Bailing out banks: who's in, and who's out?

Wall Street's latest fascination with Washington comes over the subject of bank nationalization. Senator Christoper Dodd, Chair of the Senate Banking Committee, suggested nationalization might be necessary, sending the markets plunging. The White House wasted no time in responding at the daily press conference, noting, "[T]his administration continues to strongly believe that a privately-held banking system is the correct way to go, ensuring that they are regulated sufficiently by this government. That's been our belief for quite some time and we continue to have that."

Nationalization is scary to banks because it means some investors will be saved while others are wiped out. At the extremes, who's in and who's out is obvious. Holders of common equity will almost definitely be wiped out in nationalization; deposit holders would be made whole. The intermediate providers of capital, senior and subordinated creditors, counterparties to derivative contracts, trust-preferred holders, and preferred stock holders, have differing levels of ambiguity as to whether they would be bailed out, wiped out, or something in between. This ambiguity relates to the property rights the holders of these securities possess. This ambiguity causes tremendous problems.

First, capital that has no restrictions on its withdrawal will be withdrawn. That is, there will be a bank run. Since the FDIC insures deposits, retail deposits won't run, but other short-term funding will either be withdrawn, or for short-dated maturities, will be difficult to refinance with new debt (roll over). The FDIC stepped in to limit the difficulty in rolling over senior debt by agreeing to insure this debt through the Temporary Liquidity Guarantee Program, solving in part this problem.

The second problem is that existing securities will trade with every rumor floating around as to whether the banks will be nationalized or not, AND on every rumor of whether a particular secruity will be included in the bailout or not. This particularly relevant post on the very good Bronte Capital blog describes the problem with including different securities in different situations, as shown through FDIC takeovers of banks. Indeed, this is evident in the common stock fluctuations of the major banks through the course of last Friday - the higher a chance of nationalization, as determined by Dodd's statements, the lower the share price.

It is worth noting that while management is concerned about the common equity price (WSJ, gated) to which their personal economics is tied, the common equity price is of less concern to regulators. Banks could continue to operate at any equity price, as long as the creditors of the bank do not take the low equity price to be indicative of an imminent default on the bank's debts.

The third challenge is that it makes it difficult (impossible?) to attract new private capital. New capital providers are hesitant to invest when they face the possibility of losing their capital to nationalization.

Each statement by regulators, legislators, or the Administration increases the ambiguity banks operate under, necessitating new bailout programs, increasing security volatility, and limiting the ability of banks to raise new private capital. The Administration's current approach, denying nationalization as a possibility (even while other key decision makers discuss it's virtues), has little credibility. The market's are understandbly sceptical that the Administration would rule out a course of action that many noted commentators are advocating for. Instead, the Administration should clarify the property rights of these security holders under any circumstance.

Exactly what rights need be clarified? First, what banks would be considered for nationalization, if it should come to that stage. Clearly the government would have criteria as to what banks would be nationalized (or bailed out in some other fashion). Clarifying these criteria will allow borderline banks to have a clearer sense of their future. Second, and perhaps most importantly, the government must clarify what classes of securities and other claimants would be bailed out. A best guess, as a simple starting point, is that existing depositors, counterparties, and senior creditors would be made whole (including rollovers of existing debt), while subordinated debtholders and all forms of equity-holders (including preferred, trust, common, and all options and warrant holders) would be extinguished.

Merely this clarification would have several immediate effects. Debt holders would freely leave capital committed and would permit rollovers of maturing debt. Securities markets would immediately adjust: bank securities that would be protected under nationalization would trade to prevailing yields. Equity holders, while concerned about nationalization, would benefit from the banks' ability to again conduct business free from uncertainty of solvency concerns.

Paired with this announcement, the government could encourage additional private capital into the banking market by allowing equity capital issued after the announcement to be put back to the government at par (or some fixed ratio to par, say 90%) upon a nationalization event in the next five years (at which point it would convert to common equity). With this effective government guarantee in place, the banks would be able to raise equity capital in the private markets. If nationalization never occurs, the government never intervenes or uses any taxpayer capital. If banks are nationalized, it would not be due to the very fear of that nationalization, but rather a belief that banks are deeply insolvent and that no injection of capital would produce an attractive return. (That is, losses at the bank would be so great as to swamp earnings for years to come).

This approach would minimize the disruption caused by nationalization rumors, would reopen the private capital markets, and would help to align interests. Managers could be compensated on un-guaranteed equity, re-establishing the investors balance between fear and greed. They would have the incentive to avoid nationalization by raising substantial new capital and making prudent lending decisions - they would fear losing their equity stake. On the flipside, they would want to deploy capital intelligently to maximize the return to their equity stake - the greed to maximize their options.

This solution is clearly a bridge approach - the market and regulatory failures that brought the current crisis into existence still need remedy. Other issues would also need to be considered - restarting lending, moral hazard, and agency costs - before implementation. But, this approach would stabilize markets, limit the intervention of government into the private markets, and rely predominately on private capital, virtues all.