On “The Bailout”, Part 17: The SuperBonds Alternative

I found this idea – Superbonds – through TCS Daily (I guess it is active again. The author is John Hussman – “You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet”:

But there is a middle ground — a proposal by John Hussman in You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet. He argues that help should not take the form of a purchase of assets, but should be a direct injection of capital in the form of superbonds, which are senior to existing equity and debt but subordinate to consumers’ claims. In other words, protect the customers and counterparties, but not the investors. [TCS Link]

The idea is similiar (but better) then my short-term plan on the major idea. Here are some interesting parts:

What the financial system has needed most has been for Congress to streamline the bankruptcy process for investment banks, so that in the event of failure, the “good bank” (assets and liabilities, ex the debt to bondholders) could be cut away quickly and liquidated to an acquirer, leaving the proceeds as a residual for the bondholders. Indeed, that’s exactly how it works for regulated banks. What investors overlooked in last week’s panic was that we actually saw the largest bank failure in history – Washington Mutual – with absolutely no losses to customers or the U.S. government, precisely because the good bank was seamlessly cut away and sold to J.P. Morgan, wiping out shareholder equity, preferred equity, and subordinated debt, with partial repayment to the bondholders. Snap – just like that.
If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side! You may have improved the “quality” of the balance sheet, but you’ve provided no additional capital. At best, you’ve allowed the bank to liquidate its assets more easily to meet continuing customer withdrawals in the vicious cycle described above.

The only way that buying the questionable assets will increase capital on the liability side of the balance sheet is if the Treasury overpays for them.
A better approach would be for the government to provide capital directly, in the form of a “super-bond,” in an amount no greater than the debt to bondholders. The “super-bond” would be subordinate to customer liabilities, so it could be counted as capital for the purpose of capital requirements, and would be seen by customers as a legitimate cushion of protection. However, in the event of bankruptcy, it would have a senior claim in front of both stockholders and even senior bondholders. Do that, and you’ve actually got a mechanism to protect the financial system while at the same time protecting customers and taxpayers. Ideally, the super-bond accrues a relatively high rate of interest so that financials have an incentive to shift to private financing as soon as possible, but you would also defer the interest until the bank meets a minimal level of profitability to make sure that the financing doesn’t strain the institution’s liquidity.

So, the banks get cash. They don’t get rid of the bad securities. Taxpayers are in front of Shareholders and bondholders if the bank dies. High interest rates mean the the bank will want to pay it back quickly.

I would be okay with idea. Drop it in to replace my Secured Loans idea. Drop in the Soros plan’s (which is good, but not as good) use of the bank examiner’s for determining capitalization levels. Also at this point, raise FDIC insurance to uinlimited coverage for savings accounts, checking acconts, CDs, and business transaction accounts. Also, use Kling’s lower capital requirements for banks right now so they can lend more.

Remember though, this is just the short-term stuff. Long-term we have other issues.

FYI: All of my bailout post are listed here.


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