The ''new'' Geithner plan

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My two cents on the matter. As I explained in a previous post we face two problems: first, we have to determine who is bankrupt and who is not; second, we have to make sure that bankruptcies occur at the lowest possible social cost.

The Bulow-Klemperer plan is, I think, very good for solving the second problem. The social cost of bankruptcy comes from the (temporary) disruption in the credit system. By insulating the ''good bank'' from the rest of the assets, making sure that it remains whole and operating, the BK plan effectively solves this problem. At that point the issue is how much the creditors of the original bank will be compensated, an issue which can and should be solved independently. The existing plans mix up these two aspect, wrongly linking the capacity of the banks to do their business to their capacity to compensate existing creditors. 

The BK plan doesn't solve the problem of determining who is bankrupt and who is not, in fact this is not the goal of the plan. Determining who is insolvent is equivalent to assigning a realistic price to the toxic assets. I guess that one could take two positions about the matter: a) the bankruptcy decision can be postponed; we first separate the good bank from the bad bank [''bad bank'' is a somewhat misleading term, since this would not be a bank; it would be a company owning a good bank and a bunch of toxic assets]. b) we first make an effort to assign realistic prices to the toxic assets. If it turns out that the bank is not bankrupt then no further action is needed. If it is insolvent then we can proceed with the BK plan, carving out the good bank and liquidating the bad bank.

Which approach is best depends, it seems to me, on the value of the good assets in the balance sheet of the banks. If there are enough good assets to create immediately a good bank then probably postponing the bankruptcy decision is a good idea. Otherwise, putting a price on the toxic assets becomes necessary.

The problem with the Bulow-Klemperer suggestion for bankrupcy procedure is that one has to figure out which debt-holders hold claims against the good stuff and which against the bad stuff. Right now they hold claim (in order of seniority) against a mixture of the two. If you do the splitting, what do you put in the balance sheet of the good bank, under liabilities? All the liabilities? Well, no otherwise the good bank is already broke. The most senior ones? That's not what seniority entitles you to, according to most bond covenants and exisiting regulations ... and so on.

In other words, the problem is always the same: who get's screwed? Who picks winners and loosers in this game? Until now, clearly, the government has been deciding who takes home the money and who pays for it, not the market or not even the law. Just the discretion of two different administrations. Not good.

No, I don't think this is a big problem. The liabilities are essentially of two types, deposits and non-deposits. Only deposits go into the good bank and they are therefore safe. But they are safe anyway since (mostly) they are already insured. The good bank also receives the good assets.

Currently, the other liability holders have claims against a mixture of bad assets and good assets but their claims are junior to deposits. Thus, effectively,  they have claims against bad assets and good assets minus deposits, assuming the difference is positive (which is the only case in which the BK operation makes sense). After the BK operation, they have claims against the bad bank, which means a mixture of bad assets and the equity of the good bank, which is owned by the bad bank. Since the value of the good bank is equal to the value of the good assets minus the deposits, they lose nothing. It only becomes clearer that they cannot hope for total reimbursement of their credit if the value of the bad assets is low.

Of course they lose with respect to a situation a la Paulson-Geithner plan, in which the bad assets are overpaid courtesy of taxpayers and the money is used to reimburse creditors. To make the point once again, this is exactly what I like of the BK plan. It separates the issue of how we treat creditors from the issue of keeping the banks running.