Ken Nelson

All past attempts and current administration proposals to “fix” the financial system have been “kick the can down the road” solutions.  Put another way, they put lipstick on a pig and called it pretty and hoped it would be true eventually.

Yet, an obvious solution was there all the time. It has been used countless times and it works.

Lets say I owe you money and I can’t pay.  You have something of value, lets say your company, but not enough cash.  Rather than be left out in a lurch, if I’m patient, it would be in my best interest to accept EQUITY in your company as repayment.

Using General Motors as an example, if they have contracts with workers that they can’t honor, then smart workers would take equity rather than pennies on the dollar or nothing. They would end up owning GM.   United Airlines current employee ownership structure is a recent and large example of this.

Economist’s Paul Kemperer (Oxford) and Jeremy Bulow (Stanford) propose a similar plan for banks. They focus on liabilities not assets. Who does the bank owe, and how can they repay them, versus the current focus on what do the banks own and how can they capture the value.

Say Citi’s assets were worth $1.5 trillion. A new (“bridge”) bank that included all the assets plus say $1 trillion of the old bank’s most senior liabilities would still be comfortably well capitalised, even if the asset values were overestimated. The original bank would be left with all the equity in the new bank, worth $500 billion, and the remaining $800 billion in liabilities.

The original bank would still be insolvent, but that would not prevent the healthy new bank from operating efficiently and making good loans. If a risky original bank’s marginal cost of funds is, say, 10% it will not be profitable for it to make new riskless loans at 7%, even if the market riskless rate is zero. By contrast, because the new bank is well capitalised, it can borrow on sensible terms if it has a profitable investment to fund.¹

Giving the old bank an equity stake in the new bank is the best way to compensate the holders of old bank’s liabilities to the full liquidation value — but not more than that value — of their claims. It may also facilitate the reorganisation of the old bank if, as is likely, it goes into bankruptcy, since creating marketable equity in the new bank resolves the difficulty of valuing the old bank’s assets, and avoids any need to sell the new bank on to a third-party – a transaction from which the government might be unlikely to get full value.²

That is smart, especially when assets cannot be accurately valued.  It also creates healthy, untainted banks that are ready to do business, not flounder in their own misery.

This is WAY better than Geithner & Obama’s recent plans involving more toxic asset buying, more regulation, continued moral hazards, and higher taxes.