“The problem isn’t just toxic securities, its toxic banks.”^[1]

I. INTRODUCTION

Banks have suffered serious losses in virtually all of their activities. A problem that was first diagnosed for mortgage backed securities has spread to credit card and auto receivables. Even more troubling, the problem has also infected traditional banking activities – commercial and industrial loans, and CRE Loans. And, losses from derivatives and outright speculation have added to the problem.

One solution would be to have the FDIC take over troubled institutions and liquidate them. This route has been followed for smaller institutions. However, it has not been used for ones considered “too big to fail” because there is a fear that the damage caused to the “system” by a liquidation could dwarf the costs of an intervention to save the troubled bank. Instead, the Government has utilized, or is proposing to utilize, its mandate under TARP in two ways. First, the Government has made “investments” in the preferred stock of troubled banks, hoping to shore up their capital bases. And second, the Government is poised to make direct purchases of “toxic” assets through PPIF’s.

In section II, I develop a simple model of a troubled bank that can be used to analyze the impact of alternative Government interventions that are intended to return banks to health. In section III, I use this model to examine the impact of TARP preferred stock purchases and the potential impact of PPIFs. I conclude that while these strategies may help some of the “walking wounded,” we should not be surprised that purchases of preferred stock have not resurrected “zombie banks,” nor should we expect purchases of toxic assets to win the day. The breath and depth of the losses at zombie banks are truly staggering which means that band aids, even very large ones, won’t be sufficient to return them to health in a meaningful time frame, if ever. Furthermore, as currently structured, TARP programs benefit the existing unsecured creditors and equity holders of banks at the expense of taxpayers.

Increasingly there is talk that the Government should temporarily take over large troubled banks, insulate them from their bad assets, and recapitalize them. In Section IV, I discuss some general issues associated with a Government takeover of troubled banks.

In Section V, I use the model developed above to illustrate how a Good Bank/Bad Bank Take-over might work. I conclude that, in contrast to TARP and PPIF’s solutions, a Good Bank/Bad Bank Takeover can rescue a zombie bank and that the rescue can be designed to repay taxpayers before the unsecured creditors and equity holders. However, the inability to draw a sharp distinction between good and bad assets, and the fact that bad assets will require significant on-going management means that this is an inefficient solution.

In Section VI, I describe a take-over solution that incorporates the benefits of the Good Bank/Bad Bank Solution without its pitfalls. It is a solution that is guaranteed to work – literally. I propose that the Government guarantee the performance of all of assets of a troubled bank, with the proviso that the guarantee would come into play only after the book value of the unsecured creditors and equity holders is wiped out by realized losses on assets held by the original bank on the date of the takeover – hence the name, the Backstop Guarantee Takeover.

Like a Good Bank/Bad Bank Takeover, a Backstop Guarantee Takeover can be structured to give the unsecured creditors and equity holders a chance to participate in an economic recovery without giving them priority over taxpayers. Additionally it is a simple and efficient solution that does not requiring an artificial division of good and bad assets or the creation, staffing and management of a superfluous entity (the Bad Bank).

In Section VII, I discuss some of the ownership and management issues that arise after a temporary takeover of a troubled bank. Section VIII is a brief summary and conclusion.

II. A SIMPLE MODEL OF A TROUBLED BANK