Good bank/ bad bank – why we didn’t do it
Today’s guest post is written by my aunt, the economist Susan Woodward. I recently found a paper she had written which proposed to split up banks into ‘good’ and ‘bad’ banks. This is an idea I’ve heard bandied about, and it always sounded like a good one and moreover one that’s seemingly worked in other countries. “Why hasn’t this happened?” I asked. This is her response:
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The good bank/bad bank idea is kaput. “We” (the US) did not do it because
1) it would have re-written the contract between the bank bondholders and equity holders. If the govt forced this, it would have given the bondholders the right to sue for damages for the losses imposed on them, and likely they would have won, as many thrifts did when FIRREA (1989) changed the deal ex post.
2) the only point of it would be to leave the “good” bank with plenty of equity so that it could fund its commercial paper smoothly and cheaply. Any other workout or guarantee would do the same thing, and the other loans (now we know, $7.8 trillion dollars worth) and guarantees did do the same thing. The big US banks are still undercapitalized, but forcing them to raise equity right now is sort of impossible politically. So instead we just don’t let them do anything exciting and avert our gaze from the non-performing mortgages they have not yet written-down. I know that BofA is selling its above-water mortgages in order to book gains.
But I confess I am baffled by bank accounting now — it is a mix of assets (and liabilities!) marked-to-market and others not, by logic that eludes me. In Citi’s last earnings report, a large fraction of “earnings” was a decline in the value of its bonds (if a rise in the value of an asset is income, so is a decline in the value of a liability, it is not entirely crazy, just not done much before) because markets assigned a lower likelihood to them paying the bondholders. What a reporting convention. oh dear.
Citi and BofA are maybe broke anyway. Their market caps are both below $80 billion (depending on the temperature of the Euro mess) on assets of about $2 trillion each. I imagine that various parts of the govt are working on contingency plans for orderly dismantling of them. Just in case.
As for European banks, they may need lots and lots of help, depending on what Europe does about the ECB and its ability to issue bonds, buy bank assets, and, ulp, collect TAXES. All of the pundits are right that if the ECB could buy sovereign bonds and bank bonds, it could fend off a meltdown at least for now. The US Fed has bought 11% of GDP’s worth of US bonds, and the UK has done 13%. So it is not a new or unknown strategy. But in the US and the UK, the power to tax as well as the power to print money lies behind the institution.
The situation is somewhat like the original States after 1779, when the new constitution reserved the right to print money to the federal government, and took it away from the States. The first federal power to tax was not direct, but worked through telling each state what share it owed, then counting on the States to raise the money, sort of like the ECB now. When the Federal govt finally got the power to tax directly, the value of its bonds, 23 cents on the dollar in the early chaotic years, rose to par, then above par. The federal assumption of the States’ expenses for the revolutionary war resulted in a deal — Virginia, which was very prosperous and had paid off some of its war debt, agreed for the deal to assume the burden of Massachusetts, which had not paid off so much and in any case also had a heavier burden in the revolutionary war, in exchange for moving the capital from New York to Philly (temporarily), then on to Washington. The deal was cut at a dinner party in New York attended by Jefferson, Madison, and Hamilton. I wonder what wine was poured.
In those early years, States funded their state-level budgets with earnings from owning shares in banks they chartered! And the previous colonies funded their budgets from mortgage lending! So much for the separation of finance and government.
Were Massachusetts and Virginia then more similar to each other then than Germany and Italy are now? Not so clear.
Writing clear and helpful things about the financial crisis is not easy and takes heaps of time, which is why we quit doing it. But hey, if you have it, go for it.
love, Aunt Susie
mathbabe 
In the UK, when the mortgage bank, “Northern Rock” went bust, the government bought it and split it into a ‘good bank’ and a ‘bad bank’. They are currently in the process of selling the ‘good bank’ to Virgin at a significant loss. The government has revealed that they cannot hold on to the ‘good bank’ much longer in the hope of making a profit because it would violate EU rules on state subsidy.
Meanwhile, the percentage of ‘toxic’ mortgages that defaulted in the ‘bad bank’ has been lower than expected, and it will be twenty years or so before the position has finally unwound. However it looks close to break even, with a serious risk of making a modest profit.
So you can argue that the ‘bad bank’ was good and the ‘good bank’ was bad :S
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