Paulson Changes Tack Yet Again on TARP

Restoring Confidence in our Financial Institutions



The federal government has struggled to find a coherent strategy for dealing with the crisis of confidence in our financial institutions. Fundamentally, policy confusion revolves around the conflicting goals of, on the one hand, quickly restoring confidence through government intervention and, on the other, avoiding the moral hazard and market injustices that such intervention would create.



A solution might lie in bifurcating the problem. US banks typically have two significant structural components:



A commercial banking subsidiary that is subject to extensive government regulation. The bank is funded principally with customer deposits.
A holding company that owns the banking subsidiary and perhaps other non-bank subsidiaries. The holding company is funded with risk capital (publicly traded equity securities and debt obligations).


The banking subsidiary’s primary funding obligations (deposits) are already covered by the explicit government guarantee of deposit insurance through the FDIC. In addition, there is a general market belief that regulators will use their best efforts to make sure that troubled institutions are saved intact (often through forced mergers with healthy institutions) thereby providing an extra measure of protection for the uninsured general obligations of the institution.



Given this historical partnership and interdependence between banks and the federal government, a general government guarantee of commercial bank obligations would not be a significant departure from past practice. Such a general guarantee (or the functional equivalent proposed below) would likely restore confidence in our financial infrastructure without a huge expansion of government’s role.



The holding company, on the other hand, is not generally the beneficiary of government guarantees. It is funded with risk capital, both debt and equity, that is subject to the same market forces that drive non-financial investments. It is critical to market efficiency and the avoidance of moral hazard that the government not intervene to protect these holding company security holders from loss. How can these dual goals—protect the banks while subjecting holding companies to market forces—be accomplished?



Let’s suppose the federal government forms an enormous “Bad Bank.” The Bad Bank purchases “toxic assets” from participating banks (presumably at some estimate of fair value based on a financial model), issuing in return a Capital Certificate that:



With respect to the selling bank, acts as an income producing security that can be carried on the books at par
With respect to the holding company of the selling bank, has a claw-back feature that would dilute the value (common equity value and the fixed claims of creditors) available to the holding company security holders in the event that there are ultimately losses on the toxic assets. This value would transfer to the Bad Bank.


How would this work? The holding company of the selling bank would create two classes of holding company securities—“Old Securities” and “New Securities.” The Old Securities would have a proportionate claim on the value of the holding company in the amount of the book value of the holding company at the date of the sale of the toxic assets less any losses ultimately incurred by the Bad Bank in connection with such assets. If these losses ultimately equaled or exceeded the book value of the holding company at the time of the sale, the Old Security holders would be wiped out.



Claims on the bank lost by the Old Securities holders would be transferred to, and become an asset of, the Bad Bank. Any New Securities (debt or equity) issued after the date of the sale of the toxic assets would not be subject to value dilution from losses on the assets sold to the Bad Bank—these losses would be borne exclusively by the holders of the Old Securities.



This solution would achieve several goals:



Restore confidence in our banks by inoculating them against loss from toxic assets
Send a clear signal to the capital markets that the government is intervening and taking responsibility for the toxic assets in a form that provides certainty and predictability for market participants
Allow banks to raise new capital from private investors without fear of loss from questionable historical credit decisions
Minimize moral hazard by subjecting existing holding company security holders to losses incurred by subsidiary banks under their ownership
Give the government the potential to benefit (through participation in bank holding company value) even if losses on toxic assets exceed estimates


Such a plan would require the formulation of specific rules for the allocation of value between security holders. For example, Old Security bonds issued by bank holding companies would presumably not pay interest or principal until a final accounting for the toxic assets was complete. In the interim, interest would presumably accrue and, together with principal on such bonds, would rank higher in seniority of payment than Old Security equity.



The trading value of the Old Securities would be a function of the runoff of the toxic assets and the probability of a recovery to Old Securities holders. However, the market value ascribed to the Old Securities likely would be higher than today’s market value—the certainty that the toxic assets would be managed by a patient holder such as the Bad Bank would eliminate the risk of a near term insolvency driven by a regulatory-mandated mark-to-market or forced liquidation strategy. It is reasonable to expect that the Old Securities would continue to trade actively in a liquid market.



Valuation of the New Securities would be easy by comparison. Elimination of the toxic assets “wild card” would allow the securities to be priced efficiently, thereby restoring access to the capital markets for participating companies.



Corporate governance policies in such a scheme might be controversial. Probably the simplest structure would be to have the Old Securities equity holders vote as a class, with their votes counting in proportion to their estimated ownership percentage at any given time vis-à-vis the New Security holders. Government participation in corporate governance could be more problematic, but in reality government is already participating de facto in the corporate governance of many large financial institutions.



Clearly the government would be at risk for losses incurred on toxic assets in excess of the discount established when issuing the Capital Certificates. However, a plan of this sort would likely minimize such losses by (a) creating a patient holder of toxic assets that would not be subject to the avoidable risks of forced liquidation or mark-to-market and (b) restoring certainty and predictability to the capital markets to encourage private capital formation. In any event, the government is already at risk for the large majority of losses on toxic assets through its implicit backing of the FDIC. The government would be compensated for this assuming this risk by indirectly participating in the value of bank holding companies through the Bad Bank. By taking on this relatively modest additional risk, the Federal Government would largely mitigate a much greater risk—long term loss of confidence in our financial institutions and attendant damage to the economy.
--J. Mueller