Luigi Zingales Thinks Geithner, Incumbent Bankers & Lobbyist Are Bed Fellows

Luigi Zingales, Prof at the UofC writes:

Mr Geithner, incumbent bankers and their lobbyists will always make you believe there is no alternative to the plan that benefits them the most. You cannot fall for this old trick.

We can save the banks as institutions and restart lending without a massive transfer of money from taxpayers to investors and bankers, and here is how.

One solution is the one I advanced last fall. It requires passing a new piece of legislation introducing a new form of bankruptcy for banks, where derivative contracts are kept in place and the long term debt is swapped into equity.

An alternative would be to allow banks to divide themselves into two entities, a bad bank with all the toxic assets and a good bank, with lending etc.

If the solution is so simple why has it not be done before? First, because it is much simpler to get money from the government than to obtain it through hard work. So no bank would consider doing this spinoff if it hopes to receive extra TARP money. Second, because most bank debt has covenants prohibiting exactly these splits. Even if the liabilities are shared equally between the two entities, the equityholders tend to gain from this split and the debt holders tend to lose. If the shortfall in the value of toxic assets is large enough equity in the whole entity would be entirely wiped out, while with the two split entities equity holders will retain some value in the good bank, at the cost of a lower overall repayment for the debt holders.⁸

This problem, however, can be dealt with by giving debt holders of the bad bank a warrant on the equity of the good bank, increasing their payoff at the expense of the equityholders. Furthermore, the creditors have benefited so greatly from all the government infusions of money so far that it would only be fair that they will share some of the pain for their bad investment. To allow banks to spin themselves off in two units, however, we need to pass a new law. As in October the “nay sayers” will say it is impossible. It was possible to write a $700 billion check to Paulson, it is possible to approve a $825 billion stimulus package, why it is not possible to pass a very short law allowing banks to spin off?