From halfway through a long article here:
Hussman Funds - Weekly Market Comment: Not Over by a Longshot - September 26, 2011
How to Restructure a Major Bank
And finally, since by all appearances we are likely to observe further strains in the banking sector, both on account of Greek concerns and as a follow-on to likely economic weakness, it is a good time to review
some comments on bank restructuring by Robert Hall (the Chairman of the NBER's Recession Dating Committee and one of my former dissertation advisors at Stanford), and economist Susan Woodward. This from 2009, but equally applicable today. Hall and Woodward include some technical details, but the upshot is that there is no reason to believe that banks need to be bailed out at every turn, or that bank bondholders have to constantly be made whole, in order to protect depositors or maintain an intact financial system:
"Economists are increasingly puzzled by the government's treatment of banks and other financial institutions that are teetering near insolvency. The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. The government's actions for Chrysler and General Motors follow the doctrine. In Chrysler's case, bankruptcy converts the claims of debtholders into equity, making its new relationship with Fiat financially attractive to Fiat. General Motors may be able to continue as a stand-alone automaker if the claims of its debtholders, including the debt-like claims of retirees, become equity.
"By contrast, the government's current policy for all large financial institutions is to dribble taxpayers' funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. The government injects funds into AIG, Citigroup, the Bank of America, and many other institutions to keep them just above water. The government has forgotten the doctrine of immediate full recapitalization in the case of financial institutions, despite the clear lessons of international experience. The Scandinavian countries aggressively reorganized and recapitalized banks after the crisis of the early 1990s and quickly restored full employment and growth; the Japanese followed the policy of supporting marginal banks for what became the 'lost decade.'
"The celebrated stress tests illustrate the current policy perfectly. The stress test takes the current condition of the bank as the goal for the future. The test has nothing to do with ensuring that banks are heavily capitalized, ready to resume their normal roles in the economy. The stress test is the right way to figure out the minimum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong policy. The government turned to stress tests, it appears, out of discomfort with the answers the standard capital tests gave, based on seeing that properly measured capital was adequate in relation to obligations.
"The effect of the government's current policy is to pay off all claimants on financial institutions at face value, including those which, when they were first issued, had no expectation of federal bailout and received substantial interest premiums on account of their willingness to accept the risk of default. There are much better uses for federal money than handing capital gains to debtholders.
"If an institution has substantial amounts of debt outstanding that is subordinated to all other claims, reorganization is fairly simple. The danger to the institution is that the subordinated claimants will put the institution into bankruptcy at some future time when the institution fails to make required payments to those debtholders and that the bankruptcy will plunge the entire organization into Lehman-like chaos. To sidestep this danger, the reorganization alters the claims of the subordinated debtholders so that they cannot trigger a bankruptcy or so that the bankruptcy that they can trigger does not interfere with the activities of the institution.
"The first approach is easy. It is the one that the government pushed on the debtholders of the automakers–convert debt to equity. With new powers granted by Congress, the government could figure out a conversion value for a large amount of debt that gave the debtholders the same market value as equity as they currently enjoy. The debtholders would suffer no capital gain or loss. As the experience with automakers' debt showed, it is virtually impossible to achieve such an exchange voluntarily, because both sides will play “chicken” until adult supervision intervenes. The compulsion of new law is necessary.
"If a borderline institution lacks enough fully-subordinated debt to achieve an adequate level of capital by converting debt to equity, longer-term debt could be treated as if it were fully subordinated. Again, the debtholders could be given equity equal in value to the market value of the debt they gave up. In this case, the claimants subordinate to the converted debtholders would enjoy a captial gain, at the cost of the shareholders.
"Actual exchanges of debt for equity are not needed to recapitalize shaky institutions. Recall that the goal is to prevent bankruptcy from interfering with substantive business, not to prevent bankruptcy entirely. Reorganizing an institution so that the debtholders retain a debt claim is practical. If the institution suffers further losses in value which cause it to default on the debt, a bankruptcy will occur. Our earlier post (The Right Way to Create a Good Bank and a Bad Bank) described how to do this. In brief, the debtholders' and existing shareholders' claims are moved to a holding company (if they are not already in a holding company) which owns all of the equity in the operating institution. Some people, including us in our earlier post, called the holding company the “bad bank” and the operating entity the “good bank.” If the earnings of the operating institution are insufficient to meet the obligations to the debtholders at some future time, the holding company does a simple Chapter 7 bankruptcy in which the debtholders become the shareholders in the holding company, with no implications for the operating institution. This type of reoganization involves quite a few alterations in the contracts between the operating institution and its customers and counterparties, so it definitely requires the kinds of new powers that the Treasury has sought recently from Congress.
"The bottom line is that Congress and the taxpayers are intolerant of continued expenditures for bailouts that generate large capital gains for debtholders, that the bailout policy maintains shaky financial institutions while a better policy would deliver fully capitalized, reliable ones.
"Among economists, a consensus is forming that regulation of the financial instutitons that enjoy the government's protection should compel those institutions to have a structure that eases the type of reorganization discussed above (see the Statement of the Squam Lake Working Group , an alliance of leading financial economists). The simplest version is to require that banks hold fully subordinated debt and equity of, say, 40 percent of assets, in a holding company, in such a way that the bankruptcy of the holding company would not interfere even briefly with the immediate operations of the bank. As we discussed above, if the operations of the bank, paid as dividends to the holding company, could not meet the obligations to the debtholders, the holding company would go through a Chapter 7 bankruptcy and the bondholders would take over as shareholders. The Squam Lake proposal would sidestep the bankruptcy by designing the debt to convert to equity on its own terms under adverse conditions.
"Under a requirement of substantial amounts of subordinated debt, bank deposits would become almost completely safe. Banks would be limited to financing their activities through deposits to the remaining fraction, 60 percent in our example above. For larger banks, this would not be a binding limitation."
How to Restructure a Major Bank
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