Putting the Zombies to Rest

By Dr. William W. Woolsey, Special Economic Correspondent of The Free Enterprise Foundation

Now that Democratic politicians have borrowed $787 billion to fund their pet projects, Treasury secretary Geithner is looking at the real problem—putting the zombie banks to rest. Economist Paul Krugman described the fictional “Gotham bank,” closely modeled on Citibank. Citibank is extremely large, with assets equal to 15% of the $13 trillion U.S. banking system. It has $2,050 billion of assets and $1,924 billion of liabilities. Its capital is $126 billion, or 6% of assets. Deposits in the U.S. make up $271 billion, or 14%, of its liabilities.

Following Krugman, suppose 20% of our “imaginary” bank’s assets are “toxic”; mortgage-backed securities, collateralized debt obligations, or subprime mortgages. Gotham currently overvalues them at $410 billion, but they should be written down by 50% to $205 billion. The bank’s true assets are $1,845 billion. Its capital is -$79 billion. It is insolvent, but continues to operate—a zombie.

The Bush administration tried to bail out banks like “Gotham.” The Obama administration appears ready to continue. The initial TARP plan, and now the proposed “aggregator bank,” have the government purchasing “toxic” assets. Unfortunately, that only works if the government overpays. For example, if the government purchased Gotham’s toxic assets for their current value of $205 billion, the bank would fail. If the government paid the $410 billion that Gotham wishes its toxic assets were worth, then the bank would become solvent, but the taxpayers would lose $205 billion.

The TARP funds were actually used to purchase the banks’ stock, which the Obama administration plans to continue. If Gotham’s toxic assets were written down, then the government could purchase $293 billion in new stock, paying for the write down, and increasing Gotham’s capital from $126 billion to $214 billion, enough to meet the 10% capital requirement. The current stockholders would have a dilution of ownership, now having a 30% ownership interest in the $214 billion capital, or roughly $64 billion. The taxpayers would end up with a 70% ownership interest in the capital or $149 billion. Having just paid $293 billion, the cost to taxpayers would be $142 billion.

Krugman proposed the government nationalize Gotham. With the value of the toxic assets being $205 billion, the stockholders would be wiped out. The government would absorb the $79 billion loss and run the bank.

There is an alternative. FDIC could use its traditional “purchase and assumption” method of resolution--in effect, an over-the-weekend bankruptcy. Following recent practice, FDIC would take all toxic assets. The reorganized bank would have $1,640 billion worth of good assets remaining. Responsibility for all $l,924 billion of liabilities would be assumed by the new bank. To meet the 10% capital requirement, it would need $1,924/.9 or $2,138 billion of assets. FDIC must initially contribute $498 billion, but it would sell the reorganized bank, receiving as much as possible of the $214 billion in capital from the buyer, and reducing its cost to $284 billion. If the toxic assets were really worth $205 billion, then the net cost would be $79 billion--the same as “nationalization.”

This method has traditionally involved selling a small, troubled bank to a large, growing bank. But who could afford a bank as big as Gotham? Further, many banks are equally troubled. Having one zombie bank take over another simply creates a larger zombie. An alternative would be Luigi Zingales’ proposal to swap debt for equity. FDIC would need to identify 10% of Gotham’s existing debt to be converted into shares of stock. The reorganized bank would have liabilities of $1,732 billion, the existing amount of debt less $192 billion to be converted to equity. To meet its 10% capital ratio, it would need $1,732/.9 or $1,924 billion of assets. The former debt holders would have $192 billion of debt turned into equity claims on the $192 billion of capital of the reorganized bank. The bank would begin with good assets of $1,640 billion, so FDIC would need to contribute $284 billion. If the toxic assets were worth $205 billion, then the net cost to FDIC would again be $79 billion--no different from the cost of a more traditional purchase and assumption or nationalization.

FDIC could reduce its cost by swapping more debt for equity. A “good bank” could be created using the good assets. Because the bank would have $1,640 billion in assets, it would need $164 billion in capital. The reorganized institution could have only $1,476 billion in liabilities. Since it would start with $1,924 billion in liabilities, $448 billion of debt must be swapped for equity--23% of the total. Those debt holders would receive equity claims to $164 billion of capital—a 63% loss.

To help compensate the former debt-holders for this loss, Zingales suggests creating a bad bank. At the same time the banks’ debt holders receive shares in the good bank, they could also be given shares in a “bank” that solely holds the toxic assets. This bad bank would be a closed end mutual fund gradually collecting on the toxic assets, assumed to be worth $205 billion. Together, the stock in the good bank and bad bank would be worth $369 billion. The loss to the former debt holders would be 18%.

Insolvent, zombie banks, can be rapidly reorganized as fully capitalized, fully sound institutions through a debt to equity swap. Existing stock holders are wiped out. If FDIC takes over the toxic assets and protects all debt holders from loss, then the cost to taxpayers could be huge. Assuming Gotham is “average,” the immediate cost of resolving all banks could be $1.8 trillion. With the toxic assets worth 50%, then the final cost would be $900 billion.

By increasing the amount of debt swapped for equity, the cost to the taxpayers can be reduced - all the way to zero. The cost is shifted to those holding the banks’ debt. Most importantly, the zombies can be put to rest, so that reorganized, sound banks, are ready to lend and help finance a renewed economic expansion.

Copyright © 2009 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey is a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.

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