Good bank, bad bank, Woodward and Hall reconsidered

Further to my recent post on the Woodward and Hall proposal, some reconsideration seems in order.

The following further facts and circumstances would seem worthwhile to take into account:

1. While it is desirable to protect depositors in order to prevent bank runs, bond holders have to be induced into the bad bank scheme, since otherwise, they have a proper argument, on equity grounds, to demand equal treatment.

2. The inducement for bond holders can take the form of retaining the current uncertainty on their bond claims on “toxic” assets, while giving them some measure of control over the future. Thus, the bad bank’s equity should be given to bond holders, and not to the current shareholders of the integrated bank.

3. A further important inducement for bond holders is effectively an option on the future profits of the good bank, since the purpose of the bad bank is simply either to avoid insolvency or to limit the “haircut” on them in the event of insolvency. Thus, bondholders can also be given some direct equity in the good bank.

4. There being no free lunch, the whole scheme will likely still require public funds. This can take the form of a take-up of equity by the government in the bad bank. In effect, the government and the bondholders would become partner shareholders in the bad bank.

Taking all these into account, the new balance sheets of the good and bad banks, using the Citi data as an example, would reflect something along the following lines:

(a) The bondholders appear to have a more or less equivalent claim on the long-term assets of Citi, in which case, they could retain half their bondholdings against the good bank. The rest of the bondholdings would be partly converted into equity against the good bank, for example, $250 billion.

(b) The government could put up, say, 5% of the gross capital of the bad bank, in the form of some form of common or preferred stock. Thus, the bad bank would have shareholder equity of that amount, i.e., $30 billion.

(c) The present marked-to-market equity of Citi as a whole ($11 billion) would be assigned to the good bank. This ensures that the current managers of Citi would work to promote normal and expanded lending by the good bank.

(d) Of course, the deposits of customers would remain deposits of the good bank, which would now have an equity base held overwhelmingly by current bond holders of Citi. The bond holders would also have an incentive to see that the good bank is well managed since this represents a bet that they can recover some of any losses they might face if the bad bank were to go into bankruptcy.

The following table illustrates such a revised good-bank, bad-bank proposal. The data are the same as in the Woodward and Hall proposal, except that the $1,144 billion of bond holdings is now split three ways, $610 billion of equity in the bad bank, $250 billion of equity in the good bank, and $284 billion of remaining bond holdings. This could be accomplished by a debt-equity swap in the proper proportions. The other difference is that the government puts in $30 billion of equity into the bad bank, which shows up on both sides of the balance sheet, and the $11 billion of equity of current shareholders of Citi is retained in the equity of the good bank. The capital ratio of the good bank is 20%, instead of 32% in the original Woodward and Hall proposal.

Citicorp

Good bank

Bad bank

Assets

Short-term

448

448

30

Long-term

1,295

686

610

Other

192

192

Equity in other bank

Total assets

1,935

1,325

640

Liabilities

Deposits

780

780

Bonds and other non-deposit debt

1,144

284

Equity

11

261

640

Capital ratio

1%

20%

100%

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