the government; it should be the debt-holders.

The complexity of big banks has been overemphasized. When we consider a large bank’s balance sheet, the parts that matter are not all that complicated. Imagine a big bank with $2.0 trillion in assets. It has suffered losses but still has $100 billion in equity. That leaves $1.9 trillion in debts, and of those maybe $500 million are deposits.

For those who deride “mark-to-market” accounting, consider the first question that this large balance sheet forces one to ask: How much are those assets really worth? It’s the first, last and only question. Of course we want to know the answer to that question. Mark-to-market is the only way to know.

Suppose the assets are worth 95 cents on the dollar, so the value of the assets is the same as the value of the liabilities. Then an investment of equity is a marginal investment, depending on how it is structured.

Suppose instead the assets are worth 80 cents on the dollar. Then there is a $400 million loss. The equity has some value, but it is really “option value,” which means it could have value if the assets improve. A government equity investment now looks like a bailout of the debt-holders, who would suffer a $300 million loss if the bank were liquidated.

Now, if the assets were worth 95 cents on the dollar, we wouldn’t be having a “banking crises.” So all we really need to know from Treasury Secretary Geithner’s proposed Stress Testing is if the assets are now worth considerably less than 95%. Let’s assume they are. In this case, the nationalization schemes currently being talked are debt-holder bailouts.

Why are these debt-holders being bailed out? In our hypothetical case the deposits are guaranteed so the $300 million loss must be borne by the other debt-holders, meaning their claims are now worth about 80% of par. Not great, but survivable.

Why is it better, either immediately or over time, to have the government rather than the debt-holders absorb these losses? There seem to be no good reasons. In fact, there are many good arguments for allowing the debt-holders to organize themselves as a class and control the fate of the insolvent bank.

First, they are sophisticated. Generally this debt is widely held among institutional investors who understand the credit markets very well. Who better to manage the “toxic assets” of a failed bank than professional bond fund managers?

Second, they are deep pocketed. They can absorb the losses because generally bond fund managers run balanced and diversified portfolios. A 20% loss on their big bank holdings should not wipe them out.

Third, they will do a better job maximizing the value of the assets than the government. This point should require little elaboration. Who would you hire to run a restructured Citibank, Bill Gross or Barney Frank? The debt-holder who just took a 20% haircut wants to preserve the value he still has, and hopes to get his 20% back and more. He will be profit-minded, not politically oriented.

As we see with all this distracting talk about bonus pools, if the government is in the bailout business, the average editorialist feels his or her input into Vikram Pandit’s compensation is entirely relevant. Debt-holders can quietly go about making decisions on how best to restructure the bank. They can decide on a purely rational basis whether to liquidate assets or hold them in hopes of improvement. Likewise, there is every reason to think that they will run the lending business to maximize their return, and this has a far better chance of creating value than a credit committee chaired by Christopher Dodd.

Finally, allowing the debt-holders to absorb the losses and then manage the failed enterprise avoids moral hazard and is perfectly fair. It avoids moral hazard because it restores debt-holders to their proper role as guardians of the banks’ asset quality. Because banks are so highly levered, and because management’s incentive schemes are often one-sided, it has traditionally been the debt-holders who guard against excess risk. Debt-holders are the real regulators. They were asleep at the switch and are both victims and culprits in the current mess.

But if the government were to bail out the debt-holders in the current crises, and return to them the par value of their securities, all hope for restoring a rational financial system would be lost. Temporary nationalization, as advocated by Greenspan, is the worst choice because it forever removes any incentive for debt-holders to check the excesses of bank management. For levered institutions like banks there could be no going back to a system where private capital-holders maintain vigilance over asset quality.

Bankruptcy where debt-holders take a haircut is fair because it is the one choice that does not deal anybody a free lunch. Equity-holders, preferred-stock holders, senior creditors and junior creditors will each get exactly what they bargained for when they invested in these banks.

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