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How to Detoxify the Banks

Separating the wheat from the chaff.

6:00 PM, Mar 6, 2009 • By JIM PREVOR
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The Bush and Obama administrations have shared an unwillingness to see any of the major banks go under, hence the problem we have in solving the current banking and financial crisis. Though both presidents pointed to an alleged systemic risk to the economy owing to the size of the big banks, it is probably also true that any administration would be sensitive to the enormous weight these institutions carry as symbols of American prosperity, influence, and power. A collapse of Citigroup, for example, would be seen by many as an economic equivalent to the collapse of the World Trade Center.

At the same time, there is no great constituency in America for nationalizing banks in America, and there is obvious risk that, if nationalized, such banks would be run for political purposes. Other proposals--to launch new banks, for example--are not serious responses to the scale of the problem.

Happily, there is actually wide consensus on what needs to happen, and the solution is simple. In fact, Hank Paulson almost had it right. Since there is no stomach for seeing giant banks fail, the need is to separate the "toxic waste," or the damaged assets these banks carry on their books, from the good assets. This was the idea behind the original Paulson plan, the Troubled Asset Relief Program or TARP.

The Paulson plan foundered on this unavoidable fact: If the Treasury bought damaged assets from the banks at fair market value, the banks would be revealed as insolvent; if the Treasury overpaid for the assets, so as to make the banks solvent, the shareholders would unfairly benefit.

To avoid this Gordian Knot, Paulson made equity investments in the banks. This, however, didn't solve the problem because nobody could be certain that the amount invested was sufficient. It also was a solution that had its limits. As bank stock prices swooned, the Treasury would acquire a majority stake--becoming the owner of the banks, if it put in enough cash to make the institution solvent.

Indeed, in the latest bailout for Citigroup, Treasury Secretary Tim Geithner overpaid for common stock. The main reason he did so? To keep the U.S. Treasury from becoming the majority owner.

The stock market tumbled when Geithner unveiled the Obama bank bailout, to no small extent because the plan was exceedingly vague. Undoubtedly this is because it has come up against the same problem as the Paulson Plan--there is no way to price the toxic assets in a way that saves the banks and avoids bailouts for their shareholders.

The way to cut the Gordian Knot is to leave the toxic assets where they are and focus instead on setting up a mechanism to purchase the "good" assets. To be more precise, leave the financial assets where they are and buy the operating assets.

Here is a simple four step process:

(1) A troubled bank is given an opportunity to set up a wholly owned subsidiary. The subsidiary then buys from the parent company all the operating assets. From the name and logo, to the branches, accounts and employees, the profitable parts of the bank are sold at fair market value. Because banks, branches, and deposits are sold fairly frequently, there are metrics readily available to enable us to price these assets.

(2) The federal government funds the subsidiary with both enough money to buy the operating assets and sufficient capital to operate the bank and have it function as a lending institution. The funding would come in the form of a cumulative preferred stock. Cumulative means that the new bank need not pay dividends if it can't spare the cash, but those dividends will accrue. The rate can be discussed; in the federal bailout of Chrysler in 1979, Chrysler paid one percentage point over the government's cost of funds.

(3) The bank would spin off the newly capitalized subsidiary to its shareholders. The old banks that contained the toxic assets would be renamed and operate as closed-end mutual funds working to unwind all the financial positions. The cash from the sale of the operating assets would give these funds money to unwind positions in an orderly way.

(4) Though public shareholders would own both corporations, nothing could be taken out of the "old bank" until all positions are unwound and liabilities paid off. Nothing could be taken out of the new operating bank until the government's preferred stock was brought current and bought back from the government.

When the spin-off is completed we have a rock-solid bank, with no toxic assets, no liabilities, and total transparency ready to serve its role in commerce, and we have a closed-end mutual fund gradually unwinding its toxic positions.